What is Old Institutional Economics?

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:

  1. Institutional Economics is not defined in terms of any policy proposals.
  2. Institutional Economics draws on many different fields of study such as psychology, sociology, and anthropology to develop a better analysis of human behavior.
  3. 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.
  4. 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.
  5. 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.


Related Links:

  1. Hodgson on the Essence of Old Institutional Economics

References:

  1. Commons, John R. “Institutional Economics.” American Economic Review 21, no. 4 (December 1931): 648-57. Print.
  2. Hamilton, Walton H. “The Institutional Approach to Economic Theory.” American Economic Review 9, Supplement (1919): 309-18. Print.
  3. Hodgson, Geoffrey M. “What Is the Essence of Institutional Economics?” Journal of Economic Issues 34.2 (2000): 317-29. Print.
  4. Hodgson, Geoffrey M. “On the Evolution of Thorstein Veblen’s Evolutionary Economics.” Cambridge Journal of Economics 22 (1998): 415-31. Print.
  5. Hodgson, Geoffrey M. “John R. Commons and the Foundations of Institutional Economics.” Journal of Economic Issues 37.3 (2003): 547-76. Print.
  6. Veblen, T. B. 1898A. Why is economics not an evolutionary science? Quarterly Journal of Economics, vol. 12, no. 3, July, 373-97. Print.
  7. Veblen, Thorstein. 1909. “The Limitations of Marginal Utility.” Journal of Political Economy 17.9: 620-36. Print.
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5 Comments

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5 responses to “What is Old Institutional Economics?

  1. Blue Aurora

    To zoom in on one point, one could make the argument that the definition of rationality in economics is actually an excessively narrow and special case. To a certain extent, what is called “neoclassical economics” is vindicated at the individual level of behaviour (particularly with regard to profit-maximization), but not at an aggregated level.

    However, although what is called the Old Institutionalist School of Economics does seem interesting to me, one can make the argument that any competent social scientist would know not to exclude the role of institutions. The Public Choice School, for example, has frequently made the case that politicians are self-interested and use institutions as means to advance themselves. But I feel that a major fault of the Public Choice School is an excessive degree of cynicism: what they are describing is actually one type of behaviour, and that behaviour is essentially a high degree of selfishness. Even though people are self-interested and this world isn’t an ideal world, there are still possibilities for good to be done – otherwise, there wouldn’t be anyone willing to have some sort of involvement in political matters. But now I’m going off on a tangent about something else…if you want to read an article on intellectual history comparing the Public Choice School with the Cambridge School (which I will discuss next) on politicians, please read the following article.

    http://cje.oxfordjournals.org/content/36/4/981.abstract

    The Cambridge School (particularly Alfred Marshall and Arthur Cecil Pigou) was also aware of the importance of institutions. Both Alfred Marshall and A.C. Pigou did write about public goods and clearly understood that institutions had a role in facilitating them – though of course, they didn’t think entirely on the same lines. Please see the following article that examines the differences between Alfred Marshall and A.C. Pigou on the taxation of externalities.

    http://www.tandfonline.com/doi/abs/10.1080/09672567.2011.629300

    From what I’ve gathered of the Institutionalists, it seems to me that one of the reasons they died out despite their capability of delivering insight with nuance was because they rejected the use of mathematics completely. Well, Wesley C. Mitchell has been named as a thinker belonging to the Old Institutionalist School of Economics, but I don’t think he rejected the use of mathematics completely as he helped establish the National Bureau of Economic Research and published works that feature a good amount of quantitative economic data.

    But classifying W.C. Mitchell as one of the “Old Institutionalists” suggests to me that these thinkers were not as tightly unified around core ideas as the term “school of thought” might suggest, and perhaps these thinkers (despite having similar ideas) might not really have been close enough to be considered a school of thought in the first place.

    • If you asked any economist, of course they would respond that institutions are important. No one is denying that “mainstream” economics deal with institutions, that would be ludicrous. That’s why in the post, point (5) the most important one. If anything, Old Institutional Economics is more concerned with a more realistic approach to analyzing human behavior. They also reject the methodical individualistic approach to “mainstream economics” that exists today. In fact you eluded to a reason why they reject it.

      To a certain extent, what is called “neoclassical economics” is vindicated at the individual level of behaviour (particularly with regard to profit-maximization), but not at an aggregated level.

      Keen also made this point when he talked about Emergent Orders in his book, Debunking Economics. Of course, any modern Old Institutionalist would still disagree with the first part of your sentence above.

      The examples you provided were very good though.

      From what I’ve gathered of the Institutionalists, it seems to me that one of the reasons they died out despite their capability of delivering insight with nuance was because they rejected the use of mathematics completely.

      That’s debatable. Some prominent Institutional Economists were against the use of math (I think Veblen was, although I’m not 100% sure), but others weren’t. I will concede that Institutional thought that Math was more limited in its scope (for example, they didn’t like the idea of utility functions), but they didn’t reject Math outright.

      But classifying W.C. Mitchell as one of the “Old Institutionalists” suggests to me that these thinkers were not as tightly unified around core ideas as the term “school of thought” might suggest, and perhaps these thinkers (despite having similar ideas) might not really have been close enough to be considered a school of thought in the first place.

      Yes and No. The school has a lot of different strands, but Mitchell’s 5 points are a pretty solid generalization. That problem was that back then, many of Veblen’s ideas were being heavily criticized (e.g. the behaviorist movement is psychology was in full swing, doing away with the idea of innate beliefs). This sort of put the Institutional School (which at the time, was in the spirit of Veblen) in a state of frenzy. Although people like John R. Commons came along, his methodology and ideas on institutions conflicted with Veblen. It wasn’t until the 1950s, when the behaviorist movement started to slow down, when Old Institutional Economics made a comeback with Veblen as the “godfather”. So I would say more modern incarnations of the school (1950s to the present) are more unified, but in the 1920s-1940s, things were a bit crazy.

      • Blue Aurora

        Evidently, you’re more read on the Old Institutionalists than I am. What I’ve gathered from them is mainly from secondary sources and a few excerpts from the horse’s mouth like Thorstein Veblen. So I apologise for any misconceptions I might have helped spread.

        At the aggregated level, with different sectors in the economy and with different types of organisations serving different purposes (for example, you wouldn’t describe the main motive of a successful charity organisation to be profit-seeking, right?), the profit motive isn’t the only motive around even though it does play a great part in the behaviour of private organisations.

        As for behaviour, “maintstream economics”, and Old Institutionalism…well, behavioural economics and finance was once considered outside the consensus. To a certain extent, one can make the argument that behavioural economics and finance has become incorporated into the orthodoxy. Although the scholars in this area might not have read the writings of the Old Institutionalists, their contributions can explain the observations and arguments that the Old Institutionalists made. With regard to culture, one could also say that research made by economic anthropologists (although I don’t know how well their contributions have been received by other scholars) also supports the positions of the Old Institutionalists.

        Finally, IIRC, the late Harvard economist James Duesenberry did a doctoral thesis that was partly inspired by Thorstein Veblen’s observation. (I think that another reason he made consumption the focus of his dissertation came from the writings of John Maynard Keynes, but I could be wrong.) His doctoral thesis was called “Income, Saving and the Theory of Consumer Behaviour”, and it inaugurated the “relative income hypothesis”. Although the permanent income hypothesis (which, if my memory serves me right, was formed by Franco Modigliani and Milton Friedman) became the dominant concept that was studied, James Duesenberry’s relative income hypothesis is still examined by academic economists every now and then. (I do remember coming across a few articles on the relative income hypothesis that were published in The Quarterly Journal of Economics, the American Economic Review, the Review of Economics and Statistics, the European Economic Review, and the Journal of Public Economics a while ago.)

  2. Pingback: Defending Galbraith Contra Hayek | The Curious Leftist

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