From the first day of Economics 101, we are taught that the economic problem is one of the efficient allocation of scarce goods.We are taught to solve the wrong problem. Hayek (1945) opened our eyes; the problem is the utilisation of knowledge.
Knowledge is disaggregated and fragmented. Hayek argued that the solution to this problem (the price mechanism) exists right in front of our eyes. The market allows many limited fields of vision to “…sufficiently overlap so that through many intermediaries the relevant information is communicated to all.” With deeper understanding, the price mechanism becomes an information aggregation tool.
Yet not all transactions are between individuals. We are ignoring the formal and informal institutions that shape our economy. It is therefore important to look at how and why institutions are formed. Most notably, Coase (1937) proposed that institutions were formed as a response to high transactions costs in the economy. New institutional Economics further focuses on these institutions, and why they are so important.
Taking both Coase and Hayek: institutions are responsible for, and emerge to, coordinate the knowledge of market participants. Now the focus falls in a new direction: institutions and knowledge. While knowledge is often taken as a static feature in a model, it is actually a dynamic process of learning. As humans learn, they undertake a continual process of trial and error.
Learning leads to new formal and informal institutions, and subsequently different transaction outcomes. These new outcomes provide feedback, inducing further learning.
We need a deeper understanding of the emergence of institutions. While informal institutions appear to emerge spontaneously through interaction, formal institutions emerge as an entrepreneurial response to the rules of the game. It is the interaction between these institutions that leads economic performance.
What can we take away from this? By analysing individuals at a cognitive choice level (learning, evolving, dynamic and irrational), we can begin to deepen our understanding of economic change.