EH415.

-Growth, Poverty and Policy in the Third World

C.2. The New Institutionalist Political Economy

NEW INSTITUTIONALISM AND

DEVELOPMENT :
Its Contributions and Failures when explaining the
Patterns of Economic Development in the Third World
over the last century
by

Mar Rubio
Department of Economic History
London School of Economics and Political Science
March, 1997
New Institutionalism is not a panacea. If it were so, it would have fully explained the
Worlds patterns of economic development, and it does not seem to be the case. However,
it has contributed to the understanding of the Worlds development through the extension
of the rational-choice framework and the relaxation of the basic neoclassical
assumptions. In spite of this, it is a difficult theory to test and it is subject to some failures
when explaining the evolution of LDCs along the last century.

Introduction
This paper is built around the contributions
and failures that New Institutionalist Political
Economy has achieved when explaining and
understanding the patterns of economic
development in the Third World over the last
century. Contributions will appear in first
place. This section will try to shownwhat was
unexplained in the economic history of the
Third World under the neoclassical view. It
will also dispense attention to those extensions
over the rational-choice model that are relevant
to the comprehension of the historical
evolution of LDCs . In addition to that,
definitions and comparisons to previous
theories will be presented in this section. The
second section will concentrate on the failures.
What are the lacks of New Institutionalism,
what does the model forget, what remains
unexplained, what is inconsistent theoretically
and empirically. Finally, the conclusion section
will try to extract the balance of the previous
pages, trying to disclose the real weight of the
contribution of New Intitutionalism to the
understanding of economic development in the
Third World during this century.

1.-Contributions
New Institutional Economics (NIE) could be
considered a modification of neoclassical
economics, or using different words, an
extension of the rational-choice model.

Neoclassical economics emphasise that

individual agents maximise an objective
function subject to constraints. Typically,
individuals maximise their utility and firms
maximise their profits. The former subject to
their income, the latter subject to their
production function. All this in a world of
unrestricted markets (markets clear with
supply equal demand), full information
(complete foresight exist to all possible
events), and fully defined private property
rights1. In this context, prices are perfectly
formed ; trade relations are voluntary,
harmonious, and mutually beneficial ; there are
no rooms for shirking or cheating (both parties
have always full information) ; and the market
allocation is always efficient.
Under such a restricted model, most of
the formulated questions to understand the
patterns of development of the Third World
during this century would make no sense :
population will always have the appropriate
size and rate of growth (as part of the
individual decision making in a framework of
perfect information); no overuse of
environment, no tragedy of the commons ;
peasants do always optimise ; property rights
would be fully and optimally defined and
enforced, thus no place for land reform, nor
interest groups, but immediate use of new
techniques and technologies -permanent green
1

Eggertsson, T., (1990), p.7. Brackets are mine.

Mar

NEW INSTITUTIONALISM AND DEVELOPMENT

Rubio
revolution- (instantaneously recognised as
profitable for everyone) ; no role for
imperialism or dependence theories (trade is
voluntary,
harmonious
and
mutually
beneficial) ; no possibility of implementing ISI
or EOI (the market is unrestricted) ; no space
for cultural, moral or religious values in the
economic performance ; no specific role for
entrepreneurs (firms are a black box in
neoclassical economics); the state has no
economic function ; no rent-seeking behaviour
(there is no rents outside the market, nor
opportunity for cheating), etc.
New Institutionalist agree that
decisions making is related to the maximisation
of utility and profits, that is they follow the
rational-choice model, but they do not follow
anymore the assumption of perfect
information. Relaxing this basic neoclassical
assumption, some previously non-sense
questions find justification, and even some
explanations appear to be delineated. Let see
how.
Perfect information is a theoretical abstraction
from the point of view of NIE. Under this new
vision, information is usually incomplete, and
it can even be distorted. This implies that
individuals have limited capacity when making
a decision, ie they face bounded rationality.
At this point, it is convenient to establish a
difference with respect old institutionalist.
Institutional view was born as a response to
neoclassical theory, as a dissension from
neoclassicism2.
Hence,
institutional
economist reject elements of the hard core of
neoclassical economics, such as the rationalchoice model3. For an institutional economist
bounded rationality is not just a question of
lack of information, it is a question of
incapacity to manage the information in order
to take the efficient economic decision. Even in
presence of perfect information, individuals are
unlikely to act always rationally (from the
economic point of view). People tend to have
unstable preferences, and human mind is not a
calculator which work at lightning speed
through the complete set of data relevant to
their decisions.4 Motherhood, missionaries,
voluntary workers, etc., are the usual
examples.
Nevertheless, NIE asserts that
individuals act rationally within the limits of
2

As defined by Rima, I.H., (1986). At this point of the paper, old

institutionalist refer mostly to the American Institutionalist,
(Vebble, Mitchell,Clark, Ayres), it does not include Marxist theory
which, despite its institutional approach, it will be considered
separately from institutional economist.
3
Eggertsson, T. 1990, p.6.
4
Vebblen, T. (1919), here from Eggerstson, T. p.8

the information they got. The lack of

information or the possibility of facing
unfaithful information impose a series of cost
on economic transactions. First of all, men
face uncertainty. Decision outcomes are no
longer known perfectly. This opens the door to
some of the questions above such as
demography,
peasants
rationality
and
acceptance
of
new
technologies
(implementation of Green Revolution) ; they
are related to the existence of bounded
rationality and uncertainty. A peasant could be
maximising his utility having twelve children
and not using fertilisers in his land, given that,
the set of information he faces lead him to this
conclusion. Up to his knowledge children mean
cheap labour and he does not know the effect
of using a new fertiliser. Is he acting
rationally ?, from the point of view of the NIE,
he is rational.
More costs associated to the lack of
information are the cost related to the search
of information needed for transacting, which
is no longer available directly, thus economic
actors have to look for it : information about
prices and qualities of commodities, the search
for potential buyers and sellers and the
relevant information about their behaviour and
circumstances . As the behaviour of trade
partners are no longer known, it is needed to
write contracts, to monitor and to enforce
them given that now it is possible to shirk and
cheat. All these costs, associated with the lack
of perfect information when individuals
exchange ownership rights to economic assets
and enforce their exclusive rights5, are called
transaction costs. These costs, that also enter
in the economic agents maximisation rationalchoice, where ignored by neoclassical
economists.
Therefore,
their
predicted
outcomes were askew : on the one hand, prices
can be distorted and not include all the relevant
information; on the other hand, property rights
would be not perfectly defined or enforced.
The third difference
between
neoclassical approach and the NIE is not a
modification of the former but and extension.
Rational-choice economics treats organisations
and institutions neither as independent nor as
dependent variables in the model. They are
implicitly assumed to exits but nothing is said
about their relation to the economic
performance. However for NIE, every
economic activity is developed within a
concrete framework and is overtaken by
organisations, agents and individuals. These
are the main extensions to the neoclassical
model. The framework is the most important
5

Eggertsson, T. (1990), p.14

Mar Rubio

NEW INSTITUTIONALISM AND DEVELOPMENT

contribution6. It varies with time, location,

technologies employed and with the physical
qualities of resources, commodities and
services that are exchanged.
It is the
institutional framework. Indeed, institutions
are the rules of the game in a society7.
Institutions include those formal -written- rules
(such as Constitutions, property rights, road
rules, use of money, weights and measures,
languages, etc. ) but also informal -unwritten,
social- rules (the traditional moral obligations
in the Japanese village community to cooperate in joint communal infrastructure
maintenance, Latin American machismo, trust
and kinship among Hausa traders in Africa,
cultural taboos, etc.). One should note that at
various times the term institution has been
used to refer to organisations (banks as
financial institutions) and to persons or a
position (the presidency). These are
fundamentally different things (organisations,
agents) from the institutions defined by North
and should not be confused.
Economic activity crucially depends on the
rules of the game : they can make economic
transactions easier or more complicated by
increasing or reducing transaction cost and by
defining and enforcing the appropriate or
wrong property rights. In other words, by
providing economic agents correct/incorrect
and cheap/expensive information when making
their decisions, ie creating right/wrong
incentives. Institutions are neither intrinsically
good nor bad for economic development, they
are just a new factor in the explanation.
Institutions, transaction cost, and rational
choice , as viewed by NIE, open definitively
the door to some of the main questions about
the evolution of the Third World over this
century, contributing also to explain some
phenomena.
NIE gives arguments to redefine
property
rights.
Land
reform
finds
justification in terms of replacing ill defined
property rights for new ones that make
worthwhile to undertake socially productive
activities8. It also makes comprehensible the
difficulties associated to the introduction of
new techniques in agriculture (Green
Revolution is difficult to implement). It is not
that peasants are not rational. It is on the one
hand, a question of uncertainty, and on the
6

Contract theory (or firm theory) and agency theory (which deals
with agents and individuals) are not defined in detail within the
limited extension of this paper. By the end of this section their
contribution to the question of this paper will be alluded.
7
North, D. (1990), p.3
8
North, D. and Thomas, The rise of the Western world : a new
economic history, here form Eggersson, T. (1990), p.13.

other it has associated transaction costs (in

especial those related to path dependency). It
is costly to change a way of doing which
returns are known for an uncertain and new
technique which they have to learn9. A path
chosen by some initial adopters to suit their
interest (or that have been used during long
time) may look-in the whole sytem for a long
time to come, denying later, more appropriate,
technologies [...]
NIE considers cultural, social and
religious values important when explaining the
different economic response to identical legal
frameworks. The United States Constitution
has been exported (with slightly variations) to
countries all over the world. Economic
responses are unlikely to be similar. NIE
justify this by the differences in informal
institutions (socio-cultural differences).
Last, but not the least, NIE comes to
justify some behaviours unexplained until this
point such as rent-seeking, the over-use of the
environment, the tragedy of the commons,
and the creation of interest groups.
Rent-seeking is immediately explained by the
self-interest of individuals who find more
profitable to appropriate the rents generated by
whatever new law introduced (import quota in
India10, subsidies or protective policies in Latin
America) than transact in the market. Selfinterest plus inexistent or badly defined
property rights over the natural/common
resource explain its over-use and the tragedy
of the commons. Individuals take advantage
of the use of the resource they have the right to
use but they can skip the costs associated to
the resource - cleaning the lake, reforest,because the obligations attached to the right of
use are difficult/costly to enforce. Finally, the
combination of self-interest, the need to
protect property rights and the existence of
transaction costs explained the creation of
interest groups. Individuals will joint in order
to reduce the transaction costs associated with
the defence of their own property rights and
common interests. Unions (owners of labour),
land owners, industrial groups, etc. have fully
justified existence under the NIE model.
Contract theory and agency theory are
other two important contributions by NIE 11.
The principal implications of each one are that
firms turned from being a black box to
become reducers of transaction costs and
entrepreneurs become economic agents with
specific roles (monitor, enforce, plan, etc.)
9

Bardhan, P. (1989), p. 1392. My brackets. Some historical

examples in other areas of the economy are QWERT keyboard or
the US color TV.
10
Krueger, A. ( 1974)
11
see note 6.

Mar

NEW INSTITUTIONALISM AND DEVELOPMENT

Rubio
within
firms. Entrepreneurs and firms
formation could be inhibited by local
institutions.
There is no doubt that NIE has extended the
explanatory power of the rational choice by
relaxing its perfect information assumption
and the introduction of concepts such as
bounded rationality (rational choice subject to
limited information), transaction costs and
institutions. These allow to draw a better
picture of the economic history of the Third
World by addressing some important
questions, concepts and justifications as it has
just been seen.

2. Failures
Main criticisms when evaluating the
explanatory power of NIE with respect the
economic evolution of LDCs during the last
century are on the one hand, its ambiguity
about the role of state and its relation to the
economic activity, and, on the other hand, the
idea supported by NIE that one can explain
institutional change, make it endogenous,
through the application of rational choice
theory. Further more, as long as NIE is a
synthesis of neoclassical and institutional
economics, critiques to those previous theories
also apply to NIE. A last critique focus on the
difficulties to test the empirical validity of
NIE. Finally, one has to have a look into the
things that are not contemplated by the model.
With respect to the role of the state, the
ambiguity surges from the very synthesis of
institutional economics and rational-choice.
The former comes to tell us that without the
state, its institutions, and supportive
framework of property rights (supported by the
monopoly of the violence by the state and the
legal system), high transaction costs will
paralyse the economic activity. Historically, the
state has lowered transactions costs by
establishing and maintaining standards (money,
weights, measures), and by guaranteeing
property rights. In fact, from this side of NIE,
economic growth will generally be more rapid
in states strong and autonomous enough to
adapt their property rights to changing
conditions, yet challenged enough not to
become predatory. In addition, those social
revolutions that install strong states and
property rights better suited to the society will

spur economic growth12. Take the example of

the land reform in Taiwan. The state
redistributed land among peasants through a
land reform. Peasants could obtain credits
using the state-guaranteed piece of paper
(property right over land) as collateral. As
consequence, Taiwanese economy started to
move.
Neoclassical side of NIE reminds us
that rulers are not absent of self-interest and
markets should work unrestricted. Arguments
in this direction are provided by new
intitutionalist such as Krueger and Lal for the
case of India. There, Krueger finds that the
misguided adoption of certain economic
policies, especially import quotas, itself creates
a society with certain kind of economic
irrationalities such as permanently underutilised industrial capacity13. Also in reference
to India, Lal asserts that it cannot be
assumed, if there is a market failure, that an
alternative bureaucratic (state) mode of
allocation will not also suffer from the same
problems of imperfect information and
unreducible uncertainty14.Should then the
state intervene or not ?, what does explain the
different outcome of state driven policies, such
as ISI and EOI, in Latin America and East
Asia ?, could the differences be explained in
terms of informal institutions (culture and the
like) or the existence of interest groups, ?, or is
it explained in terms of different market
behaviour ?.
As explained by North , the existence
of a state is essential for economic growth ; the
state, however, is the source of man-made
decline15.NIE affirms the important influence
of state intervention. It can tell us in a
particular moment in time and location
whether its role is good or bad, but when
introducing dynamics, NIE is not able to
provide evidence of whether growth need
strong or minimum state. If the answer is
depends on circumstances, they are still to be
identified.
Institutional change shapes the way societies
evolve through time and hence it is the key to
understand historical change16. At least under
institutionalist and NIE view this sentence
holds. It does not for traditional neoclassical
12

Rogowski, R, (1988), p. 313. Actually this is not his position

but Norths. Rogowski is drawing hypothesis based upon Norths
work
13
Literal cite of Krueger, A. (1974) , here by Toye, J., (1993),
p.159
14
Lal, D. (1989), p.284
15
North, D. (1981), Structure and change in economic history,
here from Eggersson, T., (1990), p.317
16
North, D. (1990), p.3

Mar Rubio

NEW INSTITUTIONALISM AND DEVELOPMENT

economist, who take institution as given and do

no try to explain their evolution. Traditional
institutionalists have argued that to accurately
understand how an economic system functions
one must have an in-depth understanding of the
institutional characteristics of the particular
system17 . Their usual practice is to treat
institutional changes as exogenous and then,
they attempt to explain or predict the probable
response of economic actors. Per contrary, NIE
endeavours to do institutional change
endogenous. This means that economic
institutions are innovated because it appears
profitable for individuals or groups in society
to undertake the costs of bringing about such
changes18, or in other words, through the
application of rational-choice by the rulers : if
the returns to the ruler (or interest group) of
the new institution are high, institutional
change will occur. Actually, NIE approach is
not the first one in considering institutional
change as endogenous. Marxist history often
emphasise how institutions change or do not
change depending on considerations of surplus
appropriation by a class, thus Marx had but
one engine of institutional change (or lack of
change) and that was class struggle19.
Engines of institutional change within
NIE should be hunted around the factors that
create a disequilibrium which increases the
returns (or reduces the cost) of introducing a
new institution . There are three main sets of
factors :long-run changes relative product and
factor prices, changes in the size of the market
and changes in the decision rules of
government. A good example is the case of
Thailand20 during mid-nineteen century.
Changes in the relative prices of land and
labour due to the entrance in international
trade markets, led to induced institutional
changes (the establishment of more precise
property rights over -the relative expensive
factor- and
to dismantle the system of
property rights over labour -the factor
becoming relatively cheaper.
There are at least two critiques against
this conception of endogenising institutional
change. The first critique is that institutional
change can never be fully endogenous. Two
arguments support this idea. One developed by
Field21 argues that some rules should be
anterior to self-interest individuals interacting
each
others.
Otherwise,
individuals
17

Grabowski, R.,(1988), p.385

North and Thomas, here from Bromley, D.W. (1989), p.28.
Also in Grabowsky, R. (1988), p.385
19
Bromley, D.W. (1989), p. 35, note 1.
20
Feeny, D., (1988). The rest of the paragraph is a summary of
his work.
21
Here took from Grabowski, R., (1988), p.387
18

unrestricted by any norm will degenerate into a

Hobbesian war of all against all. Thus it is
impossible to make all institutions endogenous
within a model of individual choice, at least
some institutions are previous. Second, among
three set of factors that can induce institutional
change, changes in product and factor prices
and changes in the decision rules of
government are exogenous to the model. In
fact, NIE do not attempt to make all
institutional innovation endogenous to its
model22, just the change in regulative rules.
The second critique says that an endogenous
conception of institutional change is circle
without way out. The argument is that the
reason for changing
institutions -the
perception of being profitable by the ruler- is
itself only defined by the very institutions
under transition. Models of institutional
change driven by a rationale of efficiency are
tautological at best because the very meaning
of efficiency derives from the institutional
setup that defines the arena within which gains
from the change can occur 23. Hence change
become recursive, circular. Changes will
appear profitable or not to individuals
depending on the institutional framework they
are immerse in. How do they change their
perception without external influences ?.
Indeed, the Feenys example is an
example of exogenous influence towards
institutional change : relative prices change
because Thailand was opened to international
trade. The question is whether the decision of
open the economy was fully endogenous or it
was influenced by external forces. Economic
history teach that external forces are quite
likely to act as catalyst of internal ones.
Consequently, NIE seems to fail in the
explanation of the evolution of institutions and
thus, on the evolution of economy, once again
on the dynamics of the model.
Finally, one has to allude to the difficulties of
testing the empirical validity of the model and
the questions that remain outside the model.
We cannot see, feel, touch or even measure
institutions ; they are constructs of the human
mind24 Therefore, the scope of econometric
analysis is very limited. There have been some
attempts to include institutions into empirical
tests for growth explanation. Some have been
indicators of political instability, homogeneity
index (percentage of people in the largest
common language, race, religion or group),
bureaucratic size (ratio of public servants over
22
23
24

Ibid.
Bromley, D.W. (1989), p.12
North, D. (1990), p.107

Mar

NEW INSTITUTIONALISM AND DEVELOPMENT

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the total labour force),etc.. None of these
attempts is able to catch the relevance of
institutions. One cannot calculate the
approximate contribution of institutions to
economic growth. Intuition pronounces in
favour of the great influence of institutions on
economic development, but we have no tools to
demonstrate it.
Some of the questions proposed at the
very beginning of the paper stay at the margin
of NIE. In particular those related to
imperialism and dependence theories. They
have no room within NIE as it conserves the
neoclassical assumption about trade -it is
voluntary and mutually beneficial-. Prebishs
structuralism, where the more advanced
centre countries tend to reap the gains from
international trade and investment at the
expense of less-develop periphery25, has no
space, despite the fact it is consistent with the
idea of self-interest. NIE has either room for
altruistic behaviour by individuals or
organisations. The role of charity institutions,
very important in some aspects of the socioeconomic evolution of the Third World, is
completely dismissed within the model.

3.Conclusion
This paper has made an effort to address how
effectively NIE has extended the explanatory
power of the rational choice framework and
how far it improves our understanding of the
patterns of economic development in the Third
World over the last century. It has shown that
NIE allows us to go quite further than
neoclassical model does. It permits to
formulate some relevant questions that make
no sense under the traditional rational-choice
model. NIE identifies a large amount of
concepts (institutions, transaction cost,
property rights), actors (individuals, agents,
organisations),
behaviours
(rent-seeking,
interest group creation, overuse of resources)
which intervene in the economic activity that
were previously missed. However, NIE fails
when evaluating the role that the state should
play, and over all, it appears to be weak at the
time of explaining institutional change, and
hence economic change. In other words, it fails
to explain the dynamics. In addition it is very
difficult to assert its empirical validity through
quantitative tools.
Definitely, NIE implies a huge
contribution to the understanding of economy
activity. It turns the schematic drawing of the
neoclassical model into a colour picture that
allow us to recognise better the actors (a good
25

Ayres, C.E.,1995, p.84

album of static snaps), but still it is not the

motion-picture that economic history should
be.
3606 words

Mar Rubio

NEW INSTITUTIONALISM AND DEVELOPMENT

Popkin, S.L.
Public choice and peasant organisation, in
Bates, R.H., Towards a political economy of
Development, (1988)

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