Early Institutional Theory in Economics

1. European Quarrels

It is good at the outset to acknowledge the lack of logical coherence in the strands of work to be examined. In many respects, the “old” institutional economics bears a stronger intellectual kinship with the “new” institutional approaches advanced by sociologists and organiza- tional scholars than to the “new” institutional economics. Conversely, the “new” institutional economics is more indebted to the critics of “old” institutional economics than to their early namesakes. The earli- est institutional arguments arose in Germany and Austria in the late 19th century as one by-product of the famous Methodenstreit: a debate over scientific method in the social sciences. Drawing energy and inspi- ration from the earlier Romantic movement as well as from the ideas of Kant and Hegel, a collection of economists challenged the conventional cannon positing that economics could be reduced to a set of universal laws. Led by Gustav Schmoller (1900–1904), this Historical School insisted that economic processes operate within a social framework that is in turn shaped by a set of cultural and historical forces. Histori- cal and comparative research was required to discern the distinctive properties of particular economic systems. Moreover, Schmoller and his associates called for economics to eschew its simplistic assumptions regarding “economic man” and embrace more realistic models of human behavior.

The principal defender of the classical approach in this debate was Carl Menger (1883/1963), the Viennese economist, who insisted on the utility of simplifying assumptions and the value of developing eco- nomic principles that were both abstract and timeless. Rather than denying the importance of broader societal institutional forces, Menger argued that institutions were themselves social phenomena in need of theoretical explanation. It is for this reason that Langlois (1986a: 5) concludes that Menger “has perhaps more claim to be the patron saint of the new institutional economics than has any of the original institutionalists.”

As with many intellectual debates, the warring factions each sharpened and perfected their arguments, but neither succeeded in convincing the other. Attempts at reconciliation and synthesis occurred only among scholars of a later generation—principally in the work of Weber, to be discussed later.

2. American Institutional Economists

Many of the ideas of the Historical School were embraced and further developed by American institutional economists, a number of whom were trained in Germany. An earlier cohort working in the mid- 19th century did not receive much attention, but by the turn of the century, three institutional economists had become quite influential: Thorstein Veblen, John Commons, and Westley Mitchell. While there were important differences in their views, all criticized conventional economic models for their unrealistic assumptions and inattention to historical change.

The focus of Veblen’s work was on economic change, but he did not embrace the German Historical School, which he believed was inappropriately satisfied with developing a narrative account of indus- trial and capitalist development. Rather, he distanced himself both from this group and from neoclassical economists by insisting that economics must offer a theory of economic change that embraced a realistic model of individual actors and based their theories on dynamic rather than static models of the economy/society.

Veblen was highly critical of the underlying economic assump- tions regarding individual behavior. He ridiculed “the hedonistic conception of man as that of a lightning calculator of pleasures and pain” (Veblen 1898: 398). Instead, he insisted that much behavior was governed by habit and convention. “Not only is the individual’s conduct edged about and directed by his habitual relations to his fel- lows in the group, but these relations, being of an institutional charac- ter, vary as the institutional scene varies” (Veblen 1909: 245). Indeed, Veblen (1919: 239) defined institutions as “settled habits of thought common to the generality of man.” He embraced the pragmatic con- ception of individuals as knowing actors seeking “self-realization and expression in an unfolding activity” immersed in ongoing social envi- ronments (Veblen 1919: 74).

At the same time, Veblen (1898) insisted that economics should reorient itself as an evolutionary science, moving away from its taxo- nomic approach that viewed equilibrium as the normal state. He called for the creation of a science of cumulative causation. Also, like Marx, as discussed later, Veblen viewed much of the dynamism of the economy as driven by a set of internal contradictions—in Veblen’s case, between the industrial system focusing on technology, production, and coordi- nation on the one hand, and the business system with its emphasis on acquisition, competition, consumption, and marketing on the other. Veblen was critical of the tendencies of the business systems of econo- mies, including speculation in financial markets, which he regarded as “inherently wasteful and detrimental to the community” (Hamilton and Petrovic 2009: 357).

Like Veblen, Commons (1924: 7) challenged the conventional emphasis in neoclassical economics on individual choice behavior, sug- gesting that a more appropriate unit of economic analysis was the transaction, a concept borrowed from legal analysis. “The transaction is two or more wills giving, taking, persuading, coercing, defrauding, commanding, obeying, competing, governing, in a world of scarcity, mechanisms and rules of conduct” (Commons 1924: 7). The “rules of conduct” to which Commons alludes are social institutions. Institu- tional rules were necessary to define the limits within which individu- als and firms could pursue their objectives (Commons 1950/1970).

To Commons, the institutions existing at a specific time represent nothing more than imperfect and pragmatic solutions to reconcile past conflicts; they are solutions that consist of a set of rights and duties, an authority for enforcing them, and some degree of adher- ence to collective norms of prudent reasonable behavior (Van de Ven 1993: 142).

All three institutional economists emphasized the importance of change and were critical of their colleagues for not making its exami- nation central to their work. Veblen embraced an evolutionary perspec- tive and insisted that a valid economics would emphasize the role of technological change and trace the changing phases of the economy. Commons likewise stressed the centrality of change, viewing the economy as “a moving, changing process” (Commons 1924: 376) and the firm as a “going concern” (Ansell 2009: 474). Mitchell believed that conventional economics was a hindrance to understanding the nature of the business cycle, and he devoted much of his energies to studying economic change. Like most institutionalists (except for some varieties of rational choice scholars), he was reluctant to embrace an assumption of economic equilibrium. As one of the founders of the National Bureau of Economic Research and chair of the committee that published the voluminous report Recent Social Trends (President’s Research Committee on Social Trends 1934), Mitchell pioneered the collection of empirical data on the operation of the economy and its ramifications in multiple sectors, insisting that economic principles should be grounded in facts, not solely in abstract, deductive theories.

The American institutionalists, particularly Veblen and Commons, were influenced not only by the German Historical School but also by the homegrown philosophy of pragmatism as espoused by John Dewey, William James, Charles Peirce, and others (Menand 1997). The central premise underlying pragmatist approaches is the utility of viewing human action as efforts by individuals to behave in sensible and purposeful ways within historical social contexts. We amplify these views in Chapter 3.

Jacoby (1990) argues that the approaches offered by the early insti- tutionalists departed from those adopted by their mainstream, neoclas- sical colleagues in four important respects:

  • Indeterminancy determinancy. While the orthodox model assumed “perfect competition and unique equilibria, the institu- tionalists pointed to pervasive market power and to indetermi- nacy even under competition” (p. 318).
  • Endogenous exogenous determination of preferences. Neoclassical theorists posited individual preferences or wants, while institu- tionalists argued that such preferences were shaped by social institutions, whose operation should be the subject of economic analysis.
  • Behavioral realism vs. simplifying assumptions. Institutional theo- rists argued that economists should use more pragmatic and psychologically realistic models of economic motivation rather than subscribe to naïve utilitarian assumptions.
  • Diachronic synchronic analysis. Rather than assuming the “timeless and placeless” assumptions of the neoclassical theo- rists, institutionalists insisted that economists should ascertain “how the economy acquired its features and the conditions that cause these features to vary over time and place” (p. 320).1

Regardless of whether they were correct in their accusations and assertions, the early institutional economists did not prevail within the discipline of economics: Neoclassical theory was victorious and contin- ues its dominance up to the present time. Prior to the rise of the new institutional economics in the 1970s, only a few economists attempted to carry forward the institutionalists’ agenda, the best known of whom are J. A. Schumpeter, Karl Polanyi, John Kenneth Galbraith, and Gunnar Myrdal (see Swedberg 1991). Arguably, the subfields of economics most affected by the legacy of the institutional theorists are those of labor economics, the field in which Commons specialized; industrial relations, which focuses on broader social and political factors affecting economic structures and processes; and the economics of industry, which examines the varying configurations of industrial structures and their effects on the strategies and performance of individual firms.

Why was the impact of the early institutionalists blunted? Modern- day commentators offer several explanations. The German Historical School no doubt overemphasized the uniqueness of economic systems and underemphasized the value of analytic theory. Even sympathetic critics acknowledge that Veblen exhibited “an explicit hostility to intel- lectual ‘symmetry and system-building’” (Hodgson 1991: 211) and that Commons’ arguments were hampered by his “idiosyncratic terminol- ogy and unsystematic style of reasoning” (Vanberg 1989: 343). But a more serious shortcoming was the tendency for the work to degenerate into naïve empiricism and historicism. Emphasizing the importance of the particular, of time and place and historical circumstance, institu- tional analysis came more and more to underline “the value of largely descriptive work on the nature and function of politico-economic insti- tutions” (Hodgson 1991: 211).

Here then, we have the principal reason why the godfather of the “new” institutional economics, Ronald Coase (1983: 230), so cavalierly dismissed the “old” institutional economics: “Without a theory they had nothing to pass on except a mass of descriptive material waiting for a theory, or a fire.”

The battle between the particular and the general, between the temporal and the timeless is one that contemporary institutional theo- rists continue to confront.

Source: Scott Richard (2013), Institutions and Organizations: Ideas, Interests, and Identities, SAGE Publications, Inc; Fourth edition.

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