Efficiency of Institutions From the Perspective of New Institutional Economics With Emphasis on Knightian Uncertainty

Abstract

The efficiency of institutions, understood in the sense of constraint optimization, does not make much sense when discussing the New Institutional Economics (NIE), i. e., under conditions in which institutions matter. For such a world one has to use non-optimizing methods to assess the economic effectiveness of institutions. That is how representatives of the NIE proceed. While the earlier literature on the NIE focuses on the role of transaction costs in its explanation of the economic effectiveness of institutions (e.g., Coase 1937), this paper emphasizes the role of incomplete foresight (Knightian uncertainty). We consider the answers of five well-known economists – among them two representatives of the NIE school – to the problem of Knightian uncertainty. Taking their arguments into account we discuss the economic effectiveness of the following economic institutions of capitalism: competitive markets, money, contracts, firms. The efficiency of economic institutions under conditions of Knightian uncertainty depends not only on the adaptability of institutional rules to unforeseen events, but also on the shared beliefs of their agents (corporate culture, national responsibility) and the skills of entrepreneurial or political leadership of those in charge. There is no clear-cut concept of economic efficiency of institutions comparable with Pareto efficiency. Prudent economists have no other choice but to use a balanced comparative style of reasoning – as actually applied in the NIE literature – and to warn those in power against “Utopian social engineering” (Popper).