Chapter 3: Why Economists Don’t Study Institutions, But Should.
Methodological individualists must acknowledge a place for institutions because these are
necessary to maintain the division of labor because the division of labor is limited by the cost of
coordinating activities between different people.
Transaction costs → costs of making and enforcing exchanges.
* evaluating offers; negotiating bargains; ensuring compliance; protecting
property; limiting the division of markets by raising the costs of exchange.
Adam Smith in his Wealth of Nations → suggested that the division of labor, “from which so
many advantages are derived, is not originally the effect of any human wisdom...It is the
necessary, through very slow and gradual consequence of a certain propensity in human nature
which has a iew no such extensive utility; the propensity to truck, barter and exchange one thing
*They are better able to ACT on this tendency if there are social institutions that restrain
Kleptocracy → A society governed by thieves.
Generalized Reciprocity → Performing generous acts for others as a matter of course, without
expecting any immediate return but confident that in the future someone will return the favor.
*Involves altruistic acts, sacrifices we make for others without expectation of any return form the
person helped. There is a general expectation that others will help us in the same way.
* Example: Handshakes to seal the deal instead of hiring a lawyer to draft a formal
**Related to reciprocal altruism → when an individual helps others including strangers,
without expectation of direct or immediate reward but in the hope that others, not
necessarily those aided, will provide aid and assistance in exploitation.
***With Generalized Reciprocity, we wouldn’t need transaction costs.
Robert Putnam calls generalized reciprocacy the “touchstone of social capital”.
Affective motivations → where people act from feelings of emotional connection rather than for
We value affective motivations because we want direct human connection with others;
we want others to like us and we fear that if others help us from mercenary motives,
because we are paying them rather than because they care for us, then they will betray
us if the incentives change.
We rely on feelings to support our instrumental interests in maintaining friendly relations
with us. Where we do not see such feelings, we hesitate to enter into market
Asymmetric Information → a situation where one party to a bargain has more information than
do the other parties.
Methodological Individualism → looks at behavior in terms of the individuals within it, their
individual drives, their interests, capacities, and their genetic dispositions.
Methodological Individualists begin with individual psychology and institutions by
assuming that individual are built up from individuals.
Institutional Economists → social scientists who believed that historical experience and social
institutions influenced economic circumstances. Marginal Analysis → Analysis that focuses on the impact of behavior on the margin, or the last
unit of action.
Marginal Productivity is the extra output, productivity, that comes form adding one more unit of
any particular input. The marginal productivity of labor is the extra output that comes when one
more worker is hired.
John Bates Clark → Developed the modern neoclassical theory of income distribution as part
of an explicitly ant