Old institutional economics

What Is Old Institutional Economics?

Old institutional economics (OIE) is a school of economic thought that emphasizes the crucial role of institutions in shaping economic behavior and outcomes. Unlike earlier classical or neoclassical economics that often focused on atomistic individuals and abstract markets, OIE views the economy as deeply embedded within complex social, legal, and political structures. This approach belongs to the broader category of heterodox economic thought, challenging mainstream assumptions by highlighting how habits, customs, laws, and social norms influence human action and economic processes. Old institutional economics considers institutions not merely as external constraints but as evolving entities that mold individual preferences and societal structures.

History and Origin

The roots of old institutional economics can be traced to the late 19th and early 20th centuries in the United States, emerging as a critique of the prevailing neoclassical theories. Its formal recognition is often attributed to the American economist Walton H. Hamilton, who first used the term "institutional economics" in a 1919 article titled "The Institutional Approach to Economic Theory."³⁷, ³⁸ This foundational paper argued for a shift in economic analysis to incorporate the study of collective action and evolving societal rules. Early proponents and key figures in OIE included Thorstein Veblen, John R. Commons, and Wesley C. Mitchell.³⁶

Veblen, known for his critiques of conventional economic theory, posited that the economy was profoundly influenced by social institutions, advocating for an interdisciplinary approach that linked economics with other social sciences. His seminal work, "The Theory of the Leisure Class," published in 1899, explored how social status and "conspicuous consumption" drive certain economic activities, moving beyond purely rational utility maximization. Commons contributed significantly by focusing on the legal foundations of economic transactions and the role of collective action in controlling, liberating, and expanding individual actions.³⁵ He extensively documented the historical development of labor movements and pioneered research in industrial relations.³⁴ Mitchell, meanwhile, dedicated his work to the empirical study of business cycles, seeing them as outcomes of evolving economic behavior and institutional structures.³³

Key Takeaways

• Old institutional economics examines how formal and informal institutions, such as laws, customs, and norms, shape economic activity.
• It emerged in the late 19th and early 20th centuries as a heterodox critique of classical and neoclassical economic assumptions.
• Key figures include Thorstein Veblen, John R. Commons, and Wesley C. Mitchell, who emphasized the evolutionary and interdisciplinary nature of economic phenomena.
• OIE focuses on collective action, historical context, and the dynamic interplay between individuals and their institutional environment.
• It highlights how institutions can either facilitate or obstruct economic development and social welfare.

Interpreting Old Institutional Economics

Interpreting old institutional economics involves understanding that economic phenomena are not solely driven by individual rational choices in idealized markets. Instead, OIE posits that individuals are shaped by, and operate within, a complex web of institutional arrangements. This perspective emphasizes that institutions influence preferences, technologies, and the distribution of wealth, leading to outcomes that may not always align with notions of optimal efficiency assumed by other schools of thought.³²

For OIE, economic analysis requires a deep dive into the historical, social, and cultural contexts that give rise to specific institutional frameworks. For example, understanding labor markets necessitates examining not just supply and demand but also labor laws, trade unions, and societal norms around work and wages.³¹ The focus is on the "working rules" of collective action, which define what individuals "can," "cannot," "must," "must not," "may," or "may not" do, thereby influencing economic behavior.³⁰

Hypothetical Example

Consider a hypothetical country undergoing economic development. A neoclassical economist might suggest deregulation and privatization to enhance market efficiency, assuming rational actors will optimize resource allocation. However, an old institutional economics perspective would ask deeper questions.

For instance, are there strong property rights protections? If not, privatization might lead to asset stripping rather than productive investment. Are there established legal systems to enforce contracts and resolve disputes fairly? Without reliable enforcement mechanisms, transaction costs for businesses could remain prohibitively high. Are existing social norms conducive to entrepreneurship and innovation, or do they favor rent-seeking and maintaining the status quo?

An OIE analysis would delve into these institutional realities, recognizing that simply transplanting market-oriented policies without considering the existing institutional fabric might lead to unintended and adverse outcomes. It would emphasize the need for institutional reforms that align with the society's historical development and cultural context, rather than a universal template.

Practical Applications

Old institutional economics has practical applications across various domains, particularly in areas where the interplay of social structures and economic activity is evident.

In public policy formulation, OIE informs approaches that recognize the deep impact of established practices and legal frameworks. For example, John R. Commons' work directly influenced labor legislation and social welfare programs in the United States, including worker's compensation, by analyzing the collective action and power dynamics within industrial relations.²⁹ His ideas highlighted the need for institutions to mediate conflicting interests and provide a framework for economic order.

Another application is in the study of economic development. Rather than assuming that developing economies simply need more capital or free markets, old institutional economics emphasizes that sustainable growth depends on building effective and legitimate institutions, such as clear property rights, reliable contract enforcement, and transparent governance structures.²⁸ This perspective recognizes that institutions evolve and are often resistant to rapid change, requiring a more nuanced approach to reform.

Furthermore, the OIE tradition, particularly through the work of Wesley C. Mitchell, has contributed to the understanding of business cycles as complex phenomena influenced by evolving institutional arrangements and psychological factors, rather than purely mechanical forces. Mitchell's empirical focus laid groundwork for macroeconomic analysis that incorporates real-world complexities.²⁵, ²⁶, ²⁷

Limitations and Criticisms

Despite its valuable contributions, old institutional economics faces several limitations and criticisms. One significant critique is its perceived lack of a unified theoretical framework and methodological consistency. Critics argue that OIE tends to be more descriptive than analytical, making it challenging to generate testable hypotheses or precise predictions.²³, ²⁴ The broad definition of "institution" itself has been cited as contributing to theoretical ambiguity, encompassing everything from specific organizations to cultural norms.

Another common criticism relates to its emphasis on holism and its sometimes vague understanding of how individual actions aggregate to form institutional change.²² While OIE criticizes the "rational economic agent" of neoclassical models for being too simplistic, it sometimes struggled to articulate a clear alternative model of individual economic behavior that adequately explains how preferences are formed and how individuals interact within and shape institutions.²⁰, ²¹

Some modern scholars, such as Deirdre McCloskey, have criticized both old and New Institutional Economics for focusing too heavily on material incentives and institutional structures while potentially overlooking the crucial role of changing ideas, rhetoric, and cultural values in driving economic progress.¹⁹ McCloskey argues that intellectual and ideological shifts are more fundamental drivers of societal change than institutional arrangements alone.¹⁸

Old Institutional Economics vs. New Institutional Economics

Old institutional economics (OIE) and New Institutional Economics (NIE) are distinct yet related schools of thought that both emphasize the role of institutions in economic analysis. The primary difference lies in their methodological approaches and theoretical foundations.

OIE, as discussed, emerged from the work of American economists like Thorstein Veblen, John R. Commons, and Wesley C. Mitchell. It is often characterized by an inductive, evolutionary approach, focusing on historical context, collective action, and the socio-cultural embedding of economic activity. OIE tends to be critical of the assumptions of neoclassical economics, particularly the idea of a purely rational, self-interested individual and market equilibrium. It emphasizes the "reconstitutive downward causation" where institutions shape individual behavior and preferences.¹⁵, ¹⁶, ¹⁷

In contrast, New Institutional Economics, which gained prominence in the latter half of the 20th century with figures like Ronald Coase, Douglass North, and Oliver Williamson, largely incorporates concepts from neoclassical economic theory. NIE uses tools from mainstream economics, such as microeconomics and game theory, to analyze institutions.¹⁴ A central focus of NIE is on transaction costs and property rights, seeking to explain how institutions emerge to reduce these costs and facilitate efficient economic exchange.¹¹, ¹², ¹³ While OIE is more descriptive and holistic, NIE is generally more analytical, formal, and deductive, assuming individuals are rational maximizers, albeit with bounded rationality.⁹, ¹⁰

FAQs

What is the core idea of old institutional economics?

The core idea of old institutional economics is that economic activity and outcomes are profoundly shaped by institutions, which include formal laws, regulations, and informal customs, habits, and social norms. It argues that these institutions are not static but evolve over time and critically influence human economic behavior.⁷, ⁸

Who are the main figures associated with old institutional economics?

The main figures associated with old institutional economics are Thorstein Veblen, known for his critique of traditional economics and concept of "conspicuous consumption"; John R. Commons, who focused on collective action and legal foundations; and Wesley C. Mitchell, who conducted extensive empirical work on business cycles.⁶

How does old institutional economics differ from traditional microeconomics?

Old institutional economics differs from traditional microeconomics by challenging its assumptions of isolated, perfectly rational individuals and frictionless markets. While traditional microeconomics often takes institutions as given, OIE explicitly studies how institutions are formed, evolve, and influence individual preferences, behaviors, and the very structure of markets. It adopts a more holistic and evolutionary economics perspective.⁴, ⁵

Is old institutional economics still relevant today?

Yes, old institutional economics remains relevant today, particularly in areas like developmental economics, labor economics, and the study of economic systems. Its emphasis on the historical and social embeddedness of economic activity, the role of power structures, and the importance of collective action offers valuable insights that complement or challenge more mainstream neoclassical economics approaches, and it continues to be a leading heterodox approach.¹, ², ³