A nice paper from Murali Patibandla of IIM-B.
He brings these interesting insights from New Institutional economics to help understand issues and corruption in India:
Corruption is a major political and economic issue in India. The stakes, value, frequency, and costs of corruption have become exceptionally high in the history of modern India. This is partly because some of the tenets of free market mechanism are implemented in the absence of underlying necessary institutional conditions for efficient and fair functioning of the market mechanism. The objective of this paper is to bring forth the relevance of the insights of the new institutional economics to the functioning of the Indian economy.
First what is NIE and ite relevance?
The new institutional economics (NIE) pioneered by Ronald Coase, Oliver Williamson and Douglas North takes the approach that capitalism functions effectively only if it is supported by underlying institutions such as the rule of the law, property and contractual rights, social and economic norms and transaction and information costs of enforcement; and there is nothing called optimality of markets and institutions. A simple empirical verification of this argument is the text book case of free market reforms implemented by the World Bank and IMF, which resulted in disastrous outcomes in Russia and the Eastern European countries in the 1980’s (Patibandla, 2006).
Old IE relied more on the neoclassical school. NIE rejected the neoclassical school:
The NIE had its origins in Coase’s paper (1937) ‘The Nature of the Firm’ in which he argued that market mechanism is subject to the friction of transaction costs of search, formulating and executing contracts. Owing to transaction costs, a firm as an organization comes into existence to economize on transaction costs of markets. The firm internalizes economic activity until marginal internal bureaucratic costs of hierarchy are equal to the marginal transaction costs of the market (boundaries of the firm). Once the economic activity is internalized it is hierarchy that governs resource allocation, but not strictly price mechanism. Coase rejected the neo-classical idea that a firm is just a production function (black box).
The neo-classical economists ignored Coase’s idea and still ignore it largely although he was awarded the Nobel Prize because it does not fit into their elegant models, especially of the general equilibrium kind. Since the 1970s onwards, Williamson (1975; 1985) and North (1990) in a series of seminal papers and books applied the transaction cost logic to develop the concept of institutions of capitalism. Subsequently both were awarded the Nobel Prize in economics. North used the transaction cost logic to understand the evolution of institutional environment historically, especially in the U.S. Williamson formalized different elements of transaction costs and applied them to governance mechanism.
NIE has two main ideas:
The NIE makes a distinction between institutional environment and institutions of governance. The institutional environment determines the extent and different dimensions of transaction costs which, in turn, determine the governance mechanisms. This determines how efficiently resources are utilized in a country; high transaction costs lead to a high degree of internalization which results in high costs of bureaucracy and black economy. The institutional environment deals with formal and informal institutions. Formal institutions are the constitution, the legal system, judiciary, polity, and property and contract rights. Informal institutions are the embedded conditions of customs, traditions and norms. North makes a distinction between forms and substance. Forms (organizations) can be engineered or copied from other countries, but the implementation of the rules depends on embedded norms which evolve over a period of time. For example, India has a large number of laws to protect the environment, but their effective implementation is poor.
So he then goes on to pick key ideas from NIE and shows where India has moved (capital markets) and lagged (property rights etc).
Nice stuff. Though the paper could have been written in a more fluid manner giving more examples on how we can apply NIE in Indian economy..