The New Institutional Economics is a theory or a way of economical thinking based on the neoclassical economics and which main reason is to explain the importance and influence grade that the institutions have in the people's lives and in the economical facts.
Not only these different types of institutions affect our personal or social lives, but also control the market transactions at different levels.
The founder of this theory was Ronald Coase who was awarded with the Nobel Prize of Economics in 1991, but there are also other important economists that did further research on this topic such as Douglas North (awarded in 1993) , Oliver Williamson (2009) and Elinor Ostrom (2009).
The first important term to explain are “Institutions”, which are defined by Malcolm Rutherford as “The social, legal norms and rules that underlie economic activity”.
This theory is mainly based on two articles published by Ronald Coase: “The Nature of the firm” (1937) and “The problem of social cost” (1960).
According to his article “The Nature of the firm”, Coase highlights why are firms so important: “Outside the firm, price movements direct production, which is coordinated through a series of exchange transactions on the market. Within a firm, these “market transactions” are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur coordinator, who directs production.
These are alternative methods of coordination production.”
So basically as mentioned above, the firms are a mean to reduce the cost of productions and also facilitate the market transactions, it is cheaper to establish a permanent long-term contract with a supplier so that it manufactures the product or service needed.
At the same time, a contract is a way of controlling that the supplier of the firm achieves the required volume.
This statement can be confirmed when Coase mentioned: “The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism (marketing costs). The most obvious cost of “organizing” production through the price mechanism is that of discovering what the relevant prices are. This cost may be reduced but it will not be eliminated by the emergence of specialists who will sell this information.
It may be desired to make a long-term contract for the supply of some article or service. This may be due to the fact that if one contract is made for a longer period, instead of several shorter ones, then certain costs of making each contract will be avoided.”
It is beneficial within a firm to hire and pay a person (entrepreneur) that direct the resources in order to avoid certain marketing costs.
The main challenge that this manager of the firm has is to make the best use of the resources decreasing the amount of waste, in order to increase the earnings and consequently make the company become larger.
Just like Coase stated: “It may be that as the transactions which are organized increase, the entrepreneur fails to place the factors of production in the uses where their value is greatest, that is, fails to make the best use of the factors of production. Again, a point must be reached where the loss through the waste of resources is equal to the marketing costs of the exchange transaction in the open market or to the loss if the transaction was organized by another entrepreneur.”
In addition, according to Coase there are other important factors that help a firm to become larger:
“a) The less the costs of organizing and the slower these costs rise with an increase in the transactions organized.
b) The less likely the entrepreneur is to make mistakes and the smaller the increase in mistakes with an increase in the transactions organized.
c) The greater the lowering (or the less the rise) in the supply price of factors of production to firms of larger size.”
From my point of view, the above points give a meaning to the importance of establishing contracts between a firm and its suppliers, it is easier and cheaper when the supply and production prices are already established in a written form considering the volume of production, it should always be cheaper to produce something in a high amount.
In order to establish the volume of production, the firm has to consider all the time what the consumer wants and needs and how much is it willing to pay for it.
This is what Coase defined as social organization: “The two most important characteristics of social organization are: In the first place, goods are produced for a market, on the basis of entirely impersonal prediction of wants, not for the satisfaction of the wants of the producers themselves. The producer takes the responsibility of forecasting the consumers' wants. In the second place, the work of forecasting and at the same time a large part of the technological direction and control of production are still further concentrated upon a very narrow class of the producers, and we meet with a new economic functionary, the entrepreneur.”
But the importance of the firm has a deeper meaning than helping to reduce the marketing or transaction costs, it is also a form in which an earning or income can be created to benefit someone. A person by itself cannot produce money just by having a good idea, it needs to be materialized so here relies the importance to find someone (a producer) that makes this idea to become real.
Just like Coase stated “Professor Knight would appear to leave himself open to criticism on several grounds. First of all, as he himself points out, the fact that certain people have better judgment or better knowledge does not mean that they can only get an income from it by themselves actively taking part in production. They can sell advice or knowledge. Every business buys the services of a host of advisers.”
One last point that I consider important to mention is how to determine the size of the firm according to Coase: “To determine the size of the firm, we have to consider the marketing costs (that is, the costs of using the price mechanism), and the costs of organizing the different entrepreneurs and then we can determine how many products will be produced by each firm and how much of each it will produce.”
So basically what is mentioned there is that a company has to make a deep analysis of how much does it have to invest to produce a certain volume of the product(s) the customers demand and how much the marketing will cost, but also how much does it have to pay for the entrepreneurs to manage this transaction and production. The return of investment is also a very important factor to take into account when deciding the feasibility of a firm.
On the other hand, it is very important to mention that the new institutional economics are focused on the following levels established by Oliver Williamson:
“There are four levels of social analysis:
1) Social embeddedness: Norms, customs, religion, traditions. Religion plays a large role at this level.
2) Institutional environment: Formal rules such as constitutions, laws, property and rights (North 1991, p. 97). Include the executive, legislative, judicial and bureaucratic functions of government as well as the distribution of powers across different levels of government.
3) Institutions of governance: This area includes issues of defining markets and market structures (firm, regulations, taxes)
4) Neo-classical analysis: Firms are described as a “production function”. Adjustments to prices and output occur more or less continuously.
The new institutional economics have been concerned principally with levels 2 and 3.”
It can be thought that only the economical topics or laws affect our lives, but with this previous analysis can be noticed that also the religion has a big influence in our lives and the decisions we make.
In conclusion the relevance of the firms is clearly stated by this theory, without these institutions it would be harder to get a revenue from the ideas someone has and which could satisfy the basic needs of someone, but at the same there wouldn't be a producer that manufactures the “goods” of the people. The money has to be in a continuous flow always looking up to maximize the earnings of the producer, which would not be possible if there is not someone that manages it (an entrepreneur inside a firm) or without the market regulations.
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