The revival of Veblenian institutional economics.

Author:Hodgson, Geoffrey M.
Position:Evaluation, research and growth of institutional economics

The novelties of today are a ... later generation of the commonplaces of the day before yesterday.

Thorstein Veblen, Absentee Ownership (1923)

Institutional economics is more than a century old. After a period of interwar hegemony in the United States, it suffered from decline and fragmentation, leading to its estrangement from the mainstream of economics (Hodgson 2004). By the 1990s, however, some institutional and evolutionary ideas had re-emerged in mainstream theory and elsewhere. Today, discussion of the role and nature of institutions in economics is commonplace (North 1991; 1994; Schotter 1981; Williamson 1975; 2000). The revival of evolutionary economics was much inspired by the work of Richard Nelson and Sidney Winter (1982), who have since acknowledged Veblen's contribution (Winter 1990; Nelson 1995). More particularly, writing in this journal, Mauricio Villena and Marcelo Villena (2004) have explored some similarities between modern evolutionary game theory and Veblen's evolutionary approach. Overall, there seem to be new opportunities for the revival of a Veblenian institutional and evolutionary economics.

Seven sections follow. In turn they address: key developments in the new institutional economics; some developments in mainstream economics; revised ideas on the human agent and rationality; the reemergence of endogenous preferences; and the recognition of bounded rationality and program-based behavior. Another section situates the new Veblenian economics in the wider context of economic theory. The conclusion outlines a research agenda for the early twenty-first century.

Evolution in the New Institutional Economics

In the 1970s and 1980s, a prominent theoretical project in the "new institutional economics" was to explain the existence of political, legal, or social institutions by reference to a model of given, individual behavior, tracing out its consequences in terms of human interactions. The attempted explanatory movement is from individuals to institutions, ostensibly taking individuals as primary and given, in an initial institution-free "state of nature."

However, this research program could not provide a complete general theory of the emergence and evolution of institutions. Alexander Field (1979; 1981; 1984) argued that the new institutional economics always has to presume given individuals acting in the context of governing rules of behavior. In the original, hypothetical, "state of nature" from which institutions are seen to have emerged, a number of weighty rules, institutions and cultural and social norms have already and unavoidably been presumed.

For example, in attempts to explain the origin of institutions through game theory, some norms and rules must be presumed at the start, and game theory can never explain the elemental rules themselves. Even in a sequence of repeated games, or of games about other (nested) games, at least one game or meta-game, with a structure and payoffs, must be assumed at the outset.

Williamson (1975, 20) famously proposed that "in the beginning there were markets." Some individuals then go on to create firms and hierarchies, which endure if they involve lower transaction costs. However, the market itself is an institution, involving complex rules. In reality, markets involve social norms and customs, instituted exchange relations, and information networks that have to be explained (Hodgson 1988; McMillan 2002; Vanberg 2001). Markets are not an institution-free beginning.

The institution of private property also requires explanation. It has been argued that it can generally arise spontaneously through individual interactions, involving reputation and other effects (North 1991). However, these theoretical arguments break down with large numbers or radical uncertainty. The possibility of property rights emerging in a complex society without any role for the state has been challenged by writers even within the new institutionalist tradition (Sened 1997; Mantzavinos 2001).

Individuals rely on customs, norms, and language in order to interact. Language itself is an institution. Interpersonal communication, which is essential to all stories of institutional emergence, itself depends on linguistic and other rules and norms. For instance, the shared concept of individual property requires some means of communication using common concepts and norms, both before and after explicit or tacit recognition of property rights can be established. Some prior institutions are always required.

The reception of information by individuals requires paradigms or cognitive frames to process and make sense of that information. We cannot understand the world without concepts and we cannot communicate without some form of language. As the original institutionalists argued, the transmission of information from institution to individual is impossible without a coextensive process of enculturation, in which the individual learns the meaning and value of the sense data that is communicated. Overall there are good reasons why the starting point of a given individual is generally misconceived.

What is being contested here is the possibility of using given individuals as the institution-free starting point in the explanation. Institutions constrain, influence and enable individuals. Accordingly, if there are institutional influences on individuals and their goals, then these are worthy of explanation. In turn, the explanation of those may be in terms of other purposeful individuals. We are involved in an apparently infinite regress, like "which came first, the chicken or the egg?" It is simply arbitrary to stop at one particular stage in the explanation and say "it is all reducible to individuals" just as much as to say it is "all social and institutional."

All theories must first build from elements which are taken as given. However, the argument here undermines any claim that the explanation of the emergence of institutions can start from some kind of institution-free ensemble of (rational) individuals in which there is supposedly no rule or institution to be explained. At the very minimum, stories of the development of institutions depend upon interpersonal communication of information. And the communication of information itself requires shared conventions, rules, routines and norms. Consequently, the new institutionalist project to explain the emergence of institutions on the basis of given individuals runs into difficulties, particularly with regard to the conceptualization of the initial state from which institutions are supposed to emerge.

This does not mean that new institutionalist research is without value, but it suggests that the starting point of explanations cannot be institution-free. What is required is a theory of process, development and learning, rather than a theory that proceeds from an original "state of nature" that is both artificial and untenable. In his 1989 lecture on receipt of the Nobel Prize, the econometrician Trygve Haavelmo argued that

existing economic theories are not good enough ... We start by studying the behavior of the individual under various conditions of choice.... We then try to construct a model of the economic society in its totality by a so-called process of aggregation. I now think this is actually beginning at the wrong end.... Starting with some existing society, we could conceive of it as a structure of rules and regulations within which the members of society have to operate. Their responses to these rules as individuals obeying them, produce economic results that would characterize the society. (1997, 15) Haavelmo rightly suggests that historically specific institutions should be brought into the analysis at the beginning. Such a reformulated institutionalist project would stress the evolution of institutions, in part from other institutions, rather than from a hypothetical, institution-free "state of nature."

Other recent studies have developed in this direction. Jack Knight (1992) criticizes much of the new institutionalist literature for neglecting the importance of distributional and power considerations in the emergence and development of institutions. Even more clearly, Masahiko Aoki (2001) identifies the problem of infinite explanatory regress in much of the former literature and develops a novel approach. He takes as given not only individuals, but also a historically bestowed set of institutions. With these materials, he explores the evolution of further institutions using game theory. The next step, which Aoki recognizes but does not complete, is to develop a more evolutionary and open-ended framework of analysis.

The Changing Face of Mainstream Economics

Partly because of insurmountable theoretical problems in general equilibrium analysis (Kirman 1989; Rizvi 1994), during the 1980s by game theory replaced it at the cutting edge of mainstream economics. This meant the abandonment of a general theory of economic interactions. By contrast, the results of game theory depend on the particular rules and mode of play of the game. Instead of everything interacting with everything else in a continuous universal field of infinite connections, game theory assumes a structured world of binding rules and limited interconnectedness (Potts 2000). Game theory is thus more accommodating to ideas of institutions, conventions and rules (Schotter 1981; Sugden 1986). Furthermore, game theory has revealed that standard neoclassical definitions of rationality are problematic, and in some contexts, rationality has ambiguous outcomes (Sugden 1991; Hargreaves Heap and Varoufakis 1995; Gintis 2000).

However, full-blown models of individual interaction in game theory, where every possible human interaction and defined response is considered, and every agent assumes that every other is fully rational, have fallen into widely acknowledged problems of tractability and relevance. In response, some have hinted at an altered direction of...

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