"The new institutional economics (NIE) builds on and modifies the neoclassical theory of economics. What is builds on is the funamental assumption of scarcity--hence competition. It views economics as a theory of choice subject to constraints. It employs the price theory as an essential part of the analysis of institutions. In particular, it sees changes in relative prices as a major force inducing change in institutions.
What NIE modifies in the neoclassical theory is the instrumental rationality assumption. In a world of instrumental rationality, there is perfect information. Economic and political markets are naturally efficient. Hence, institutions are unnecessary; ideologies don't matter.
The fact is, however, people have incomplete information and limited mental capacity by which to process information. In consequence, human beings impose contraints on human interaction in order to structure exchange. This implies that the consequent institutions inherent in the intrumental rationality assumption is not necessarily efficient. In the real world, ideologies actually play a major role in choices. Markets are not inherently efficient because the act of making an exchange has a cost. Transaction costs result in imperfect markets. And so NIE adds institutions as a critical constraint and analyzes the role of transactions costs as the connection between institutions and costs of production. It extends economic theory by incorporating ideologies into the analysis. More importantly, it models the political process as a critical factor in the performance of economies, as the source of the diverse performance of economies, and as the explanation for "inefficient" markets.
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First, it must be remembered that individuals enter into economic exchange using mental models they use to interpret the world around them. These mental models are, in part, culturally derived. In another part, they are acquired through experience which is local to the environment where the individual is situated. Naturally, mental models vary widely with different environments and so there is immense variation in mental models. As a result, there are different perceptions about how people look at the world and the way the world "works." Even the formal learning that individuals acquire from educational institutions frequently consists of conflicting models by which the world around is interpreted.
Now as indicated, individuals entering into economic exchange make choices based on their mental models. The incomplete information and limited mental capacity by which to process information determines the cost of tranacting. The costs of transacting arise because information is costly and are assymetrically held by the parties to exchange. Transactions costs are determined by the costs of measuring multiple valuable dimensions of the goods and services exchanged, or of the performance of agents, and the costs of enforcing agreements.
This underlies the formation of institutions. Institutions are formed to reduce the costs of transactions (the uncertainty in human exchange). Together with the technology employed, they determine the costs of transacting and producing.
It should be remembered that at issue is not only the rationality postulate, but the specific characteristics of transacting that prevents the actors from achieving a joint maximization result of the zero-transactions cost model of neoclassical theory. The neoclassical result of efficient markets is only obtained when it is costless to transact. When it is costly to transact, institutions matter.
Because a large part of a country's national income is devoted to transacting (the act of making the exchange), institutions (especially property rights) are crucial determinants of the efficiency of markets."
Source:
Douglass North. 1993. "The new institutional economics and development"