Institutional theory in economics

Institutional theory in economics originated in the late 19th century in Germany and Austria and was further shaped by US scholars. Veblen (1909) challenged the traditional assumption that individual behaviour is calculated and contended that individual behaviour is driven by habits (see Table 2.3). Veblen (1919) further suggested that individual behaviour changed as the institutional surroundings evolved. Therefore, individual behaviour within organisations carries an institutional character. Veblen (1919) focused on the effect of individuals and groups on institutional development, but did not explain the role of institutions in organisational activities. Individuals and groups, including the government, are crucial to the development of institutions that influence the behaviour and operations of organisations.

Commons (1924) added to Veblen’s (1909, 1919) view by arguing that individual choice in behaviour is driven by transactions, a process between two or more parties in an environment where mechanisms and rules of

Table 2.3 Institutional theory in economics - key perspectives and their descriptions

Key perspectives

Description

Exemplary studies

Individual behaviour is related to the institutional character

Individual behaviour is governed by the institutional character

Institutional character changes because of changes in institutional environments

Veblen (1909, 1919)

Individual choice behaviour is governed by transaction

The transaction is seen as a process between two or more parties where rules of conduct and formal mechanisms prevail

Rules of conduct are social institutions

Focus on broader social and political factors that affect the economic structure

Commons (1924)

Transaction cost economics

Exchange within a firm is governed by rules and hierarchy and not a price mechanism

Transaction costs include the cost of negotiating and a contract for each exchange transaction

Coase(1937)

Transaction cost

The effectiveness of transaction

Williamson (1975,

economics

cost depends on two conditions: bounded rationality and individual opportunism

1985, 1991)

Notion of game

Formal and informal institutions.

Focus on macro analysis

North (1990, 1991);

North & Weingast

(1989)

Disciplinary foundations 27 conduct dominate. He referred to rules of conduct as social institutions, or institutional rules that provide boundaries for individuals and companies so they can achieve their goals. This implies that social institutions and rules are socially embedded. Coase (1937) posited that the transaction process is based on exchange within an organisation, which is governed by hierarchically enforced rules. Therefore, the transaction process is seen as the exchange that incurs the cost of negotiating a business transaction (Williamson, 1975). The boundaries outlined by the established rules enable organisations to rationally engage in the opportunism provided during this exchange process (Williamson, 1985,1991). This school of thought facilitates examining how organisations operate within various governance structures.

The governance structure within a national state comprises cultural, political, and legal environments, within which formal and informal institutions create the 'rules of the game’ (North, 1990). North (1990, 1991) refers to formal institutions as constitutions, laws, property rights, and sanctions, and to informal institutions as taboos, values, customs, and traditions. Institutional economists view institutions as being dominated by a regulatory system, where rules and their enforcement mechanisms play a dominant role when examining the institutional environment (North & Weingast, 1989). The state develops the rales and enforcement mechanisms (North, 1990). However, the state sometimes acts with its own interests as the primary concern and serves as rale maker, referee, and enforcer during the exchange process between different actors (Evans et al., 1985).

The exchange process unfolds as a result of networking, which underscores the importance of informal institutions in developing the institutional environment (North, 1991; Williamson, 1985). Although the state makes and enforces rales and regulations, various actors’ interpretations of these rales and regulations may differ. North (1991) states that societies have been using these forms of institutions for thousands of years in trade exchanges, such as those within and beyond local trade. This is important, because the relationships that have emerged between different actors are not simply an exchange process. Rather, they have been driven by the creation of formal and informal institutions and are based on political and economic ties between parties. The fact that both formal and informal institutions can be used by the actors involved illustrates that these institutions do not develop in a vacuum, and that their use is strategic.

 
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