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Transition to ‘institutional economics’ from ‘neoclassical economics’

The transition from neoclassical to institutional economics marks a shift in focus from purely market-driven analyses to the broader role of institutions, norms, and social structures in economic behavior. While neoclassical economics emphasizes rationality, equilibrium, and efficiency within markets, institutional economics integrates the influence of rules, organizations, and historical contexts in shaping economic outcomes.


1. Neoclassical Economics: Core Assumptions and Limitations

  • Core Assumptions:
    Neoclassical economics assumes individuals are rational, self-interested agents who maximize utility (consumers) or profit (producers). Markets are depicted as efficient mechanisms for resource allocation through supply and demand dynamics.
  • Limitations:
    • Overemphasis on mathematical models and equilibrium conditions often abstracts from real-world complexities.
    • Ignores the influence of institutions like laws, norms, and organizations on economic behavior.
    • Assumes perfect information, static preferences, and well-defined property rights, which rarely hold in practice.

2. Emergence of Institutional Economics

Institutional economics emerged in the late 19th and early 20th centuries as scholars began questioning the reductionist assumptions of neoclassical theory.

  • Key Proponents:
    Thinkers like Thorstein Veblen, John R. Commons, and later, Douglass North and Oliver Williamson emphasized the importance of institutions in economic analysis.
  • Core Principles:
    • Role of Institutions: Institutions, both formal (laws, contracts) and informal (customs, traditions), structure human interactions and economic behavior.
    • Behavioral Insights: Economic actions are influenced by bounded rationality, cultural norms, and power dynamics, rather than pure rationality.
    • Historical Context: Institutional economics considers historical and evolutionary factors in shaping economic systems.
    • Focus on Processes: Unlike the static equilibrium of neoclassical models, institutional economics examines processes like technological change, institutional evolution, and path dependency.

3. Key Differences

  • Analytical Focus: Neoclassical economics focuses on individual choices within markets, while institutional economics examines the broader socio-economic framework.
  • Rationality: Neoclassical models assume perfect rationality, whereas institutional economics accounts for bounded rationality and social influences.
  • Efficiency vs. Evolution: Neoclassical economics prioritizes efficiency in allocation, while institutional economics explores how institutions evolve to reduce transaction costs and manage collective action problems.

Conclusion
The transition to institutional economics reflects an attempt to address the limitations of neoclassical theory by incorporating social, historical, and institutional dimensions. It provides a more comprehensive understanding of economic behavior in real-world contexts, emphasizing the interplay between markets, institutions, and society.

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