Institutions are the humanly devised constraints that shape human interaction. They reduce uncertainty by providing a structure to political, social, and economic exchange. In order to understand the role of institutions in making choices we must rethink our views about human behavior and then explore the costs of exchange. In this chapter I shall first briefly examine the behavioral assumptions used in economics in order to develop a transaction-cost theory of exchange. I then apply the framework to both economic and political exchange. I conclude with a brief discussion of the implications of the theory for analyzing institutions.

THE BEHAVIORAL ASSUMPTIONS OF ECONOMICS

The basic behavioral assumption of neoclassical economics makes a direct connection between expected utility and outcomes with no intervening dilemmas of uncertainty. There are no institutions in such a setting. They are unnecessary precisely because this behavioral assumption ignores the uncertainty that arises from the incomplete and imperfect processing of information, a pervasive feature of human interaction. Institutions reduce the costs of human interaction from those that would be found in an institution-free world (although there is no implication in that statement that they are “efficient” solutions).

The behavioral assumptions of economics have recently been the subject of a good deal of critical scrutiny (Hogarth and Reder 1986), which has focused on the anomalies of intransitivity, preference reversal, framing, and inconsistent processing of subjective probabilities. Less attention has been given the much more fundamental issue of which behavioral assumptions are consistent with the existence of institutions.