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Vol. VI, Issue 4 Scientific Papers (www.scientificpapers.org) August 2016 Journal of Knowledge Management, Economics and Information Technology

The Contribution of Several Nobel Economic Laureates in the Development of Institutional Theory - Views, Assumptions and Estimates

Authors: Florentina Xhelili Krasniqi, Faculty of Economics, University of Prishtina, Kosovo, [email protected]; Rahmije Mustafa Topxhiu, Faculty of Economics, University of Prishtina, Kosovo, [email protected]

The development of institutional theory has been contributed by several Nobel laureates with theories known as theory of agency, the theory of games, theory of transaction costs, theory and other important theories. Among them these Nobel laureates who contributed to the development of institutional theory are Coase and North, Fogel, Myrdal, Hayek, Simon, Buchanan, Stiglitz and Arrow. In this paper will be presented some of their views on the development of institutional theory and their influence in this direction. Since Coase and North considered the Chairperson of new , their thoughts will be explored in more details. All these thinkers have contributed by explaining various issues according to the role, importance, dynamics and the emphasizing . Since the institutions and their evolution are the main source of political and economic changes need understanding and recognition of the achievements so far in institutional theory.

Keywords: institutions, institutional old theory, new institutional theory, Nobel Laureates.

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Introduction Institutions are the formal and informal rules and norms that organize social, political, and economic relations (North, 1990). Examples of formal institutions presented by various authors are law, regulations and contracts, and among informal institutions are norms, ethical and political standards [1]. Enhancing the role and importance of institutions is more pronounced from 1990 until now. In the development of institutional theory have largely contributed two main schools: The old institutional school (“old” institutionalisms) and the new institutional school (“new” institutionalisms). According to Coase, the main difference between the two institutional schools is that the old institutionalists were concerned in the main with describing institutions rather than with analyzing them [2], and according to North, the new institutional economics is an attempt to incorporate a theory of institutions into economics [3]. Regarding the importance of institutions (2011) states that we live in the world of many institutions, including trade, government, law, political parties, media, etc., so we need to determine how these institutions should complement and strengthen each other, rather than diminish the effectiveness of each one of them[4].

The old institutionalisms

Institutional foundations of the theory are implemented in institutional school in late 1880 in the US, which was under the influence of German Historical School and British historians. Founder of the institutional school was . Other well-known founders of the institutional school, are: J. R. Commons, W.C. Mitchell, C.E.Ayres and Kenneth Galbraith. Veblen in his famous book "Theory of the Leisure Class" (1899), investigated the social and institutional problems and he has sharply criticized the classical and neoclassical economic analysis. According to Veblen, human beings are more complex led by instincts, their creativity and skills. So, Veblen theory regarding cultural and institutional changes followed theory of biological evolution ( "Darwinian"), where "goals" are not exactly foreseen.

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John R. Commons expands the definition of institutions according Veblen. His interest was functioning of institutions such as monopoly and regulatory agencies as well as to the issues that affect private property, legislative framework and judicial decisions. In the book "Legal foudation of capitalism," he stresses justice and courts as important elements in the structure of the economy. C.E. Ayres was close to Veblen. In his books "The Theory of Economic Progress" (1944) and "Toward a Resonable Society: The value of Industrial Civilization" (1961), although he was preoccupied with philosophy as Veblen, his orientation was the main pragmatic- instrumentalist approach of John Dewey . Mitchell has provided the statistical basis of institutional economy, Commons has driven economy institutional in social reforms program (especially legislative), and Ayres has expanded the concept of Veblen theory of technological values. Meanwhile, [6] has strongly criticized the orthodox theory which considers it as unrealistic. However, old institutionalism was short-lived, so on the '20s, only a few schools remained in the hands of institutionalist. (1987) associated with the decline of the old school institutional writes: "Why did the older institutionalist school fail so miserably, though it contained such able as Thorstein Veblen, J.R. Common and W.C. Mitchell? I now think that... [one of the answers is in the] important specific analysis .... of the New Institutional Economics movement. But it does not consist of giving new answers to the traditional questions of economics – resource allocation and the degree of utilization. Rather, it consists of answering new questions, why economic institutions emerged the way they did and not otherwise; it merges into but brings sharper [microanalytic] – reasoning to bear than had been customary [7] " However, old institutionalists were not able to construct a comprehensive theoretical framework out of their ideas, so in the 30s and 40s, Kejnsian ideas taked off the institutionalism as mainstream economic research. When the so-called welfare economy begins to challenge the traditional economy in the 60s, it begins a new phase of research institutions, namely the introduction of new institutional economics.

The new institutionalisms

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For the first time this new direction appears on the occasion of issuing the Journal (University of Chicago, 1958) in the US, so the new institutional school can be thought of as a result of the School of Chicago ("economic imperialism "). The new institutional economics studies how people arrange their affairs, how they create institutions including legal sanctions, social norms and organizational structures, how to govern their relationships, how those institutions spur or hinder and how these institutions improve through trial and error [8]. The school had a tough empirical analysis. It originates in the criticism of orthodox theory, who believe that institutions are important, but they are also sensitive to be analyzed [7].

The contributions of several Nobel Laureates in the development of institutional theory

Nobel laureates who have contributed in the development of institutional theory are: and Douglass North, Kenneth Arrow, , , Herbert Simon, James Buchanan, . The first two are considered chairman of the new institutional economics, so their opinions will be further discussed. Ronald Coase first addresses the economic problems in combination with the legal and institutional aspects of an economy. It has expanded microeconomic theory and managed to define the principles by which can be explained the institutional structure of an economy. Coase has made significant contributions to the Theory of the firm ( "", 1937), in which presents the arguments for the existence of a company, the type of its organization, its size and the series of other aspects considering the size of so-called transaction costs. So, unlike the previous economic theory which restricted the handling costs of production and transportation, Coase argued that firms are faced with a wide variety of costs relevant to the preparation, supervision of various agreements with suppliers, employers, its buyers and other similar costs included in transaction costs of [9]. Since transaction costs absorb a certain weight of resources in an economy, must be taken in consideration during decision-making.

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He is familiar with the so-called "Coase Theorem" (1960) which became famous for the world. "Coase theorem" gives a different interpretation of Pigo's theory of externalities through taxation and subsidy. According to this theory is not about imposing the costs of a partner to the other, but not coordinated activities among the partners, so by Coase settlement agreement is possible between them. Only if transaction costs are zero, the initial definition of property rights leads to effective results. In all other cases, the amount of transaction costs opens up the possibility of agreement between the partners in order to achieve efficient outcomes [10] [9]. Coase is known by its contribution to the economy of welfare through the "Problem of Social Cost". He studies the relationship between the two companies / producers, analyzed the mechanism of price action through various forms of reparations [11] [9]. On the occasion of the presentation of the Nobel lecture "The Institutional Structure of Production" (1991), Coase notes that during the two centuries since the publication of "The Wealth of Nations", the main activity of economists was how to fill gaps in the system of Adam Smith by correcting it and trying to make it right. Economists are concerned over what is happening in the market regarding the purchasing of factors of production and sale of products or services, by not interested in agreements, internal arrangements within organizations. Most of the resources in modern economic system are employed in firms and how these resources are used depends on administrative decisions and not directly by the market action. The efficiency of the economic system depends on how organizations conduct their affairs, especially modern corporations. Modern economic theory states that transaction costs depend on the institutions, that institutions are endogenous and the distribution of wealth directly affects economic efficiency, and through its effects institutions. The economy of transaction costs was one of the most influential approaches of the New Institutional Economics [12] [13]. Douglas Cecil North was a key figure in the history of New Institutional Economics. He analyses the model of US economic growth before 1860 and has determined the role of institutions in economic growth.

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In a study of economic history (1968) through the analysis of shipbuilding, it reaches the conclusion that in the economic development has greater impact organizational changes than technical changes. According to the North, to understand the great role of institutions in economic growth, of any country should take into account all the economic, political and social development of the relevant period, as well as impacts on the ideological institutions and non-economic factors. North argues the role of institutions in economic changes, including the of property rights. New institutions arise from the efforts of certain social groups to maximize their profits, by changing the existing institutional conditions. He confirms this hypothesis through the analysis of economic development in the US 19th century, when agricultural policy, constructions and transport explained by institutional arrangements. Likewise, the development of Western Europe in the period of transition from the middle Ages of 19th century and economic growth in that period, explained by incentives based on private ownership. According to North's, relative price changes and fluctuations in population growth led to institutional changes. Factors that are discovered and technical changes, although included in the process of economic growth are not sufficient to explain economic growth. The key to explaining economic growth is efficient economic organization and new institutions governing the respective relations. These institutions provide rules, procedures and interests of individuals to achieve their goals in maximizing profits and wealth. Analyzing the situation of poor countries, north argues that in poor countries there are no appropriate institutions to protect the interests of individuals. As a result, the uncertainty is greater and economic costs of financial transactions are high. [9] [14]. In the lecture on "Economic Performance through Time, 1993), North has highlighted the importance of the time factor on the occasion of the analysis of economic phenomena in order to understand the economic changes. Neoclassical theory is simple and is not suitable tool to analyze and describe the policies that will promote development. This theory is more worried about the market action, not how the market develops. North explains that economic history and development focuses on developing

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more recent technological and investment in human capital, and ignores the incentive structure of institutions. According North, two errors that come into consideration in the analysis of economic interpretation through time are not taken into account: time and the institutions. North's essay is about institutions and time and provides the basis of an analytical framework, which is a modification of neoclassical theory. From neoclassical theory remains fundamental assumption of scarcity, competition and analytical tools of microeconomic theory, while the rationalization modified and added the dimension of time. According to him, it should develop economic and political theory, as it determines the rules of the game and still do not clearly understand the interaction between politics and the economy that would enable us to understanding this issue. It’s better to understand social norms and informal obligations that are fundamental source for greater achievements in less developed countries. This implies the collection of evidence from other sciences (sociology, anthropology) and integrates that knowledge in economic theory and policy, and will arrive at some generalizations that we will need [15] [14]. So, the purpose of the North's research was the creation of an analytical framework of economic changes, if possible would be ideal to be "comparable in precision to general equilibrium theory" [15]. North made the important connection between institutions, transaction costs and neo-classical theory. According to him, the interaction between institutions and organizations helps the institutional development in the economy. North states that "If institutions are the rules of the game, organizations are those who play these rules". There are organizations that will reflect the opportunities provided by the institutional framework. "If the institutional framework rewards piracy, then piratical organizations will come into existence; and if the institutional framework rewards productive activities, then organizations –firms- will come into existence to engage in productive activities". (North 1994). Robert William Fogel explained the crucial role of institutions in economic growth. In his Nobel Prize Lecture, Fogel stresses that it is important that policy makers to understand when the decisions is been made they should take into account long-term processes. Regarding the statement of Keynes that "In the long run we are all dead," he explains that this was an appropriate moment to do during the depression

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years of the 30's. Then the activities undertaken urgently needed to regain control of the money supply, to care for the millions of unemployed and prevent failure of , but now is another time. The key issue of economic policy in OECD countries should not be understood in terms of short-term perspective. The crisis in medical care, pensions and the challenges of globalization are guided by long-term processes which decision makers must understand. He emphasizes the need for economists to mind the long-term dynamic processes in the study of history [16]. Karl Gunnar Myrdal in 1935 was elected deputy of the Swedish Parliament and this turned G. Myrdal from theorist economist in a political economist, respectively in an institutionalist economist. In his book "Asian Drama" criticizes the economic and social theories of his era. According to him, the concepts used for development, economic growth and welfare must reflect the needs and realistic assessments of people and not statistical abstract concepts. Myrdal notes that social program of a party, cannot be summarized in a computer program, because without imagination and intuitive understanding of social psychology, tools / methods and economic instruments do not provide adequate results. Myrdal in their work gives a number of proposals of a political nature that define and constrain economic development. It proposes institutional development format underdeveloped countries by providing basic principles of development based on economic development of accelerators [5] [9]. Friedrich August von Hayek’s work is based on market competition system and describes the competition as immanent features of the mechanism of action of the capitalist market of the economy as a process. According to Hayek, the state must define in social and economic life the "rules of the game", under which individuals in conditions of free competition can realize its goals. According to him, the complications encountered in the modern economy, is giving the strongest argument against planning. It is difficult to any brain or state planification to represent thousands of links associated with each other, so that the social planning system, necessarily, will cause not rationalize economic, because state intervention through planning

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instruments does not allow formation of real prices and rational allocation of production factors. Post-Coasian organizational economy (which means the agency theory, the theory of incomplete contracts and the economy of transaction costs), not addressed in a comprehensive way of organizing the economy in the context of The Knowledge Economy. "Distributed knowledge" by Hayek are essential to understand the organizational options. These insights are not owned by a particular tune which may be private, but which will nevertheless be necessary in order to mobilize foster productive tasks. (Hayek 1945). Hayek's emphasis was that the market system encourages the tendency towards the allocation of property rights to those who can use them best. Herbert Alexander Simon is known through his book "Administrative Behavior" that represents a contribution to the theory of organization, giving a new content to the decision making process based on logic and psychology of human choice. Simon notes that economic science mainly dealt with normative . This author in the theory of the firm considered as a participant only the entrepreneur, which mainly considered as rational individual. Simon argued that organizations like people if act on the basis of asymmetric information are able to investigate only a limited number of alternatives in making decisions () [5] [11]. James Buchanan has made a significant contribution to the "Public Choice Theory", which presents both scientific approaches: specific analysis of political party and responsibility to voters and institutional approach that preaches the consequences of elections Voters in the content of specific institutions. Buchanan gives vision of social policy by looking individuals as the basic unit of social and state system. He explain the role of the state in the field of social policy and the need for completion of state institutions. His thoughts regarding the solution of social and economic problems are based on the opinions of Veblen, Mitchell etc. Buchanan prefers its own methodology for studying the activity of the state in different directions socio-economic development, so the Theory of individual behavior in the political process can make wide practical application. It contains elements of economic development and , so it can be applied from the processes of the market to the political processes [17].

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Joseph E. Stiglitz besides his influential contributions to microeconomics played an important role in political life as well. During his visits to the countries of the third world states have detected significant differences between the models he had learned and those that he sees or practices. He stresses that the model of perfect markets seemed completely inappropriate for these countries. What had attracted his attention were asymmetric information, lack of markets and the existence of dysfunctional institutions, and so on. Stiglitz wrote that the process of development is no longer viewed as a process of capital accumulation, but rather as a process of organizational change. There are not only preferences and technologies that define actions in that field, but the inclusion of certain institutions in the vicinity. According to him, these institutions cannot be drawn from neoclassical model bases. There are not only institutions, prices and choices that are endogenous; the preferences and technologies are endogenous [18] [19]. Today, the community has a greater role in our perceptions of sustainable development. Prerequisite for effective markets is the existence of institutions that establish rules for ensuring private ownership, strengthen contracts / agreements and ensure detection (receiving) of information. This requires government. Stiglitz, as Coase noted that when the enforcement of private property rights is costly, the market may or may not be the best system of allocation [18] [19] [20]. Keneth Arrow has contributed to welfare theory through "The Impossibility Theorem", which in the branch of the science of well-being is known as "Arrow's Theorem". The essence of this theory consists in the fact that under certain conditions cannot be calculated a social utility function, to express preferences of all members of the relevant society. Decisions concerning the selection of the best alternatives to the collective might not maximize the benefit to the individual criteria (eg high tax rates or increase public spending on road construction may be preferred by an individual but it is rebutted by another individual), but should aim at maximizing a social welfare function. This theory explains to the supporters and opponents of Arrow's the problem of the role of the state in the market economy, which faced two extremes, the expansion of state intervention and that of minimizing the

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role of the state in a market economy. Arrow itself does not support any of the extremes mentioned. How institutional theory can be found taking in consideration that Arrow addresses his theories of welfare economics? Institutionalist admire his approach to the economy of information and formulating conceptual interdependence when people together shape and are shaped by their institutions [9] [21].

Conclusion

As many Nobel Laureates have contributed to more than one field or scientific problem, it is not easy to make a final classification of their contributions by problems that have addressed or by areas of economic science in which they have contributed. However in this area may be placed emphasis on the contribution of Ronald Coase and Douglass North, Kenneth Arrow, Friedrich Hayek, Gunnar Myrdal and Herbert Simon, James Buchanan, Joseph Stiglitz with theories known as agency theory, the theory of the costs of transactions and other theories of popular approaches which were among the most influential approach of new institutional economics. The theoretical framework of institutional schools emphasis on institutions because institutions are instrument which we possess to change the way in which the economy functions.

References

[1]. Stanley Fischer and Ratna Sahay, "Transition Economies: The Role of Institutions and Initial Conditions, IMF Draft," in Conference in honor of Guillermo Calvo at the IMF , 2004, p. 5. [2]. The Ronald Coase Institute (1997, September 17) Interview with Ronald Coase? What is New Institutional Economics?. [Online]. https://www.coase.org/coaseinterview.htm

[3]. Douglass C. North. The new institutional economics and development, Washington University St. Louis, p.1.

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[4]. Amartya Sen What is development about?, G. Meier & J. Stiglitz, Frontiers of :The future perspective, 2011, p. 512. [5]. Isak Mustafa, Ndërmarrja në biznesin bashkëkohor. Prishtina, Kosove, 1997, pp. 94-95, 104, 511, 512, 514-515, 528, 542-543. [6]. Jr. & Robert F. Hebert Robert.B. Ekelund, Povijest ekonomike misli. Zagreb, Croatia, 1990, pp.460-461. [7]. Oliver E.Williamson, "The New Institucional Economics: Taking Stock, Looking Ahead," Journal of Economic Literature, vol. XXXVIII, pp. 595-613, 2000. [8]. Virginia Postrel. Post Politics. (2004) The New Institutional Economics. [9]. Aristotel Pano, Nobelistët e shkencës ekonomike. Tirana, Albania, 2002, pp. 53-57, 164, 175. [10].Michael P.Todaro & Stephen C.Smith, Economic Development. UK, 2003, p.111. [11]. Nikolai J.Foss, "Coase vs Hayek: Authority and Firm Boundaries in the Knowledge Economy," LINK. [12]. Ronald Coase, "The Institutional Structure of Production, Nobel Lecture," , 9 December 1991. [13]. Carsten A.Koch, "Who needs the asumption of Opporunistic behavior? Transaction Costs Economics does not!," Roskilde University, Research Paper 4/00, p. 1. [14]. Daniel Ankarloo, ”Does histori really matter? A critique of the institucional economic history of Douglass C.North”, p. 1. [Online]. http://copejournal.com/wp-content/uploads/2015/12/Ankarloo- Does-History-Really-Matter-A-Critique-of-the-Institutional- Economic-History-of-Douglass-C.-North-1999.pdf [15]. Douglass North, "Needed: A theory of cange," in Frontiers of Development Economics: The Future in Perspective. p. 491. [16]. Robert William Fogel, "Nobel lecture: Economic Growth, Population Theory, and Physiology: The Bearing of Long-Term Processes on the Making of Economic Policy" , 9 December 1993. [17]. Charles K.Rowley, "Five market-friendly Nobelists: Friedman, Stigler, Buchanan, Coase, and Becker," The Independent Review, vol. III, no 3, 1999.

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[18].G. Meier & J. Stiglitz, Frontiers of Development Economics: The future in perspective., p.389, 427. [19]. J. Stiglitz, "Nobel Lecture: Information and the change in the paradigm in economics," , 8 December 2001. [20]. J. Stiglitz ” ”, Globalization and its discontents., 2002, p.3-22. [21]. “Keneth Arrow”. Free encyclopedia.

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