CHAPTER 9:

Institutionalist School

1–1
What is an "institutional" economist?
• Focus on understanding the role of human-
made institutions in shaping economic behavior
• Institutions may include the family, the
corporation, the trade union, the financial
system, the legal system, the state (government)
• Economics cannot be separated from the
political and social system within which it is
embedded
Who are they?
• Thorstein Veblen
• John R. Commons
• Wesley Mitchell
• Generally a diverse group of writers who have a
few common themes
What are these common themes?
• Critics of orthodox economics (Neoclassical)
• Objected to the notion that the "laws"
constructed by Neoclassical economists were
timeless generalizations and contended instead
that the economic behavior of men, like any
other human activity, had to be analyzed in
terms of the social context in which it was
imbedded
What are these common themes? (cont’d)

• Neoclassical economics could be applied only to

special historical circumstances and in very
restricted contexts
• "A gang of Aleutian Islanders slashing about in
the wrack and surf with rakes and magical
incantations for the capture of shell-fish are held,
in point of taxonomic reality, to be engaged in a
feat of hedonistic equilibration in rent, wages,
and interest." (Veblen)
What are these common themes? (cont’d)

• Focus on collective rather than individual action

• Preference for an “evolutionary” rather than a
mechanistic approach to economics
• Emphasis on empirical observation over
deductive reasoning
• Generally, institutionalists do not believe in the
harmony of a market system and the policy of
laissez faire
What are these common themes? (cont”d)

• Neclassical economics studied allocation of

scarce resources among alternative uses
• Institutionalists studied how the institutional
structure evolved and how institutions reflected
the prevailing social/political/economic structure
New institutional economics
• Combines economics, law, organization theory,
political science, sociology and anthropology to
understand social, political and commercial
(e.g., business) institutions. “Its goal is to explain
what institutions are, how they arise, what
purpose they serve, how they change and how,
if at all, they should be reformed.” Peter Klein
at http://encyclo.findlaw.com/0530book.pdf
M
o
n
d
Thorstein Bunde Veblen
a
y
,
N
o 1857-1929
v
e • Born on July 30, 1857 in a
m
b
log cabin on a small farm
e in the western Wisconsin
r
2 frontier.
6
,
• Grew up in Minnesota—in
2 a Norwegian community.
0
1 • Veblen attended Yale for
8
graduate work.
 Developed a close
friendship with the sociology
professor, William Graham
Sumner
(Ashley & Orenstein, 2001, pp. 351-353)

© 2002-2006 by Ronald Keith Bolender 9

1
0

Thorstein Bunde Veblen

• Throughout his life, Veblen saw himself as an outsider,

really neither a part of the Norwegian community in which
he was born, nor a part of the larger U.S. society in which
he spent his adult years.
• He compared himself with the secularized European Jew,
whom Veblen saw as fully at home neither in his culture
nor in the larger society.
• Nonetheless, Veblen believed it was precisely his partial
distance from modern U.S. society that allowed him to
see various aspects of social life of which others were not
aware.
 The theorist, Ezra Park, would later term this sociological
phenomenon as the marginal man.
© 2002-2006 by Ronald
Monday, November 26, 2018 Keith Bolender
Veblen's criticism of Neoclassical theory
• Classical and neoclassical assumptions are
“unscientific”
• He also believed this to be true of Marxism and
German Historical School
• Did not believe that there was “harmony” in a
market system – it did not conform to “natural”
laws
• Did not believe that market outcomes were
necessarily good or desirable
Veblen's criticism of Neoclassical theory
(continued)
• He charged that Classical and neoclassical economics
was pre-Darwinian in that it was moving toward some
determined end (long run equilibrium) rather than
constantly evolving in response to environmental forces
(Darwin lived 1809-1882)
• This is an interesting point, I think, since capitalism is
sometimes called “Economic Darwinism.”
• Did not like static analysis, too many factors are held
constant (our friend, “ceteris paribus”)
• Did not believe that self interest would promote the
public good
Veblen's criticism of Neoclassical theory
(continued)
• He criticized the idea that “making profits is the
same as making goods;” this may have been
true in Smith’s time, but not in a more advanced
industrial society where production is separated
from ownership.
• Large corporations may reduce output in the
quest for profits (monopoly power)
• Part of this came from Veblen’s farm
background, where agrarian populists were
against big businesses (Railroads, banks, etc.)
Veblen's criticism of Neoclassical theory
(continued)
• Populism holds that the common person is
oppressed by the “elite" in society, which exists
only to serve its own interests, and therefore, the
instruments of the State need to be grasped
from this self-serving elite and instead used for
the benefit and advancement of the people as a
whole. A populist reaches out to ordinary people,
talking about their economic and social
concerns, and appeals to their common sense.
Veblen's criticism of Neoclassical theory
(continued)
• Veblen believed that big industrialists were anti-
competitive so that the whole assumption of
perfectly competitive markets was completely
wrong
• He also called for more empirical work to test
the neo-classical models
Veblen’s Dichotomy
• Conflict between industrial employment and
pecuniary employment
Industrial (Technological) Employment
• Promotes the economic life process
• Arises from instincts of parenthood,
workmanship and idle curiosity
• It is what workers do – it is good because
workers make products for society
Pecuniary (Business) Employment
• These are the people who make money
• Basically, the capitalists
• Based on ceremonial behavior of the past
• Men engaged in pecuniary activities are parasites
growing fat on the technological leadership and
innovation of other men
• "The leisure class lives by the industrial community
rather than in it.'' The "captains of industry" make no
industrial contribution and therefore have no progressive
function in the evolutionary process; rather, they retard
and distort it.
Veblen’s Leisure Class
• The wealthy in the economy must have a way to
exhibit their wealth, much like the witchdoctors
and the powerful in pre-industrial societies
• Conspicuous consumption is the method
through which the wealthy display their
“predatory abilities”
• The wealthy engage in pecuniary employment
only to make money, not goods
• They do not engage in “honest work”
Conflict in an Capitalist System
• The conflict is between industrial employment and the pecuniary
employment
• Business cycles are based on the pecuniary activities of business
people
• Economic society is based on conspicuous consumption,
advertising, waste
• Over time, workers become relatively poorer – they strive to emulate
the wealthy class with its conspicuous consumption
• This may lead to tension and the eventual abolition of private
property
• But Veblen was not certain of this – economic society may be
rescued by those engaged in industrial employment such as
engineers and workers and that control of the economy will be
placed in the hands of “technocrats”
Veblen’s Most Important Contributions to
Economics
• Interesting critic but many do not consider him to
be an economist
• His criticism of perfect competition model is a
valid one
John R. Commons
• American (1862-1945)
• Wisconsin School
• Labor economist
• Helped write social reform legislation
• Not a socialist, but believed in laws to correct
problems with laissez-faire capitalism
Commons and the Welfare State
• Regulation of public utilities
• Industrial Safety Laws
• Child Labor Laws
• Minimum wage laws for women
• Unemployment compensation laws
John Kenneth Galbraith (1908-2006)
• Modern Competition and Business Policy, 1938.
• A Theory of Price Control, 1952.
• American Capitalism: The concept of
countervailing power, 1952.
• The Great Crash, 1929, 1954.
• The Affluent Society, 1958.
• The New Industrial State, 1967.
• Economics and the Public Purpose, 1973
• Money, 1975.
• The Age of Uncertainty, 1977.
Countervailing Power
• Galbraith argued that capitalism does not lead to
greater and greater levels of competition among
producers.
• Instead, it leads to the gradual emergence of
monopoly (a market with one seller) or oligopoly (a
market with a handful of sellers).
• However, that does not mean that the monopolists
and oligopolists get to do whatever they want.
• Workers form unions, buyers form retail
cooperatives and retailers form large chain stores,
all to balance the huge power of the producers.
• Capitalism, in other words, fights monopoly with
monopoly.
Countervailing Power
• Galbraith went on to argue that it was pointless
for the government to try to encourage
competition through its anti-trust policies.
• That approach would not work because modern
capitalism has a tendency towards
monopolization.
• A more practical approach would be for the
government to encourage and strengthen all
sources of countervailing power.
Dependence Effect
• Galbraith argued that the notion of consumer
sovereignty—central to neoclassical economics—is
largely untrue.
• Large corporations with huge advertising budgets are by
and large able to persuade consumers to buy whatever
stuff they make.
• One consequence of the power of advertising in
determining our tastes is the existence of “public squalor
amidst private affluence”.
• We pay too much attention to goods that are advertised
and ignore those that aren’t, including public amenities
such as good roads, clean subways, etc. We end up with
nice and clean homes on the one hand and nasty
subways and broken highways and bridges on the other.
The modern corporation

• The modern corporation is characterized by the separation of

ownership and control in business firms.
• Galbraith argued that modern economies are dominated not by
small mom-and-pop stores but by large corporations.
• These corporations are owned by millions of shareholders who
each own a tiny portion of the firm.
• It is not possible for them to run the day to day operations of
the firm directly.
• Therefore, they typically hire a professional manager (the
CEO) to run the company.
• As the person who controls the firm does not own the firm, it no
longer makes sense, according to Galbraith, to assume—as
neoclassical economics does—that firms maximize profits.
• Modern corporations tend to be more interested in maximizing
sales, not profits
The modern corporation
• Of course, the CEO cannot ignore profitability
altogether for fear of being sacked by the
shareholders.
• But the CEO does not have to maximize profits
either.
• All that the CEO has to do is ensure an adequate
level of profits to keep the shareholders happy.
• Galbraith argued that after reaching that adequate
level of profitability, the CEO turns his or her
attention to other goals, such as the firm’s sales,
size or market share.
 RECAP: “Old” Institutional economics
• Emerged as the protest against methodological
individualism of the mainstream Neo-classical
Economics.
• Emphasized importance of institutions but
lacked rigorous and systematic theoretical
foundations, as well as empirical support. Often
it was country specific or even case specific.
• Concerned more with description of institutions.
 New Institutional Economics (NIE)
The purpose of NIE is two-fold:
1) Explain (opposed to describe) the determinants
of institutions and analyze the institutional
change;
2) Evaluate impact on economic efficiency and
distribution.
 New Institutional Economics

• Coase R. (1937) “The Nature

of
• the Firm”
• Coase R. (1960) “The theory
of social cost”.
• Williamson O. (1971) coins the
term “New Institutional
Economics”.
• North D. (1990) “Institutions”.
• International Society for NIE
(ISNIE) established in 1997.
Coase R. and North D.
 Williamson’s framework: 4 level of social
analysis
• Level 1: Embeddedness. Informal institutions, customs,
traditions, norms and religion; Frequency of change is
100 - 1000 y.
• Level 2: Institutional environment. Formal rules of the
game: property, bureaucracy. Frequency of change is 10
- 100 y.
• Level 3: Governance: play of the game - contract.
Frequency of change is 1- 10
• Level 4: Resource allocation and employment (prices
and quantities; incentive alignment). Continuos.
 NIE as a scientific “umbrella”
New Economic History
(North, Fogel)

Public Choice and Political Economy

(Buchanan, Olson)

New Social Economics

NIE Social Capital

Transaction Costs Economics

(Coase, North, Williamson) Property rights literature

Theory of Collective Action Economics of information

(Ostrom, Hardin) (Akerlof, Stiglitz, Stigler)

Law and Economics

 How good is NIE?

• NIE is the framework for social scientists that puts

institutions and transactions costs on the forefront
of analysis.
• NIE is evolutionary and rapidly developing being
focused on institutional change (dynamics).
• NIE is very good in empirical testing and analysis;
however:
• Is the forum for scientists with different background
to “de-isolate” knowledge.
• Major weaknesses are associated with
methodologies and thinness of empirical
application
 The mandate of NIE
• “There is no greater challenge facing today’s
social scientist than the development of a
dynamic theory of social change that will fill in
many of the gaps in the foregoing analysis and
give us an understanding of adaptive efficiency”.
• (D. North 1993)