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Institutional Economics

Updated on January 29, 2024
Article byJyotsna Suthar
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Institutional Economics?

Institutional economics, or institutionalism, is a school of thought that studies how institutional rules influence the economy and its behavior. It focuses on the role of different institutions in shaping the economy. It guides developing countries to learn from developed countries and make appropriate policies.

Institutional Economics

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Institutional economics theory determines the factors that influence the economy. It describes how developed countries and their institutions grew to become large and successful. In addition, it also explains the effect of different institutions on the daily transactions of the economy. However, it also criticizes how every part of society is accountable for economic development. 

Key Takeaways

  • Institutional economics studies institutions (rules) and their respective influence on the economy’s behavior. Institutions can be formal or informal. 
  • In December 1918, American economist Walton H. Hamilton first used the word in the paper “The Institutional Approach to Economic Theory.” 
  • It considers various norms, rules, and laws that countries should constantly adapt to develop their economies rather than sticking to one institution.
  • New institutionalism is different from the old one as it studies individuals’ economic and sociological behavior. 

Institutional Economics Explained

Institutional economics means rules that impact the economy’s overall behavior. In other words, rules help any economy grow and succeed. They are manual instructions by the state or government. These rules can be formal or informal, depending on their nature. The prime intention of institutionalism is to make transactions less risky and predictable. Examples include international forums like the International Monetary Fund or United Nations. These organizations follow the rules and frameworks that have made them work efficiently and prevail globally. 

Institutionalism considers a wide set of rules, norms, and laws as ongoing principles that vary continuously. Simply put, people do not stick to one single rule or institution. Instead, depending on the situation, the rules change for collective well-being. Here, institutionalism decides which values will be applicable at what time. In addition, it’s vital to study all institutional environments since the real world is dynamic. Also, it is necessary to determine the institutional structure they wish to follow. 

However, certain factors can bring hurdles during the process. For instance, developing a framework but lacking communication can make it unsuccessful. Likewise, even currency plays an important role in transactions. The transactions will be opaque unless there is a common currency within the state. Thus, having a similar currency can bring uniformity and efficiency to work. 

Other factors include the financial system, language, and even some powers within the economic system. A few of these powers might oppose the creation of institutions to protect their interests. In addition, increased corruption, bribery, and distrust have caused the country’s growth hindrances. Later, in 1994, institutionalist Douglass C. North stated that when it is costly to transact, use institutional economics. It is necessary as more institutions will imply higher economic growth in the country’s economy.

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History Of Institutional Economics 

Although American economist Thorstein Veblen got the credit for proposing the institutional economics theory, the pioneer was someone else. American economist Walton H. Hamilton first used “institutional economics” in the paper entitled “The Institutional Approach to Economic Theory” in December 1918. Hamilton focused on how economics must follow certain rules to deal with daily challenges. During the presentation at the American Association, many other economists also supported it. Among them were Thorstein Veblen, John R. Commons, and Wesley Clair Mitchell. However, Veblen argued the traditional economic theory. Instead, it stated how people’s habits would build institutions within the economy. 

Commons institutional economics stated a different outlook on the concept. Later, in 1934, Common frequently used the word in its book “Institutional Economics: Its Place in Political Economy.” Commons institutional economics journal stated that the economy should use institutions (rules) to develop public policies. Likewise, Mitchell also stated how business cycles result from economic behavior. Simply put, business values are nothing but institutions that succeed in them. Ultimately, all institutionalists aimed to explain how a proper societal framework can successfully build an economy. According to them, markets result from various institutions’ complex interactions.

Difference Between Old and New Institutional Economics 

Although old and new institutional economics are almost similar, there is a slight difference between them. While the former focuses only on economic behavior, the latter aims to study both economic and social behavior. Moreover, although the former requires rational reasoning, the latter adopts deductive reasoning. 

BasisOld Institutional EconomicsNew Institutional Economics
MeaningIt studies the institutions (rules) and their effect on economic behavior.It studies both the economic and social impact of institutions.
OriginDecember 191821st century
FounderAmerican economist Walton H. HamiltonGerman economist Max Weber
FocusFocuses only on consensus (or group) behavior.Aims to study individual behavior.
ApproachRational thinkingDeductive reasoning

Examples

Let us look at the examples of institutionalism to comprehend the concept better:

Example #1

Suppose Africa aims to target 4-4.2% GDP (gross domestic product) by the end of this year. However, they face certain flaws in their economy. So, the ministers and other governing bodies decide to install institutions within the country. Every business has to adhere to certain guidelines to achieve growth. Likewise, every individual has to incorporate institutions and norms. At the end of the year, Africa was successful in at least reaching 4.1% of GDP. Thus, developing countries could change their status if they try to install proper institutions and laws within the economy. 

Example #2

Douglass North, a pioneer of the Institutional economics journal, stated that developing countries should refrain from copying the institutions of the developed ones. The main reason to state this was that developed countries like Europe, the U.S, and Japan have different institutions. Thus, replicating them will be a bad idea. A transfer of Western institutions to the Eastern world would not result in enough growth. Because highly developed countries tend to follow proper rules, norms, and institutions. Thus, it leads to potentially increasing growth. 

Institutional Economics vs Neoclassical Economics

Although institutional and neoclassical economics had similar pioneers, they differed hugely. The former aims at understanding how institutions influence the economy. At the same time, the latter focuses on creating wealth through the optimum use of resources. However, both theories had the same economists working on them. 

BasisInstitutional EconomicsNeoclassical Economics
MeaningIt studies the effect of institutions on the economy.It studies the demand, supply, production, and distribution theories.
PurposeTo understand the institutions (rules)To create wealth and achieve overall efficiency
LimitationsDynamic, difficult to understand its working.Unrealistic assumptions like rational behavior, full transparency, and others.
Origin19181900
FounderWalton H. HamiltonAlfred Marshall

Frequently Asked Questions (FAQs)

What is the essence of institutional economics?

The essence of institutionalism lies in the institutions. Here, the context of institutions refers to the rules and norms of the economy. It aims at understanding and applying them correctly. 

Who is the father of institutional economics?

Although Thorstein Veblen propagated the theory, Walton H. Hamilton was the first person to use this word in a paper in 1918. Later, many economists like John R. Commons and Wesley Clair Mitchel contributed to the theory.

How is Institutional economics effective?

When society starts following (or adhering) to the norms and rules, it’s then that institutionalism becomes effective. However, there are certain outcomes and necessities. First, a majority of the population must accept the norms. Once accepted, they must follow them too. Also, they must see to it that the rest does not oppose it. 

How does Institutional economics influence the dual labor theory?

The labor market and institutions are somehow connected. As institutionalism studies, the economic behavior of institutions, labor is also a part of it. The dual labor theory determines the pricing and allocation of resources, which is the institution’s role. 

This article has been a guide to What is Institutional Economics. Here, we explain its history, Old and New Institutional Economics, and its examples. You can also go through our recommended articles on economics –

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