In Thorstein Veblen’s famous essay, Why is Economics not an Evolutionary Science, he makes his famous critique of the “hedonistic” assumptions of “classical economics”.
The hedonistic conception of man is that of a lightning calculator of pleasures and pains, who oscillates like a homogeneous globule of desire of happiness under the impulse of stimuli that shift him about the area, but leave him intact. He has neither antecedent nor consequent. He is an isolated, definitive human datum, in stable equilibrium except for the buffets of the impinging forces that displace him in one direction or another. Self-imposed in elemental space, he spins symmetrically about his own spiritual axis until the parallelogram of forces bears down upon him, whereupon he follows the line of the resultant. When the force of the impact is spent, he comes to rest, a self-contained globule of desire as before. (Veblen 1898: 389-390)
Unfortunately, not much has changed since Veblen wrote this paper. The most prominent assumption in neoclassical models, the “rational economic agent”, is no different from the hedonistic “lightening calculator” that Veblen criticized over a century ago. While these assumptions may be useful for isolating variables and analyzing mechanisms, they limit the real world application of Neoclassical models. This narrow methodological approach leaves little room for institutional arrangements, things like culture, social norms, and other important factors that can shape behavior. Old Institutional Economics tries to mitigate this gap in Neoclassical Economic theory.
In his paper, The Institutional Approach to Economic Theory, Walton Hamilton gave five propositions that summarized the various aspects of Old Institutional Economics:
- Institutional Economics is not defined in terms of any policy proposals.
- Institutional Economics draws on many different fields of study such as psychology, sociology, and anthropology to develop a better analysis of human behavior.
- Institutions are a vital component of any economy and a major task for economics should be to study institutions and the process of institutional change.
- The economy is an open ended system subject to evolutionary change, embedded with complex elements such as culture, social class, political power, and other variables.
- The neoclassical idea of the rational utility maximizing agent is inadequate and erroneous. Institutional Economics doesn’t take the individual as given. Instead, individuals are shaped by institutional and cultural arrangements. The “downward causation” of institutions can influence behavior in important ways.
Neoclassical economics has in some form incorporated (1), (2), (3), and (4) in their models (e.g. the theories of Gary Becker incorporate biology in Neoclassical Economic theory, striking 2 off the list). So the first four descriptions are necessary, but not sufficient conditions for defining Old Institutional Economics. Logically, it’s the fifth point that ties everything together.
The notion that individuals are not given, but shaped by institutions is what separates Old Institutional economics from mainstream economics:
Institutionalism is distinguished from both mainstream economics and the “new institutional economics” precisely for the reason that it does not assume a given individual, with given purposes or preference functions. Instead of a bedrock of given individuals, presumed by the mainstream and new institutional economics, the old institutionalism holds to the idea of interactive and partially malleable agents, mutually entwined in a web of partially durable and self-reinforcing institutions. No other criterion demarcates so clearly the old institutional economics, on the one hand, from new institutional and mainstream economics on the other. (Hodgson 2000: 325)
The quintessential feature of Old Institutional Economics is that it rejects methodological individualism. The relationship between the individual and the economy isn’t a one way street. Human preferences and motives aren’t solely determined by individual cognition and socioeconomic activity isn’t solely determined by individuals. Human preferences are shaped by institutions and institutions are the outcomes of individual behavior. There is both an upward and downward causation:
The growth and mutations of the institutional fabric are an outcome of the conduct of the individual members of the group, since it is out of the experience of the individuals through the habituation of individuals, that institutions arise; and it is in this same experience that these institutions act to direct and define the aims and end of conduct. (Veblen 1909: 629)
This doesn’t mean that Old Institutional Economics isn’t compatible with Neoclassical Economics, it could very well be complementary. John R. Commons argued that the insights of institutional economics could compliment the insights of the “classical school”:
All of these notions are doubtless involved in institutional economics, but they may be said to be metaphors or descriptions, whereas a science of economic behavior requires analysis into similarities of cause, effect or purpose, and a synthesis in a unified system of principles. And institutional economics, furthermore, cannot separate itself from the marvelous discoveries and insight of the classical and psychological economists. It should incorporate, however, in addition, the equally important insight of the communistic, anarchistic, syndicalistic, fascistic, cooperative and unionistic economists. (Commons 1931: 648)
However, while methodological individualism isn’t necessarily a pre-requisite for Neoclassical Economics, it is currently a defining feature. Until that changes, its analysis of human behavior within an economic context will continue to be woefully inadequate.
- Commons, John R. “Institutional Economics.” American Economic Review 21, no. 4 (December 1931): 648-57. Print.
- Hamilton, Walton H. “The Institutional Approach to Economic Theory.” American Economic Review 9, Supplement (1919): 309-18. Print.
- Hodgson, Geoffrey M. “What Is the Essence of Institutional Economics?” Journal of Economic Issues 34.2 (2000): 317-29. Print.
- Hodgson, Geoffrey M. “On the Evolution of Thorstein Veblen’s Evolutionary Economics.” Cambridge Journal of Economics 22 (1998): 415-31. Print.
- Hodgson, Geoffrey M. “John R. Commons and the Foundations of Institutional Economics.” Journal of Economic Issues 37.3 (2003): 547-76. Print.
- Veblen, T. B. 1898A. Why is economics not an evolutionary science? Quarterly Journal of Economics, vol. 12, no. 3, July, 373-97. Print.
- Veblen, Thorstein. 1909. “The Limitations of Marginal Utility.” Journal of Political Economy 17.9: 620-36. Print.