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New Institutional Economics and the Information Theoretic Approach: (Re-) Introducing the Non -Economics in Neoclassical Economics

Written by Siyaduma Biniza 1

New Institutional Economics (NIE) and the Information Theoretic Approach (ITA) share some commonalities and divergence. They are both concerned with re-introducing the relevance of the non-economics into neoclassical economics. By non-economic I mean historic, political and social considerations which do not impact the rational decisions of the self-interested-utility-maximising individual according to neoclassical economics. NIE and the ITA are therefore attempts at reintroducing the non-economic which have the same underlying concepts, different proposed mechanism and the same policy proposals. However, the relation to neoclassical economics is divergent depending on what is being analysed as shall be further discussed below. Therefore this essay is a comparative analysis of NIE, the ITA and neoclassical economics. The paper analyses these theories in terms of the underlying concepts, proposed mechanisms and the various policy proposals. Both the ITA and the NIE take neoclassical economics as a starting point the approach respectively critique or supplement neoclassical economics. Both theories attempt to incorporate the non-economic by arguing for its relevance and impact on the economic which is seen as a missing element in neoclassical economics. For example, Stiglitz (2002) who is a notable contributor in the ITA claims to have been inspired by his perceived inefficient outcomes such as unemployment in labour markets and the lack of certain markets in developing countries which could not be explained using neoclassical economics. On the other hand, a significant contribution to NIE by Coase (1960) was motivated by a need to understand why firms exist which is something that is not explained in neoclassical economics. Although these theories lead to a critique or a strengthening of neoclassical economics both NIE and the ITA accept and utilise the underlying concepts of neoclassical economics in their accounts. The dominant economic paradigm, neoclassical economics, is largely the result of an academic evolution known as the Marginalist and Formalist Revolution. Significant

Siyaduma Biniza is currently a B.Com. (Hon) in Development Theory and Policy student at the University of the Witwatersrand, holding a B.Soc.Sci in Politics, Philosophy and Economics from the University of Cape Town.

contributors in this revolution are Walras, Jevons and Menger whose work contributed towards the de-historicising, de-politicising and de-socialising economics; and the introduction of methodological individualism and mathematisation of economics (Milonakis & Fine, 2009; Blaug, 2003). Consequently economics evolved from the methodologically holistic and inductive conceptual underpinnings of political economy and became deductive, mathematical and underpinned by a foundational principle known as methodological individualism. Methodological individualism is the assertion of the pre-eminence of the agent over the structure in defining society and human behaviour; making the structure, such as society, an aggregation of individuals (Milonakis & Fine, 2007). This revolution also resulted in an academic distinction of the economic and non-economic. Non-economic refers to historic, political and social considerations which do not impact the rational decisions of the self-interested-utilitymaximising individual who is only concerned with expected utility according to neoclassical economics (Fine, 2010). As a result, the economic is solely concerned with individual behaviour and choices which are defined as individualistic-utility-maximising. A consequence of this, as contributed by Walras, neoclassical economics asserts the existence of perfectly competitive markets which clear since the actors are rational, individualistic-utilitymaximising individuals with full information which is the most efficient outcome (Milonakis & Fine, 2009). In simple terms, individuals can find anything they want in the markets and all goods demanded will be met by concomitant supply. But this precludes inefficient market outcomes, market failure and non-existence of markets which is common feature of economics (Stiglitz, 2002). Moreover, as might be clear from the economic and non-economic distinction, neoclassical economics cannot explain the existence of the non-economic which is defined as institutions according in the NIE (North, 1993). Hence, in seeking to explain inefficient market outcomes or the impact of the non-economic on economics, the ITA and NIE incorporate the noneconomic either making it endogenous or explaining it in economic terms. Because efficient outcomes of markets depends on perfect information according to neoclassical economics, the ITA asserts that informational asymmetries mean that markets are no longer perfectly competitive which means information is important to understanding inefficient outcomes of markets (Stiglitz, 2002; Stigler, 1961). The implication of this is that equilibrium can exist even if it is not efficient so markets do

not always clear or that they simply wont exist (Akerlof, 1970). This is therefore a critique of the neoclassical type of theorising which makes the neoclassic-type markets an ideal. The proposed mechanism is different in NIE. NIE asserts that its not that markets are not perfectly competitive, rather that when markets have high transaction costs institutions become important to ensure markets function perfectly competitive. The implication of this is that whenever there are transaction costs institutions, or the noneconomic, will make rational sense because they reduce transaction costs allowing for perfect functioning of markets (Coase, 1960). Thus NIE and the ITA come from very different analytical starting points. However, both are not opposed to the methodological foundations of neoclassical economics even though both argue for the significance of the non-economic which has been excised in neoclassical economics. The proposed mechanisms in relation to the non-economic are quite divergent as well. Even though the ITA can be understood as a critique of neoclassical economics assumption of perfect information and its implications, it is not a methodological shift but a mechanistic shift from neoclassical. Moreover, the ITA does not shed much light on how the non-economic plays a role except that it is important for the economic. On the other hand NIE has been criticised for being a form of economics imperialism (Fine, 2000) because it simply explains the non-economic in economic terms. The central in NIE is that the existence and functioning of institutions is defined by the rational decision-making of individuals in order to facilitate market mechanisms or remedy market failures. This makes economics the central preoccupation of even the noneconomic because the non-economic is only explained in relation to the economic. With regards to policy, both the ITA and NIE allow for a role of the state but only in matters pertaining to the economy and ensuring perfect functioning of markets. Therefore, for the ITA government has a role in reducing information asymmetries in order to allow for Pareto efficient outcomes or to allow for the existence of markets that would otherwise be non-existent (Stiglitz, 2002). For NIE the objective of the state is by default the reduction of transaction costs and aiding in the perfect functioning of markets. However NIE lacks an underlying theory to explain when and under what conditions institutions such as the state encourage perfect markets since states also have political prerogatives which are arguably separate from economics. Nevertheless

this common policy proposal is very different from that of neoclassical economics which asserts that the state would either be obsolete or even detrimental according to various strands of neoclassical economics (Pollin, 1998). Therefore, NIE and the ITA are both analogous to neoclassical economics because of the underlying concept, specifically methodological individualism. The different theories have different proposed mechanisms and analytical starting points. One assumes that markets are perfectly competitive but this is undermined by transaction costs whilst the other assumes that markets with imperfect information do not function like perfect markets. Nevertheless, both are concerned with re-introducing the relevance of the non-economics into neoclassical economics. But they do this through different mechanisms even though they have the same policy recommendations. However in this regard, NIE and the ITA are starkly different from neoclassical economics. NIE and the ITA are therefore attempts at reintroducing the non-economic, which has been excised in neoclassical economics, using the same underlying concepts, different proposed mechanisms and the same policy proposals.

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