Adam Smith began his Wealth of Nations with an examination of the internal works of a pin factory, but he soon turned his attention to other things: … - Þráinn Eggertsson

Demsetz (1980) refers to the hypothetical economic system of neoclassical economics as the decentralized model. According to the usual implicit and explicit assumptions of the decentralized model, the cost of information is zero; private property rights are fully defined and enforced at zero cost; and the state stays in the background, upholding the institutions of market exchange. Economic outcomes derived from this model are found in the standard textbook: For any underlying distribution of resources, wealth is maximized; output is valued by consumers who take indirectly into account the value of leisure and other extra-market activities; income distribution depends on wages and the prices of nonhuman inputs which equal the value of marginal products; and economic resources always find their highest-valued uses.

This book grew out of my interest in organizational forms and institutional arrangements and their impact on economic outcomes. Price theory or microeconomics, in its conventional form, treats organizations and institutions the same way as it treats the law of gravity: These factors are implicitly assumed to exist but appear neither as independent nor as dependent variables in the models. Such economy in model making can be eminently reasonable. It enables us to isolate critical relationships and simplifies the use of mathematical tools in the analysis. However, unlike the law of gravity, organizations and institutions are not invariant; they vary with time and location, with political arrangements and structures of property rights, with technologies employed, and with physical qualities of resources, commodities, and services that are exchanged. In fact, production involves not only the physical transformation of inputs into outputs but also the transfer of property rights between the owners of resources, commodities, and labor services. In the transfer of rights, whether within firms or across markets, agents maximize their objective functions subject to the constraints of organizations and institutions.

Let us define institutions as sets of rules governing interpersonal relations, noting that we are talking about formal political and organizational practices.