Question

Carefully explain why the following structures of production are inefficient and how the New Institutional Economic approach to (and explanation of) that inefficiency varies from the neoclassical approach. (

a) A monopoly;

(b) Externalities in production.

Answer 1

a) The monopoly pricing creates a deadweight loss because the firm forgoes transactions with the consumers. Monopolies can become inefficient and less innovative over time because they do not have compete with other producers in a marketplace. In the case of monopolies, abuse of power can lead to market failure.

b) A negative externality causes either the demand curve to be higher than the social benefits (negative consumption externality) or the social costs to be greater than the supply curve. In the presence of externalities, the market outcome is inefficient and differs from the social optimum.

New institutional economics (NIE) is an economic perspective that attempts to extend economics by focusing on the institutions that underlie economic activity and with analysis beyond earlier institutional economics and neoclassical economics. It can be seen as a broadening step to include aspects excluded in neoclassical political economy. The NIE assume that individuals are rational and that they seek maximize their preferences, but that they also have cognitive limitations, lack complete information and have diffculties monitoring and enforcing agreements. As a result, institutions form in large part as an effective way to deal with transaction costs.