Neoclassical economics has the advantage of strong theoretical foundations, in terms of individual constrained maximization and market equilibrium. However it suffers from a narrow representation of economic institutions. On the other hand, institutional economics addresses a wide variety of agrarian structures, but without deeper theoretical underpinnings. The new institutional economics or NIE seeks to ground the analysis of a wide variety of economic institutions on neoclassical foundations. This is done by broadening the types of constraints and costs, and relaxing competitive market assumptions. Key considerations in NIE are transaction costs, risk, imperfect contract enforcement, and asymmetric information.
Oliver Williamson distinguishes between first-order, second-order, and third-order economizing. First – order economizing covers the institutional environment that determines the “rules of the game”, in the areas of property rights, polity, judiciary, and bureaucracy. Second – order economizing involves governance structures and contract design. Third – order economizing is straightforward resource allocation subject to marginalist efficiency conditions, which is the traditional subject matter of neoclassical economics. Hence, while neoclassical theory specializes in third-order economizing, NIE specializes in the first two.
(To be continued)