Nature and Types of Institutions:

Broadly, institutions can be considered to be of two types: internal institutions and external institutions. Internal institutions evolve from experience incorporating solutions that have tended to serve people in the past. Examples include customs, ethical norms. good manners, conventions in matters of trade, etc. Violations of internal institutions are normally dealt with informally e.g. social exclusion. There can also be formal sanctions by way of a ban from professional practice or association. External institutions, on the other hand, are imposed and enforced through political and administrative machinery i.e. laws enacted through legislation. Institutions are thus rules of human interaction which constrain opportunistic and erratic individual behavior making transactions predictable and facilitating in terms of division of labor and wealth creation. They mould social objectives by defining the norms for social and economic relationships. Contributions to institutional economics have been made mainly by two groups of' writers. Writers identified in the previous section (viz. Thorstein Veblen, John R. Commons and Maurice Clark) belong to the group of early institutional economists. They are also sometimes referred in the literature as traditional institutionalisms or contributors to the original old institutional economics (OIE). Such institutionalisms radically opposed the mainstream neoclassical economists owing to the fundamental premise opposed by the neo-classicists that economics cannot be separated from the political and social system within which it is embedded. Later contributors like Oliver Williamson, Ronald Coase, Douglas North, etc. made an attempt to integrate institutionalism into the mainstream neoclassical framework. The contributions by the latter school of writers have come to be referred to as new institutional economics (NIE).

While both the OIE and the NIE include institutions within economics, they differ significantly in philosophical and methodological orientation as well as in the theoretical direction and normative content. One aspect on which the OIE focuses on the effects of technology and established institutional structures in which it particularly looks at the ways in which established social conventions and vested interests resist change. A second major area on which it concentrates encompasses the aspects of law, property rights and organizations. The evolution of all these three aspects, in terms of institutional structures to promote development, is examined by the OIE for their impact on the efficiency with which economic transactions are effected resulting in better distribution of income in the society. While the NIE also focuses on the importance of property rights as fundamental to economic development, it also emphasizes on the processes of public choice and organizations. Like Veblen for OIE, Douglass North is one of the principal contributors to the NIE.

According to North, institutional economics retains and builds on the fundamental assumption of scarcity and hence competition which is the basis of the 'choice theoretic approach' underlying micro-economics; what it abandons is the assumption of neoclassical economics on instrumental rationality which makes the economic process a institution-free theory. He maintains that human beings are in fact faced with incomplete information and limited mental capacity to process available information. Further, as transaction costs result in incomplete markets, ideas and ideologies play a major role in the analysis of choices forcing the imposition of constraints on human interaction with a view to structuring exchange. Agreeing that there is no implication that the consequent institutions are necessarily efficient, North advocates that the place to begin a theory of institutions is with a modification of the instrumental rationality assumption. In a significant reference to the concept of equilibrium, North suggests that owing to a continuum of theories that agents can hold there is not one determinate equilibrium but a situation of 'multiple equilibrium'. The cost of transaction determined by informational asymmetry results in the formation of institutions. Acknowledging the contribution of another major contributor to NIE, Ronald Coase, for making the crucial connection between institutions, transaction costs and neoclassical theory, North states that the neoclassical result of efficient markets only obtains when it is costless to transact. And because a large part of our national income is devoted to transacting (in which respect he estimates that 45 percent of US'S economy over 1870 to 1,970 was devoted to transacting), institutions and specifically property rights are crucial determinants of the efficiency of markets. Ayres underlines the roles of culture in shaping institutions revealing a social vision in them.