The Approach of Institutional Economics (March 1998)

Journal of Economic LiteratureVol. XXXVI (March 1998), pp. 166–192

Hodgson: Institutional Economics

The Approach of InstitutionalEconomics

GEOFFREY M. HODGSONThe Judge Institute of Management Studies, University of Cambridge

The author is particularly grateful to Peter Corning, Masashi Morioka, Richard Nelson, JohnNightingale, Douglass North, Paul Twomey, and three anonymous referees for discussions,critical comments, or other assistance. The Japan Society for the Promotion of Science, andthe European Commission, Phare-ACE program are thanked for their financial assistancewith this research.

By means of the old, we come to know the new.

Confucius

I. Introduction

TODAY, THE TERM “new institutionaleconomics” is in widespread use and

is associated with a vast literature.Clearly, the temporal adjective in theadopted title of this broad set of postwartheories and approaches has been in-tended to demarcate the “new institu-tional economics” from the “old” institu-tional economics of Thorstein Veblen,John Commons, and Wesley Mitchell.This earlier institutionalism had actuallybeen dominant in economics depart-ments in American universities just afterthe First World War.1

Despite this, little detailed referencehas been made by leading exponents ofthe “new” institutional economics tothis predecessor. Two factors mayhelp to explain this oversight. Thefirst is that the history of economicthought is currently a much neglectedsubdiscipline, and there is now wide-

spread unfamiliarity with the “old”American institutionalism, despite itsfavored geographic location and ac-cessible language. The second reasonis that since its decline in Americaafter 1930 the “old” institutionalismhas been repeatedly written off, and isdismissed for failing to provide a sys-tematic and viable approach to eco-nomic theory. It is also widely—andwrongly—believed that institutionalismwas essentially anti-theoretical and de-scriptive.

However, characterizations of the“old” institutionalism as purely descrip-tive or anti-theoretical do not bear upto close scrutiny. Particularly in thewritings of Veblen and Commons, thereis a strong emphasis on the importanceand priority of the tasks of theoreticalexplanation and theoretical develop-ment. Whatever their limitations, theearly institutionalists addressed crucialtheoretical issues.

For example, Veblen (1899, 1919)was the first social scientist to attemptto develop a theory of economic and in-stitutional evolution along essentially

1 Throughout this article, the terms “institution-alism” and “institutional economics,” when with-out a temporal adjective, will be taken to refer tothe institutionalism in the tradition of Veblen,Commons, and Mitchell.

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Darwinian lines (Hodgson 1993). Veb-len’s work shares common features withthe much later attempts by economiststo use evolutionary metaphors from bi-ology by Armen Alchian (1950), Fried-rich Hayek (1988), Kenneth Boulding(1981), and Nelson and Sidney Winter(1982). In addition, Commons (1924,1934) has been acknowledged as a ma-jor influence on, for example, the be-havioral economics of Herbert Simon(1979) and even the “new” institutional-ism of Oliver Williamson (1975). Insti-tutionalists also developed a number oftheories of pricing behavior in imper-fectly competitive markets (Marc Tool1991). Traces of the surviving influenceof “old” institutionalist ideas are foundin many other areas of theoretical andapplied economics. Indeed, the influ-ence of institutionalism persisted forsome time after the Second WorldWar.2

Nevertheless, there is a shred of jus-tification for the dismissive statements.Ever since Veblen there has been a fail-ure of the “old” institutionalists toagree upon, let alone develop, a system-atic theoretical core. American institu-tionalism has bequeathed no integratedtheoretical system of the stature orscope of that of Karl Marx, Alfred Mar-shall, Léon Walras, or Vilfredo Pareto.The reasons for this failure cannot bediscussed here, save to note that it was

not because of a naive and unsustain-able belief that economics can proceedwith data alone, and without any theory.Although several institutionalists puttheir faith in data, they all retainedsome degree of belief in the importanceof a theoretical project.

The primary reasons for the failure ofinstitutionalism lie elsewhere. In par-ticular, the old institutionalism waspartially disabled by a combined re-sult of the profound shifts in social sci-ence in the 1910–1940 period and ofthe rise of a mathematical style of neo-classical economics in the depression-stricken 1930s. Behaviorist psychologyand positivist philosophy displaced theinstinct psychology and pragmatist phi-losophy upon which the early institu-tionalism had been built. With their useof formal techniques, mathematicaleconomists caught the imagination ofboth theorists and policy makers. Incomparison, institutionalism was re-garded as technically less rigorous, andthereby inferior.

An adequate history of American in-stitutionalism remains to be written.The purpose of the present essay isquite different. The main aims are: tooutline the institutionalist approach inbroad terms, and to address and evalu-ate a few “hard core” propositions thatwere prominent in early institutional-ism. A key argument in this paper isthat the “old” institutionalism offers aradically different perspective on thenature of human agency, based on theconcept of habit. Habits and rules areseen as necessary for human action. Ahabit-dominated conception of humanbehavior not only has significant sup-port from psychology, it is also worthyof development and further elaborationby economists.

In an institutionalist view, the con-cept of habit connects crucially with theanalysis of institutions. This issue has

2 Notably, several institutionalists or their fellowtravelers have been elected as Presidents of theAmerican Economic Association since 1945: JohnKenneth Galbraith, Edwin Witte, MorrisCopeland, George Stocking, and Boulding. In ad-dition, the “old” institutionalists Simon Kuznetsand Gunnar Myrdal received Nobel Prizes in 1971and 1974 respectively. Other schools of thoughtresemble institutionalism. For example, much ofpost-Keynes “Cambridge” economics had a stronginstitutionalist flavor, particularly the work ofNicholas Kaldor and Joan Robinson. The more re-cent work of Robert Boyer, Michel Aglietta, andother members of the French régulation schoolalso has strong institutionalist affinities.

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important implications for both micro-economic and macroeconomic analysis.Some illustrative applications of thisgeneral approach are considered inboth these domains, with argumentswhy it is important to take account ofhabit in human behavior. These ap-proaches do not rely on the standard as-sumptions of individual rationality.However, while outlining the essentialsof a broadly institutionalist approach, itis conceded that institutionalism itselfrequires much more theoretical andmethodological development.

The structure of this paper is as fol-lows. Section II sketches how institu-tional economists proceed in practice.It is noted that institutionalism does notattempt to build an all-embracing, gen-eral theory. Instead, complex phenom-ena are approached with a limited num-ber of common concepts and specifictheoretical tools. Section III of this pa-per defines and elaborates the core con-cepts of habits and institutions, asrooted in the early institutionalist the-ory of Veblen and Commons. Section IVshows how much work in the “new” in-stitutionalist vein, including the prob-lem of “institutional infinite regress,”points to a required reformulation ofthe “new” institutionalist project and apossible convergence with the thinkingof the “old” institutionalists. Section Vconsiders the circumstances in which itis necessary or convenient for an agentto rely on habits and rules. Not only arehabits and rules ubiquitous, but we aretypically required to rely on themwhether or not (bounded) optimizationis possible. Section VI concludes the es-say.3

II. Institutionalist Approaches toEconomic Analysis

The core ideas of institutionalismconcern institutions, habits, rules, andtheir evolution. However, institutional-ists do not attempt to build a single,general model on the basis of thoseideas. Instead, these ideas facilitate astrong impetus toward specific and his-torically located approaches to analysis.In this respect there is an affinity be-tween institutionalism and biology. Evo-lutionary biology has a few laws or gen-eral principles by which origin anddevelopment can be explained. Analysisof the evolution of a specific organismrequires detailed data concerning theorganism and its environment, and alsospecific explanations relevant to thespecies under consideration. Evolution-ary biology requires both specific andgeneral theories. In contrast, in physicsthere are repeated attempts to formu-late the general theory of all materialphenomena—the so-called “theory ofeverything” (Jack Cohen and Ian Stew-art 1994). In its relatively greater em-phasis upon specificities, institutionaleconomics resembles biology ratherthan physics.

The institutionalist approach movesfrom general ideas concerning humanagency, institutions, and the evolution-ary nature of economic processes tospecific ideas and theories, related tospecific economic institutions or typesof economy. Accordingly, there are mul-tiple levels, and types, of analysis. Nev-ertheless, the different levels must belinked together. A crucial point here isthat the concepts of habit and of an in-stitution (both defined in Section III)help to provide the link between thespecific and the general.

In contrast, neoclassical economicsmoves from an universal theoreticalframework concerning rational choice

3 Restrictions of space prevent extensive refer-ences to the literature. The reader is referred toHodgson et al. (1994) for an encyclopedic treat-ment of some of the topics discussed here, forwider references, and for discussions of manyother issues pertinent to institutionalism.

168 Journal of Economic Literature, Vol. XXXVI (March 1998)

and behavior, and moves directly totheories of price, economic welfare, andso on.4 However, institutional econom-ics does not presume that its habit-based conception of human agency it-self provides enough to move towardoperational theory or analysis. Addi-tional elements are required. In par-ticular, an institutionalist would stressthe need to show how specific groups ofcommon habits are embedded in, andreinforced by, specific social institu-tions. In this manner, institutionalismmoves from the abstract to the con-crete. Instead of standard theoreticalmodels of given, rational individuals,institutionalism builds upon psycho-logical, anthropological, sociological,and other research into how people be-have. Indeed, if institutionalism had ageneral theory, it would be a generaltheory indicating how to develop spe-cific and varied analyses of specific phe-nomena.

A. An Illustration: Theories of Pricing

As an illustration, consider the theoryof price formation. Subsequent to Ve-blen’s iconoclastic attacks on rationaleconomic man, institutionalists werethemselves divided on whether Mar-shallian or other neoclassical pricetheories were acceptable and compat-ible with institutionalism. While in-stitutionalists generally rejected ra-tional economic man, this did not nec-essarily mean the abandonment of allthe apparatus of Marshallian price

theory.5 Unlike the stationary outcomesof general equilibrium theory, partialequilibrium models could seemingly beplaced in an ongoing, evolutionary con-text. Where institutionalists did agree,however, was that it was necessary todevelop specific theories of pricing thatreflected the institutional and marketstructures of the modern economy. Fur-thermore, any attainable general theoryof prices would necessarily be highlylimited in its explanatory properties, be-cause of the variety of institutional pro-cesses of price formation in the realworld.

The basis of price theory in institu-tionalism is thus quite different fromthat in other schools of economics.Neoclassical economics relies on theuniversal concepts of supply, demand,and marginal utility. Adam Smith,David Ricardo, and Marx relied on thelabor theory of value. By contrast, in in-stitutionalism prices are social conven-tions, reinforced by habits and embed-ded in specific institutions. Suchconventions are varied and reflect thedifferent types of commodity, institu-tion, mode of calculation, and pricingprocess.

If prices are conventions then theydepend in part on ideas and habits. Atheory of price must in part be a theoryof ideas, expectations, habits, and insti-tutions, involving routines and pro-cesses of valuation. Without such a the-ory, there is no adequate explanation ofhow individuals calculate or form expec-tations of the future.

It was in this vein that a great deal ofempirical and theoretical work on thepricing process was carried out by insti-tutionalists and others in the first halfof the twentieth century. Instead of a

4 Neoclassical economics (a term originallycoined by Veblen) may be conveniently defined asan approach which (1) assumes rational, maximiz-ing behavior by agents with given and stable pref-erence functions, (2) focuses on attained, or move-ments toward, equilibrium states, and (3) excludeschronic information problems (such as uncertaintyof the type explored by Frank Knight and JohnMaynard Keynes). Notably, some recent develop-ments in modern economic theory—such as ingame theory—reach to or even lie outside theboundaries of this definition.

5 Note that “new” institutionalist Ronald Coasehas also rejected the standard rationality assump-tions while working within a broadly Marshallianframework.


general theory of price, attempts weremade to develop specific theories ofpricing, each related to real-world mar-ket structures and types of corporate or-ganization. It was in this context thatmuch of the early work on oligopolypricing was pioneered, including severaltheories of “mark-up,” “administered,”or “full cost” pricing (Tool 1991). Noless than other economists, institution-alists want to develop theoretical expla-nations of such crucial real world phe-nomena as price. Where they differ,however, is in stressing the practicaland explanatory limitations of any possi-ble general theory of all prices.

An institutionalist approach to thetheory of pricing proceeds by first ex-amining the institutions in which theprices are being formed. All aspects ofthe institutions that are closely boundup with the process of price formationare relevant. What are the costs andhow are they evaluated? What routinesgovern the calculation of prices? Whatinformation is available and what is un-known? By what routines is informationobtained and used? What routines areused to revise prices in line with the ex-perience on the market? What is thestrategy concerning competitive pric-ing? How does this relate to marketstructure?

Obviously, a process of abstractionand simplification is required to dealwith all this complexity. As a result ofdetailed investigations, it may be possi-ble to abstract some key processes gov-erning the formation of prices. One ofthe best examples of this approach isthe work on “administered pricing” byGardiner Means and his collaborators(Caroline Ware and Means 1936).There is also a close institutionalist af-finity with the behavioral theory of thefirm (Richard Cyert and James March1964) and with the theory of informa-tion clustering and networking in finan-

cial markets (Wayne Baker 1984). Noneof these studies assumes perfect infor-mation or perfect competition. Thestarting point is an investigation of howprices are actually formed in specific in-stitutional contexts, followed by the for-mulation of a pricing theory that is spe-cific to the type of institution beinginvestigated.

Institutionalism has no general theoryof price but a set of guideline ap-proaches to specific problems. Theselead to historically and institutionallyspecific studies which are arguably ofmore operational value than any all-embracing general theory. Regrettably,specific studies of market institutionsand pricing processes have received farless research resources and prestigethan general equilibrium and otherhighly abstract approaches.

B. Starting from Habit: Some Macroeconomic Illustrations

Much empirical data in economicsare consistent with the prevalence ofhabitual activity, even at the macro-economic level. Consider, for example,the now neglected theory of the con-sumption function developed by JamesDuesenberry (1949). This theory washeavily influenced by Veblen andstressed the role of habit in consumerbehavior. Duesenberry’s theory did notfall out of favor because it did badly onempirical tests. In fact it predictedrather well. Instead, the theory was dis-carded primarily because it was notseen to conform with the presumptionsof rational choice theory (Francis Green1979). Duesenberry’s theory proceededon the assumption that an establishedlevel of income, plus prevailing culturalnorms, would lead to an habitual pat-tern of consumer behavior. The con-sumer acts imitatively and adaptively,and also on the basis of ingrained hab-its. Similarly, the major subsequent


study of aggregate consumer demand inthe USA, by Hendricks Houthakker andLester Taylor (1966), also found that amajor part of consumer spending is sub-ject to inertia, that is, primarily depen-dent on preceding consumption.

It is beside the point to suggest thatall such phenomena can be recast into amore complex model where habit is for-mulated as a convoluted result of utilitymaximizing behavior. In principle, thepossibility of such a recasting cannot bedenied. The point is that the evidencealone does not bestow theoretical pri-macy to rational choice modeling.(Theoretical arguments against the pri-macy of the rationality assumptions areraised later in this essay.) Furthermore,the standard principle of parsimony canbe used to support a fundamental as-sumption of human inertia or habit, noless that the standard axioms of ration-ality.

In general, institutional economistsapproach the analysis of macroeconomicsystems by examining patterns andregularities of human behavior, expect-ing to find a great deal of imitation,inertia, lock-in and “cumulative causa-tion.”6 Importantly, regularities orstability at the systemic level may arisenot despite, but because of variations atthe micro-level. In complex systems,macro-stability may depend on micro-chaos (Francesca Chiaromonte andGiovanni Dosi 1993; Cohen and Stewart1994). Or systemic constraints may pre-vail over micro-variations (Gary Becker1962; Dhananjay Gode and Shyam Sun-der 1993).

The prominent view that it is neces-sary to build microeconomics on “soundmicrofoundations”—to derive macro-

regularities from micro-stabilities—isquite different. In contrast, institutionaleconomics sees regularities at the sys-temic level as being reinforced throughpositive feedbacks that act, in part,upon the microeconomic elements.Hence the latter are not taken as given.The institutionalizing function of insti-tutions means that macroeconomic or-der and relative stability is reinforcedalongside variety and diversity at themicroeconomic level. Ironically, byassuming given individuals, the micro-foundations project in orthodox eco-nomics had typically to assume further-more that each and every individual wasidentical in order to attempt to makethe analysis tractable. In contrast, insti-tutionalism points not to a spurious su-pra-individual objectivity, nor to theuniformity of individual agents, but tothe concept of socio-economic order,arising upon variety at the micro-level.

Individual habits both reinforce, andare reinforced by, institutions. Throughthis circle of mutual engagement, insti-tutions are endowed with a stable andinert quality. Further, institutions playan essential role in providing a cogni-tive framework for interpreting sense-data and in providing intellectual habitsor routines for transforming informa-tion into useful knowledge. The stronginfluence of institutions upon individualcognition provides some significant sta-bility in socioeconomic systems, partlyby buffering and constraining the di-verse and variable actions of manyagents.

With this line of argument the rela-tive autonomy of macroeconomics andthe idea of the workability of aggregatesis reinstated. This contrasts with reduc-tionist modes of theoretical analysisthat see macroeconomic phenomena asnecessarily explained by the micro-economic. Here the institutionalistsmade a significant contribution. Mitchell

6 Veblen was one of the first to develop the con-cept of cumulative causation that directly or indi-rectly influenced Allyn Young, Myrdal, Kaldor,and others. See Veblen (1919, pp. 70–77, 173–77,240–43, 370, 436) and Hodgson (1993, ch. 9).


and his colleagues in the National Bu-reau for Economic Research in the1920s and 1930s played a vital role inthe development of national income ac-counting and suggested that aggregate,macroeconomic phenomena have an on-tological and empirical legitimacy. Thisimportant incursion against reduction-ism created space for the Keynesianrevolution. Through the development ofnational income accounting, the work ofMitchell and his colleagues influencedand inspired the macroeconomics ofJohn Maynard Keynes. Partly for thisreason, there is a close and explicit af-finity between institutionalism and whatis often described as “Post Keynesian”macroeconomics.

The fact that institutions typicallyportray a degree of invariance over longperiods of time, and may outlast indi-viduals, provides a reason for choosinginstitutions rather than individuals as abasic unit. Most institutions are tempo-rally prior to the individuals that relateto them. We are all born into and so-cialized within a world of institutions.Recognizing this, institutionalists focuson the specific features of specific insti-tutions, rather than building a generaland ahistorical model of the individualagent.

However, the proposed alternative isnot a methodological collectivism whereindividual behavior is entirely explainedby the institutional or cultural environ-ment. Complete explanations of parts interms of wholes are beset with prob-lems of equivalent stature to those ofthe inverse procedure. Just as struc-tures cannot be adequately explained interms of individuals, individuals cannotadequately be explained in terms ofstructures.

The failure of the mainstream micro-foundations project confirms the diffi-culty of modeling the whole in terms ofthe individual parts (S. Abu Turab Rizvi

1994). Furthermore, institutionalists re-ject the idea of the primary ontologicalunit of the given, institution-free indi-vidual, upon which the microfounda-tions project rested. (This issue is ex-plored in more detail below.) Arguably,the failure of the mainstream micro-foundations project points to the needto develop a quite different overall ap-proach. In this there are both micro-economic and macroeconomic levels ofanalysis, each with a degree of relativetheoretical autonomy, but at the sametime both levels are connected by con-ceptual links and spanning explanations.

The abandonment of a standard mi-crofoundations approach does not meanthat institutionalists are necessarily de-prived of the capacity to build modelsor make predictions. On the contrary,repeated studies—including those citedabove—have shown that models withstrong elements of inertia, explained interms of habit persistence, are goodpredictors in the macroeconomicsphere. It is also well-known econo-metric folklore that naive predictionmodels, based on simple extrapolationsfrom the recent past into the future, areoften much better predictors of macro-economic performance than much moresophisticated economic models. Institu-tionalists regard such results as confir-mation of the phenomena of habit per-sistence, and of institutional lock-in andself-reinforcement.

Institutionalism works from the “styl-ized facts” of the macroeconomic sys-tem and attempts to uncover the under-lying structural features of the systemthat help explain these outcomes. Thisrequires analyses that are both quantita-tive and qualitative. Consider an exam-ple, starting from the stylized fact thatproductivity growth in the UnitedStates economy has been lower in thelast 40 years or so than in many EastAsian and other competing countries.


Data may also reveal the stylized factthat the proportion of GNP devoted toinvestment in the United States hasbeen relatively low. But, for the institu-tionalist, the analysis does not stop withmere statistical correlation. The task isto explain the institutional constraintsand causal processes giving rise to bothlow investment and low productivitygrowth.

Consider a tentative hypothesis. Thefunctional and cultural separation of fi-nancial from industrial institutions mayhave encouraged a short-term orienta-tion toward investment returns. Thesparse institutional connections be-tween finance and industry, and therelative lack of shared personnel andshared vested interests, may allow thefinancial sector to concentrate on maxi-mizing its returns to short-, rather thanlong-term, investment. Furthermore,the relatively low degree of cross own-ership between industrial corporationsmay further encourage a primary orien-tation of the corporation toward short-term financial markets and short-terminvestment decisions. A first step in ap-praising this hypothesis would be tovalidate its key assumptions, for exam-ple by looking at the U.S. data on thedistribution of share ownership, includ-ing cross share ownership between fi-nancial and industrial corporations. Animportant next step would be to carryout similar and comparative investiga-tions in relevant economies with higherrates of productivity growth, such as Ja-pan. The existence elsewhere of higherdegrees of corporate cross ownership ofstocks and shares would provide a basisfor attempting to evaluate the hypothe-sis still further. Econometric evidenceof a significant statistical correlation be-tween the relevant variables would beimportant, but far from enough. Institu-tionalists stress the need to outline thereal causal linkages involved, rather

than mere correlation between vari-ables. Hence it is important to explainthe causal mechanisms linking shareownership structures with low invest-ment, and, in turn, with lower growthrates of productivity. Such causal expla-nations could involve many factors, in-cluding national cultures, political sys-tems, and so on. Institutionalists are notwedded to any one hypothesis or anyone theory on this issue, but in generalthe institutional approach stresses theimportance of comparative institutionalanalysis, and the examination of a broadset of factors, in searching for an ade-quate causal explanation.

C. The Institutionalist Approach: Some General Remarks

For some, the general approach out-lined above may seem fairly obvious,adding nothing new. Several points canbe made in response to such a remark.First, there is a degree of emphasis oninstitutional and cultural factors that isnot found in mainstream economic the-ory. Second, the analysis is openly inter-disciplinary, in recognizing insightsfrom politics, sociology, psychology, andother sciences. Third, there is no re-course to the model of the rational, util-ity-maximizing agent. Inasmuch as aconception of the individual agent is in-volved, it is one which emphasizes boththe prevalence of habit and the possibil-ity of capricious novelty. Fourth,mathematical and statistical techniquesare recognized as the servants of, ratherthan the essence of, economic theory.Fifth, the analysis does not start bybuilding mathematical models: it startsfrom stylized facts and theoretical con-jectures concerning causal mechanisms.Sixth, extensive use is made of historicaland comparative empirical material con-cerning socio-economic institutions. Inseveral of these respects, institutionaleconomics is at variance with much


of modern mainstream economic theory.This should not and does not mean,

however, that institutionalists becomemere data-gatherers. No understandingnor explanation is possible without the-ory. Veblen and Commons, as foundersof the “old” institutionalism, knew thattheory does not arise by induction fromdata. All empirical analyses presupposea set of concepts and an implicit or ex-plicit theory. For this reason, to startfrom stylized facts must itself require aprior conceptual framework. Institu-tionalism attempts to provide this broadframework in terms of a set of meta-theoretic and methodological guide-lines. There is no single, agreed set ofdefinitive guidelines among institution-alists, but a number of common themesemerge.

For example, a central problem is theidentification of what may be termed“ideal types.” These are abstract de-scriptions of situations, phenomena, orpersons that indicate the general fea-tures on which a theorist will focus ascrucial for purposes of explanation. It isimpossible to include all details and allfeatures in such a venture because so-cio-economic systems are too complexand are open in the sense in which theyinteract with their outside environment.A process of abstraction must occurwhere the essential structures and fea-tures of the system are identified. Thecrucial question, of course, is whichideal type is to be selected in the analy-sis of a given phenomenon. To answerthis question requires a methodology todistinguish between the general and thespecific aspects of any given phenome-non. By making this distinction, andperhaps by using comparative materialfrom other socio-economic systems, it ispossible to construct and develop hy-potheses concerning the key causal link-ages behind the observed phenomena.

This is an all-too-sketchy account of

the methodological and meta-theore-tical foundations of the institutionalistapproach. Constraints of space preventfurther elaboration. What is clear, how-ever, is that such methodological issueshave become lively topics of debate inthe 1980s and 1990s, with a veritableexplosion of literature in the area ofeconomic methodology. Institutionalistshave made significant contributions tothis literature and are thus playing apart in the development of appropriateapproaches to economic analysis.

D. Some Contemporary Issues in Institutionalist Theory

It has already been admitted that in-stitutionalism lacks a systematic coretheory. Institutionalism does not seek ageneral theory of everything but it doesrequire a coherent framework of analy-sis and a workable methodology.

In particular, there remains impor-tant scope for the development of an in-stitutionalist microeconomics. Althoughpast institutionalists made significantprogress in the development of theoriesof pricing in imperfectly competitivemarkets, there is still a great of workthat can be done. In economics sincethe Second World War such alternativeapproaches have received negligible re-search resources. However, alternativetheories of consumer behavior haveflowered in other disciplines, such asmarketing (Roger Mason 1995). Someof this research has a strong institution-alist flavor, in part because it brings to-gether insights from psychology andother social sciences. In developingtheories of individual economic behav-ior, as well as elsewhere, institutional-ists look forward to the possibility of amuch more extensive and fruitful dia-logue across disciplinary barriers.

The institutionalist emphasis on habitand routine also fits in well with theevolutionary models developed by Nel-


son and Winter (1982) and their follow-ers. As Veblen (1899) himself sug-gested, the evolutionary paradigm pro-vides a basis for encapsulating bothcontinuity and change, both inertia andnovelty. Habits or routines may adaptslowly or “mutate” as agents attemptpurposeful improvements. In addition,there is some selection process bywhich some habits and routines are re-tained and imitated, and others fall outof use. Institutionalism is congenitallyan “evolutionary economics.” Like allwork in this vein, it is biased toward dy-namic rather than equilibrium-orientedmodes of theorizing.

Problems of cognition and learninghave been thematic to institutionalismsince its inception. Instead of the pre-sumed bedrock of given individuals,there is the idea of interactive and par-tially malleable agents, mutually en-twined in a web of partially durable andself-reinforcing institutions. Institution-alist theory is admittedly underdevel-oped in this area but institutionalistsmay potentially be in a relatively strongtheoretical position. Although main-stream economics has addressed theconcept of learning in recent years, atroot there are severe problems in theapproach based on the assumption of arational actor. The key question is whatis meant by “rational learning.” Howcan agents be said to be rational at anygiven moment when they are in the pro-cess of learning? The very act of learn-ing means that not all information ispossessed and global rationality is com-promised or ruled out. Furthermore,much more than inputting data or esti-mating probabilities is involved. Learn-ing is more than the acquisition of in-formation; it is the development of newmeans and modes of cognition, calcula-tion, and assessment. This means thatagents are building up new repre-sentations of the environment in which

they operate, in place of former concep-tions and habits of thought. In particu-lar, if the methods and criteria of “opti-mization” are themselves being learnedhow can learning itself be optimal?

Institutionalists bring a different per-spective to the analysis of learning byseeing it, in part, as a transformativeand reconstitutive process, involvingthe creation of new habits, propensities,and conceptual frameworks (Veblen1919; James Murphy 1994; Henry Plot-kin 1994). Institutionalists need to capi-talize on their prima facie conceptualand methodological advantage in thisarea and develop theories of learningthat are appropriate for a knowledge-intensive and rapidly changing world.

The remainder of this essay exploresfurther some of the methodological andtheoretical issues that have been raised.The following section outlines some ofthe core theoretical characteristics ofinstitutionalism. Subsequent sectionsaddress the problem of reductionism ineconomic theory, and show that main-stream explanations of economic and in-stitutional phenomena in terms ofgiven, rational individuals are not as ro-bust as is often supposed. These argu-ments give further credence to the in-stitutionalist approach.

III. Some Core Characteristics ofInstitutionalist Theory

A. The “New” and the “Old” Institutionalisms Compared

What is the essential difference be-tween the “old” and the “new” institu-tionalism? Answering this question ismade more difficult because there is nounanimity, even among its adherents, asto what is precisely to be included inthe “new” variety. Nevertheless, an an-swer is possible if we focus on the com-mon theoretical core of some of themost prominent and influential “new”


institutionalist writings, such as byNorth (1981), Richard Posner (1973),Andrew Schotter (1981), and Williamson(1975). Despite their analytical and pol-icy differences, there are some commonpresumptions behind all these works.

The characteristic “new” institution-alist project is the attempt to explainthe emergence of institutions, such asthe firm or the state, by reference to amodel of rational individual behavior,tracing out the unintended conse-quences in terms of human interactions.An initial institution-free “state of na-ture” is assumed. The explanatory move-ment is from individuals to institutions,taking individuals as given. This ap-proach is often described as “methodo-logical individualism.”7

Along these lines, Carl Menger(1892) long ago saw the institution ofmoney as emanating in an undesignedmanner from the communications andinteractions of individual agents. Onceconvenient regularities become promi-nent, a circular process of institutionalself-reinforcement takes place. Emerg-ing to overcome the difficulties of bar-ter, money is chosen because it is con-venient, and it is convenient because itis chosen. Other similar examples in the“new” institutionalist literature includetraffic conventions (Schotter 1981;Robert Sugden 1986). For example,once a majority of car drivers stick tothe right-hand side of the road, it isclearly rational for all drivers to followthe same rule. Accordingly, the emer-gent convention is reinforced and insti-tutionalized by imitation, and by effi-cient use of “all relevant information”(Schotter 1981, p. 160). We may stylizea core idea involved here in terms of anaction-information loop, as shown inFigure 1.

As well as in Menger’s writings, thisimportant core theme of an action-in-formation loop is clearly evident, for ex-ample, in North’s (1981) theory of thedevelopment of capitalism, William-son’s (1975) transaction cost analysis ofthe firm, and Schotter’s (1981) game-theoretic analysis of institutions. Thevalue of this core idea should not be de-nied.

However, despite the temporal adjec-tive, the “new” institutionalism is builtupon some antiquated assumptions con-cerning the human agent, derived fromthe individualism of the Enlightenment.In this 300–year tradition, a key idea isthe notion that the individual can, in asense, be “taken for granted.” Accord-ingly, the individual is taken as the ele-mental building block in economic the-ory. Strictly, it is not a question ofwhether or not a theorist is found to ad-mit that individuals—or their wants andpreferences—are changed by circum-stances. Indeed, many economists admitthat individuals might so be changed.What is crucial is the individualisticeconomist assumes, for the purposes ofeconomic enquiry, that individuals andtheir preference functions should betaken as given. Thus the demarcatingcriterion is not the matter of individualmalleability per se, but the willingness,or otherwise, to consider this issue asan important or legitimate matter for

7 The enormous and controversial literature onthis topic is too large to address here. See Hodg-son (1988) for a survey and discussion.

Figure 1. The Institutionalist Action-Information Loop

Individuals

Institutions

Action Information


economic analysis. The commonplacestatement by mainstream economiststhat tastes and preferences are not theexplananda of economics thus derivesdirectly from the individualist tradition.Likewise, the conception of economicsas “the science of choice” takes thechoosing individual and her preferencefunctions as given. Unlike the “old” in-stitutionalism, the “new” institutional-ism has also taken such individualisticpresuppositions on board.

A common thread in the literature of“old” institutionalism, from Veblenthrough Commons and Mitchell, toMyrdal and Galbraith, is the idea that ineconomic analysis the individual shouldnot always be taken as given. The gen-eral use of given preference functionsto model individuals is rejected by insti-tutionalists. Individuals interact to forminstitutions, while individual purposesor preferences also are molded by so-cio-economic conditions. The individualis both a producer and a product of hercircumstances.8

It is possible to distinguish the newinstitutionalism from the “old” bymeans of the above criterion. This dis-tinction holds despite important theo-retical and policy differences withinboth the new and the old institutionalistcamps.9 However, there are conceptual

difficulties with the “new” institutional-ist approach. It is argued below that toproceed from the assumption of givenindividuals in an institution-free “stateof nature” is theoretically misconceived.Accordingly, developments in the “new”institutionalism show some sign ofyielding some ground to the “old,” or atleast creating the possibility of a fruitfuldialog between the two approaches.

Notably, some leading mainstreameconomists seem to be moving towardthe view that the individual should notbe taken as given. Joseph Stiglitz (1994,pp. 272–73) has accepted that “certainaspects of human nature are endoge-nous to the system . . . traditional eco-nomic theory was clearly wrong in treat-ing individuals as immutable.” Aforemost agenda item for institutionaleconomics is to incorporate a richer,context-dependent conception of hu-man agency within a systematic and rig-orous theory.

B. Agency and Habit

Rejecting the mainstream approachto economic theory, with its conceptionof the utility-maximizing individual, thefounders of the “old” institutionalismpromoted an alternative conception ofhuman agency. Such an alternative waswell developed by the early twentiethcentury, in the influential writings of in-stinct psychologists such as WilliamJames and William McDougall, andpragmatist philosophers such as CharlesSanders Peirce. For all these writers theinfluence of Darwinian biology was cru-cial. Although instinct psychology wassubsequently eclipsed by behaviorism(Carl Degler 1991) it enjoys a rehabili-tation today (Leda Cosmides and JohnTooby 1994a, 1994b; Plotkin 1994; Ar-thur Reber 1993).

Following these leading psychologistsand philosophers of their time, the earlyinstitutionalists saw habit as the basis of

8 The recent work of Becker (1996) might atfirst sight appear to “take account of tastes” bybuilding a model with “endogenous prefer-ences”—in which individual utility functions con-tain arguments such as “culture.” This is notthe case because an immanently conceived(meta)preference function for each individual isstill assumed at the outset; it is an unexplored“black box” that still remains to be explained.

9 Notably, and in contrast to the accounts inRichard Langlois (1986) and Malcolm Rutherford(1994), this criterion places the work of Nelsonand Winter (1982) squarely in the “old” institu-tionalist category. This affinity with the “old” insti-tutionalism is now recognized by Nelson and Win-ter themselves. In addition, some of the laterwritings of Hayek (1988) come closer to the oldinstitutionalism, as do recent works by North(1990).


human action and belief. Habit can bedefined as a largely non-deliberativeand self-actuating propensity to engagein a previously adopted pattern of be-havior. A habit is a form of self-sustain-ing, nonreflective behavior that arisesin repetitive situations.

Many modern economists have ad-dressed habit. However, mainstreameconomists typically regard habit as anevocation or appendage of rationalchoice, and thereby explicable in itsterms. Habits are seen as the result ofan earlier choice, or as a deliberatemeans of avoiding endless deliberation.Rationality thus retains explanatory pri-macy (Becker 1992; Robert Pollak1970).

The treatment of habit by the phi-losophers and psychologists who influ-enced the early institutionalists wasquite different. The explanatory arrowran in the opposite direction: instead ofhabits being explained in terms of ra-tional choice, rational choice was ex-plained in terms of habits. Further,habit was linked with knowledge andbelief, seeing the essence of belief asthe establishment of habit. All ideas, in-cluding beliefs, preferences, and ra-tional modes of calculation, were re-garded as evolutionary adaptations tocircumstances, established through theacquisition of habitual propensities.

At first sight, both approaches seemfeasible: habit can be regarded as thebasis of rational choice, or rationalchoice can be seen as the procreator ofhabits. The fact that economists displayan habitual inclination to assert the lat-ter should not obscure the possibility ofa reverse ordering. (If the allegation ofthe priority of rationality over habit isitself simply a matter of habit then it isby that fact undermined.) The problemof adjudication between these two para-digms is not as straightforward as isoften assumed.

It is as if institutionalists and rationalchoice theorists have been engaged in acentury-long game of Go. Each hasbeen trying to place the pieces of an ar-gument in an intricate attempt to encir-cle the postulates of the other. Notably,however, leading advocates of the ra-tional choice paradigm, such as Becker(1962) have demonstrated that an “irra-tional” mode of behavior, in whichagents are ruled by habit and inertia, isjust as capable of predicting the stan-dard downward-sloping demand curveand the profit-seeking activity of firms.Becker showed how the negatively in-clined market demand curve can resultfrom habitual behavior. Actors “can besaid to behave not only “as if” they wererational but also “as if” they were irra-tional: the major piece of empirical evi-dence justifying the first statement canequally well justify the second” (Becker1962, p. 4).

Kenneth Arrow has also accepted thepossibility of an alternative approachbased on habit. After outlining a possi-ble “non rational” and habit-basedmodel of human behavior, Arrow (1986,p. S386) remarked: “Without belaboringthe point, I simply observe that this the-ory is not only a logically complete ex-planation of behavior but one that ismore powerful than standard theoryand at least as capable of being tested.”

Accordingly, the “accuracy of the pre-dictions” or other familiar criteria fortheory selection do not give outrightvictory to rational choice. Common ar-guments for regarding rational choice aspre-eminent do not carry as muchweight as has been supposed. This ques-tion of the explanatory primacy of habitversus that of rational choice will be ex-plored again later in this essay. Fornow, there is at least a prima facie casefor examining the distinctive treatmentof habit in the work of the “old” institu-tionalists.


To many mainstream economists,such a habit-driven characterization ofthe agent is excessively deterministic,seemingly denying free will andchoice.10 However, it can be arguedthat the conception of the agent as anutility-maximizer based on fixed prefer-ence functions itself denies free willand choice. An individual ruled by herpreferences is made a prisoner, not sim-ply of her social environment, but alsoof her utility function. It is as if she is arobot, programmed by her preferences.Within such a deterministic machinery,critics find it difficult to find any placefor real choice. As James Buchanan(1969, p. 47) once remarked: “Choice,by its nature, cannot be predeterminedand remain choice.”

In trying to gain a deeper under-standing of the nature of human agencywe are addressing an age-old, highlycomplex, and inadequately resolvedphilosophical and psychological prob-lem. In some of the best writings in thearea we find attempts to reconcile ha-bitual behavior, on the one hand, andpurposefulness, choice, novelty, andcreativity, on the other (Michael Po-lanyi 1967; Murphy 1994; Plotkin 1994).Common to these approaches is theidea of habits being the foundation oflearned behavior. Accordingly, examin-ing the ways in which new habits areacquired is as important as a recogni-tion of their durability. This dual stressis thematic to the institutionalism ofVeblen and others, and retains itstheoretical relevance today.

C. From Habits to Institutions

One of the most useful definitions ofan institution was provided by the insti-tutional economist Walton Hamilton

(1932, p. 84). He saw an institution as“a way of thought or action of someprevalence and permanence, which isembedded in the habits of a group orthe customs of a people.” This elabo-rates Veblen’s (1919, p. 239) earlierdefinition of an institution as “settledhabits of thought common to the gener-ality of men.” Notably, in the “old” in-stitutionalism, the concept of habitplays a central role both in its definitionof an institution, as in its picture of hu-man agency.

Although, by contrast, definitions ofan institution in the “new” institutional-ism do not typically include the notionof habit, they often share with the olderinstitutionalism a broad, rather than anarrow, conception of an institution. In-stitutions, are regarded as general regu-larities in social behavior (Schotter1981, p. 11) or “the rules of the game insociety or . . . the humanly devised con-straints that shape human interaction”(North 1990, p. 3).

All these definitions, “new” and “old”institutionalist alike, involve a relativelybroad concept. They encompass notsimply organizations—such as corpora-tions, banks, and universities—but alsointegrated and systematic social entitiessuch as money, language, and law. Thecase for such a broad definition of insti-tutions is that all such entities involvecommon characteristics:

• All institutions involve the interaction of agents, withcrucial information feedbacks.

• All institutions have a number of characteristic andcommon conceptions and routines.

• Institutions sustain, and are sustained by, sharedconceptions and expectations.

• Although they are neither immutable nor immortal,institutions have relatively durable, self-reinforcing,and persistent qualities.

• Institutions incorporate values, and processes ofnormative evaluation. In particular, institutionsreinforce their own moral legitimation: that whichendures is often—rightly or wrongly—seen asmorally just.

10 Note that, contrary to a widespread miscon-ception, Veblen (1899, p. 15; 1914, pp. 31–32;1919, p. 75; 1934, pp. 80, 175) repeatedly assertedthat human behavior was purposeful.


A broad definition of an institution isconsistent with long-standing practice inthe social sciences. More narrowly, or-ganizations may be defined as a specialsubset of institutions, involving deliber-ate coordination (Viktor Vanberg 1994),and recognized principles of sovereigntyand command. Language is an exampleof an institution that is not an organiza-tion. A business corporation is an institu-tion and also an organization. All institu-tions and organizations exhibit the fivecharacteristics above.

However, a key difference betweenthe “old” and the “new” institutionalismhere is that in the former the concept ofhabit is central. For the “old” institu-tionalists, habit is regarded as crucial tothe formation and sustenance of institu-tions. Habits form part of our cognitiveabilities. Cognitive frameworks arelearned and emulated within institu-tional structures. The individual relieson the acquisition of such cognitivehabits, before reason, communication,choice, or action are possible.

Learned skills become partially em-bedded in habits. When habits becomea common part of a group or a socialculture they grow into routines or cus-toms (Commons 1934, p. 45). Institu-tions are formed as durable and inte-grated complexes of customs androutines. Habits and routines thus pre-serve knowledge, particularly tacitknowledge in relation to skills, and in-stitutions act through time as theirtransmission belt.

Institutions are regarded as imposingform and social coherence upon humanactivity partly through the continuingproduction and reproduction of habitsof thought and action. This involves thecreation and promulgation of concep-tual schemata and learned signs andmeanings. Institutions are seen as a cru-cial part of the cognitive processesthrough which sense-data are perceived

and made meaningful by agents. In-deed, as discussed below, rationality it-self is regarded as reliant upon institu-tional props.

The availability of common cognitivetools, as well as congenital or learneddispositions for individuals to conformwith other members of the same group,work together to mold individuals goalsand preferences. Accordingly, individu-als are not taken as given. In main-stream economics, widespread lip-ser-vice to notions of individuality andchoice may have helped to obscure thedegree in reality to which conformismor emulation actually occur, even inmodern competitive economies. For an“old” institutionalist, such outcomes arean important part of the institutionalself-reinforcing process.

From an “old” institutionalist per-spective, the institutional action-infor-mation loop in Figure 1 stands out inhigher relief. The imitation and emula-tion of behavior leads to the spread ofhabits, and to the emergence or rein-forcement of institutions. In turn, insti-tutions foster and underline particularbehaviors and habits, and help transmitthem to new members of the group.The additional emphasis here concernsthe role of habit both in sustaining indi-vidual behavior, and in providing the in-dividual with cognitive means by whichincoming information can be inter-preted and understood. Our under-standing of the durable and self-rein-forcing qualities of institutions isenhanced.

The thrust of the “old” institutionalistapproach is to see behavioral habit andinstitutional structure as mutually en-twined and mutually reinforcing: bothaspects are relevant to the full picture(Commons 1934, p. 69). Choosing insti-tutions as units of analysis does not nec-essarily imply that the role of the indi-vidual is surrendered to the dominance


of institutions. A dual stress on bothagency and structure is required, redo-lent of similar arguments in sociologyand philosophy (Roy Bhaskar 1979; An-thony Giddens 1984; Harrison White1992). Both individuals and institutionsare mutually constitutive of each other.Institutions mold, and are molded by,human action.

Institutions are both “subjective”ideas in the heads of agents and “objec-tive” structures faced by them. The twinconcepts of habit and institution maythus help to overcome the philosophicaldilemma between realism and subjectiv-ism in social science. Actor and struc-ture, although distinct, are thus con-nected in a circle of mutual interactionand interdependence.

Summarizing the argument so far, ithas been shown in this section that thewider recognition of the importance ofinstitutions and rules in human societyis endorsed by institutional economicsin the Veblen-Commons tradition, butwith an additional and crucial stresson the role of habit. A circle of interac-tion between actor and structure isbased on the linked concepts of habitand institution. Section IV below addsfurther credence to this argument byconsidering some difficulties that areraised when the explanatory circle isbroken and the individual is given un-warranted ontological and explanatorypriority.

IV. Explaining Institutions: TheProblem of Institutional Infinite Regress

In this section it is argued that at-tempts to explain the origin and suste-nance of institutions on the basis of theassumption of given individuals have in-ternal flaws and inconsistencies. Ac-cordingly, attempts to explain institu-tions in this way may have to beabandoned. The door is opened to a

more open-ended and evolutionary ap-proach, redolent of the earlier institu-tionalists.

Two opposite types of error arepossible. The “cultural determinists”place too much stress on the molding ofindividuals by institutions.11 Such“oversocialized” views of human be-havior have been widely criticized(Mark Granovetter 1985). At the oppo-site end of the spectrum, the “newinstitutional economics” gives no morethan weak stress to the processes of in-stitutional conditioning, and focusesprimarily on the emergence of institu-tions out of the interactions of given in-dividuals. This section explores theproblems that may arise if exclusivestress is put on the latter direction ofcausality.

The distinctive “new” institutionalistproject has been identified as the at-tempt to explain the existence of insti-tutions by reference to a given model ofindividual behavior, and on the basis ofan initial institution-free “state of na-ture.” The procedure is to start withgiven individuals and to move on to ex-plain institutions.

Admittedly, substantial heuristic in-sights about the development of insti-tutions and conventions have beengained on the basis of the assumption ofgiven, rational individuals. The mainproblem addressed here is the incom-pleteness of the research program inits attempt to provide a general theoryof the emergence and evolution ofinstitutions. Some tentative and “evolu-tionary” approaches to solving thisproblem are addressed at the end ofthis section.

11 Rutherford (1994, pp. 40–41) notes howAmerican institutionalism itself moved toward cul-tural determinism and methodological collectivismin the post-1940 period. Such a one-sided empha-sis was not found in the earlier institutionalism ofVeblen and Commons.


A. Internal Problems in Explanations Based on Given Individuals

Alexander Field (1979, 1984) has ad-vanced a key problem in the new insti-tutionalist project to attempt to explaininstitutions solely in terms of given, ra-tional individuals. In trying to explainthe origin of social institutions fromgiven individuals, the new institutionaleconomics has to presume a socialframework governing their interaction.In any original, hypothetical, “state ofnature” from which institutions are seento have emerged, a number of rules,and cultural and social norms are al-ready presumed. No “thought experi-ment” involving an institution-free“state of nature” has yet been postu-lated without them.

For example, game theorists suchas Schotter (1981) take the individual“for granted,” as an agent unambigu-ously maximizing her expected pay-off. Yet, in attempting to explain theorigin of institutions through gametheory, Field (1984) points out thatcertain norms and rules must inevitablybe presumed at the start. There canbe no games without prior rules, andthus game theory can never explain theelemental rules themselves. Even in asequence of repeated games, or ofgames about other (nested) games, atleast one game or meta-game, with astructure and payoffs, must be assumedat the outset. Any such attempt to dealwith history in terms of sequential ornested games is thus involved in aproblem of infinite regress: evenwith games about games about gamesto the nth degree there is still at leastone preceding game left to be ex-plained.

As another example, Williamson’stransaction cost theory of the firm takesits original state of nature as the mar-ket. In a famous passage he writes that

“in the beginning there were markets”(Williamson 1975, p. 20); this startingpoint is characteristic of his approach.From this original context, some indi-viduals go on to create firms and hierar-chies. These endure if they involvelower transaction costs.

However, the market itself is an insti-tution. The market involves socialnorms, customs, instituted exchange re-lations, and—sometimes consciously or-ganized—information networks thatthemselves have to be explained (Dosi1988; Hodgson 1988). Market and ex-change relations themselves involvecomplex rules. In particular, the institu-tion of private property itself requiresexplanation. Markets are not an institu-tion-free beginning. As if in search ofthe original, institution-free, state ofnature prior to property and markets,Williamson (1983) argues that privateproperty can emerge through “privateordering,” that is, individual-to-individ-ual transactions, without state legisla-tion or interference.

The question of the possibility ofproperty and contract without any rolefor the state is debated in legal theory.However, there is another fundamentalobjection to the idea of attempting toground explanations of property or in-stitutions on individuals alone. Evenif the state is absent, individuals relyon customs, norms, and, most em-phatically, the institution of language,in order to interact. Interpersonalcommunication, which is essential to allstories of institutional emergence, itselfdepends on linguistic and other rulesand norms. The shared concept of indi-vidual property requires some means ofcommunication using common conceptsand norms, both before and after ex-plicit or tacit recognition of propertyrights can be established. Even if thestate can be absent from these pro-cesses, some prior institutions are still


required.12 Before an individual maychoose, he or she requires a conceptualframework to make sense of theworld.13 More generally, consideringthe action-information loop in Figure 1above, the reception of “information” inthe new institutionalist story requires aparadigm or cognitive frame to processand make sense of that information.Further, our interaction with others re-quires the use of the institution oflanguage. We cannot understand theworld without concepts and we cannotcommunicate without some form oflanguage. Without the priorinstitutionalization of individuals, theaction-information loop cannot be com-pleted. As the “old” institutionalists ar-gue, the transmission of informationfrom institution to individual is impossi-ble without a coextensive process of en-culturation, in which the individuallearns the meaning and value of thesense-data that is communicated. The“information” arrow on the right handside the figure always and necessarilyinvolves such a process of encultura-

tion. Information cannot be receivedunless the individual has to some de-gree been enculturated through priorengagement with institutions.14 Com-munication requires an institutionalizedindividual.

In the “old” institutional economics,cognition and habit have a centralplace. Knowledge and learning arestressed. There is also an insistence thatthe perception of information is notpossible without prior habits of thoughtto endow it with meaning. Without suchhabits, agents cannot perceive or makeuse of the data received by their senses.Habits thus have a crucial cognitiverole: “All facts of observation are neces-sarily seen in the light of the observer’shabits of thought” (Veblen 1914, p. 53).Such habits are acquired through in-volvement in institutions.

The central “new” institutionalist pro-ject of explaining institutions from indi-viduals alone is thus misconceived. Theproblem of infinite regress identifiedhere undermines any “new institutional-ist” claim that the explanation of theemergence of institutions can start fromsome kind of original, institution-freeensemble of (rational) individuals, inwhich there is supposedly no rule or in-stitution to be explained. At the veryminimum, “new” institutionalist storiesof the development of institutions de-pend upon interpersonal communica-tion of information. And the communi-cation of information itself requiresshared concepts, conventions, rules,routines, and norms. These, in turn,have to be explained.

12 Whether common agreement to and practicalenforcement of property can arise without the ex-istence of a state is a matter of continuing debate.The classic “old” institutionalist argument that thestate was required historically in order to establishlabor, land, and money markets is in Karl Polanyi(1944). Despite his celebrated argument concern-ing the undesigned evolution of money from indi-vidual interactions, even Menger (1936) recog-nized that the state may be necessary to maintainthe integrity of the monetary unit.

13 This raises a problem in Young-Back Choi’s(1993) innovative work. While developing a theoryof conventions and institutions he takes the indi-vidual as “the basic unit of analysis” (p. 5). Choi(pp. 32–39) is thus impelled to have this individualsomehow choosing the conceptual “paradigm” bywhich she makes sense of the uncertain world inwhich she is situated. The unanswered question ison what basis has such an individual “elected toadopt” (p. 39) one paradigm rather than another?Surely this choice itself requires a conceptualframework or paradigm, and norms and criteria ofjudgement, to make some sense of the situation inwhich the choice is made. The choice of paradigmitself requires a paradigm. Again we have a prob-lem of infinite regress.

14 This raises the question of how a newborninfant may acquire information. Our incapacityto learn without prior conceptual frameworksmeans—as James argued long ago and Plotkin(1994) and others elaborate—that much of our in-itial capacity to learn must be genetically inheritedand instinctive. In the eyes of modern psychology,Veblen’s adherence to the concept of instinct isnot as old-fashioned as it used to seem.


B. Which Came First: The Chicken or the Egg?

What is being contested here is thepossibility of using given individuals asthe institution-free starting point in theexplanation. It is not possible to under-stand how institutions are constructedwithout seeing individuals as embeddedin a culture made up of many interact-ing institutions. Institutions not onlyconstrain but also influence individuals.Accordingly, if there are institutionalinfluences on individuals and theirgoals, then these are worthy of explana-tion. In turn, the explanation of thosemay be in terms of other purposeful in-dividuals. But where should the analysisstop? The purposes of an individualcould be partly explained by relevant in-stitutions, culture, and so on. These, intheir turn, would be partly explained interms of other individuals. But these in-dividual purposes and actions couldthen be partly explained by cultural andinstitutional factors, and so on, indefi-nitely.

We are involved in an apparently infi-nite regress, similar to the puzzle“which came first, the chicken or theegg?” Such an analysis never reaches anend point. It is simply arbitrary to stopat one particular stage in the explana-tion and say “it is all reducible to indi-viduals” just as much as to say it is “allsocial and institutional.” The key pointis that in this infinite regress, neitherindividual nor institutional factors havecomplete explanatory primacy. The ideathat all explanations have ultimately tobe in terms of individuals (or institu-tions) alone is thus unfounded.

There is thus an unbreakable circle ofdetermination. This does not mean,however, that institutions and individu-als have equivalent ontological andexplanatory status. Clearly, they havedifferent characteristics. Their mecha-

nisms of reproduction and procreationare very different. Individuals are pur-poseful, whereas institutions are not, atleast in the same sense. Institutionshave different life spans from individu-als, sometimes enduring the passing ofthe individuals they contain. Crucially,each individual is born into, and moldedby, a world of pre-existing institutions:even if these institutions were made byothers and can be changed.

We have seen that the new institu-tionalist project to explain the emer-gence of institutions on the basis ofgiven individuals runs into difficulties,particularly with regard to the concep-tualization of the initial state fromwhich institutions are supposed toemerge. This does not mean that all“new” institutionalist research is with-out value, but it indicates that the start-ing point of explanations cannot be in-stitution-free: the main project has tobe reformulated as just a part of a widertheoretical analysis of institutions. Thereformulated project would stress theevolution of institutions, in part fromother institutions, rather than from ahypothetical, institution-free “state ofnature.” What is required is a theory ofprocess, evolution, and learning, ratherthan a theory that proceeds from anoriginal, institution-free, “state of na-ture” that is both artificial and unten-able.

C. Toward Evolutionary Explanations of Institutional Change

In some cases the “comparative stat-ics” character of such “new” institution-alist explanations is obvious. However,one of the reasons for the rise of “evolu-tionary” thinking in economics since theearly 1980s has been an attempt tobreak the constraints of this mode of ex-planation with its two fixed end-points.Because there is no answer to thechicken-or-egg question, the question


itself has to be changed. The questionshould no longer be “which came first?”but “what processes explain the devel-opment of both of them?” This impliesa movement away from comparativestatics and toward a more evolutionaryand open-ended framework of analysis.Some moves in this direction by twoprominent “new” institutionalists havealready led to a degree of convergencewith the evolutionary and open-endedideas of the “old” institutionalists. Thisis apparent in the later works of Hayek(1988) and the recent writings of North(1990).

Such evolutionary explanations in-volve the search for “a theory of theprocess of consecutive change, realizedto be self-continuing or self-propagat-ing and to have no final term” (Veblen1919, p. 37). Emphatically, abandoningthe attempt to explain all institutions interms of given individuals does notmean the abandonment of theoreticalexplanation. Instead, the origins and de-velopment of organizations and institu-tions are seen as an evolutionary pro-cess. Today, there is a substantialamount of work going on in this area,with extensive use being made of evolu-tionary metaphors taken from biology.

V. The Necessity of Habits and Rules

This section extends the argumentfurther by showing how rational indi-viduals depend on habits and rules. Theprominent idea of the utility-maximiz-ing individual has permitted economiststo ignore the procedures and rules thatare knowingly or unwittingly employedby agents. Most explanations of behav-ior, including the role-driven and thehabitual, can seemingly be encom-passed within the framework of utility-maximization. Accordingly, the underly-ing psychological and other explanatoryissues have been largely ignored. The

encompassing assumption of the “ra-tional” agent is deemed to be sufficient.

The contention here, however, con-cerns the explanatory primacy of habitover such all-encompassing conceptionof rational behavior. We start by posinga question: under what circumstances isit necessary or convenient for an agentto rely on habits or rules?15 The ques-tions of how habits and rules are repli-cated and transmitted in society is side-stepped here to focus on a decisionsituation giving rise to their use. It isargued that even optimization requiresthe deployment of rules, and for thisreason mainstream economics cannotlegitimately ignore these questions.This suggests that a detailed analysis ofthe evolution of specific habits andrules—including the pecuniary rational-ity of agents in a market economy—should be installed at the core of eco-nomics and social theory.

Rules are conditional or uncondi-tional patterns of thought or behaviorwhich can be adopted either con-sciously or unconsciously by agents.Generally rules have the form: in cir-cumstances X, do Y. Habits may have adifferent quality: rule-following may beconscious and deliberative whereas ha-bitual action is characteristically unex-amined. Rules do not necessarily have aself-actuating or autonomic quality butclearly, by repeated application, a rulecan become a habit. Often it is easier tobreak a rule than to change a habit, be-cause our awareness of our own habitsis often incomplete; they have a self-ac-tuating character, being established insubliminal areas of our nervous system.However, habits still have the samegeneral form: in circumstances X, actionY follows.

A familiar question of enduring con-

15 For a treatment of this issue in greater depthsee Hodgson (1997).


troversy is the extent to which optimiz-ing techniques are applicable to deci-sion situations in the real world. Muchof modern economics is founded on theassumption that they are. If assump-tions of perfect information aredropped, it is typically assumed that un-certain or complex decision problemscan still be accommodated using prob-abilities. Against this, a number of crit-ics have argued that a significant pro-portion of decision problems are notamenable to probabilistic or other opti-mization techniques (e.g., Veblen 1919;Keynes 1937; Simon 1957, 1979).

A. Optimization and Rules

However, we shall side-step this well-known controversy here, to focus on a(large or small) class of decision situ-ations in which (bounded) optimizationmay be possible. Consider mathematicaloptimization problems and their solu-tions. The procedures of linear pro-gramming and differential calculus, forexample, sustain methods of optimiza-tion with strict rules. Optimizing proce-dures always involve rules: namely therules of computation and optimization.16

Conventional accounts sometimes ne-glect the universal need for rules of cal-culation to reach optima. One reasonfor this is that optimization processesare often confused with optimal out-comes. However, statements of equilib-rium conditions are not the same thingas the specification of algorithmic orother procedures required to attainequilibria: outcome is not the same asprocess. Another reason for the neglectis the widespread belief that optimiza-tion involves choice and rule-followingdenies it. On the contrary, as arguedabove, mechanical optimization ex-cludes genuine choice.

All explicit optimization proceduresmust involve rules. This raises the sec-ondary but important question of theirorigin. Notably, optimization itself can-not provide a complete explanation ofeither the origin of rules or the adop-tion of rule-driven behavior. As all opti-mization involves intrinsic rules, theidea of explaining all rules on the basisof the optimizing behaviors of agentsinvolves circular reasoning and is thusmisconceived. Hence the question of“where do the original rules comefrom?” remains, and it cannot be an-swered completely in terms of optimiza-tion itself. It is necessary to consideradditional explanations of their genesis,at least to supplement the optimizationstory. In search of this “first cause” weare forced to consider explanationsother than optimization for the relianceof the individual upon rules.

There is also the case of the intuitiveoptimizer, with tacit skills. Although theskills may not be codifiable, they areembedded in habits of the same generalform: in circumstances X, do Y. Like-wise, the formation of these habits can-not be explained by optimization alone,without addressing the other rules, hab-its, or instincts that led to their origin.

This primary reliance on habits or

16 Notably, Vanberg (1994) has suggested thatrational choice and rule-following behavior are in-compatible. He argues that it is inherently incon-sistent to speak of a “rational choice to followrules” or a “rational choice among rules.” To Van-berg, the essence of following a rule is to be par-tially unresponsive to the changing particularitiesof each choice situation. This is contrasted withthe concept of choice, where an individual isdeemed free of such “pre-programmed behavior.”However, first, the quality of being unresponsiveto changing particularities is not an universal fea-ture of rule-following behavior. There are condi-tional rules that discriminate between differentenvironmental conditions and point to differentoutcomes in different circumstances. Second, thevery idea of rational calculation, as shown below,must itself depend on computational rules. Van-berg has also failed to recognize that strict optimi-zation must necessarily exclude choice. As notedabove, an utility-maximizer is essentially a taste-satisfying machine. If choice means the possibilityof acting otherwise then it cannot be predeter-mined by either preference functions or rules.


rules limits the scope of rational optimi-zation. Rationality always depends onprior habits or rules as props (Hodgson1988). Hence rational optimizationalone can never supply the complete ex-planation of human behavior and insti-tutions that some theorists seem to bestriving for. Given that explanation insocial science requires more than thispowerful idea at its core, arguably wemust rely on more complex, contingent,and multifaceted behavioral specifica-tions.

As a result, neoclassical economicscould be regarded as a special and(highly) restricted case of the “old” in-stitutional economics, which acceptedthe ubiquity of habits and rules. In con-trast to their image as myopic and anti-theoretical data-gatherers, institutional-ists have the potential to achieve ahigher level of theoretical generality.Winter (1971) has argued that neoclas-sical economics is a special case of be-havioral economics. We may conclude,further, that both behavioral economicsand neoclassical economics are specialcases of institutional economics. At itsfoundations, institutional economics hasgreater generality and encompassesneoclassical economics as a special case.

B. The Ubiquity of Habits and Rules

The importance of habits and rules isunderlined by consideration of types ofdecision situation or procedure otherthan optimization, such as decisionmaking in the context of complexity oruncertainty. In particular, RonaldHeiner (1983) has shown that individu-als are obliged to rely on relatively sim-ple procedures and decision-rules insuch situations. There are long and es-tablished arguments that individualsmust rely on “conventions” or “rules ofthumb” in situations of radical uncer-tainty (Keynes 1937; Simon 1957).

Skilled deployment of rules must also

involve acquired habits. Habits are usedeven by firms or individuals attemptingto optimize in some way. As the “old”institutional economist John MauriceClark (1918, p. 26) noted, “it is only bythe aid of habit that the marginal utilityprinciple is approximated in real life.”It is an institutionalist tenet that habithas ontological and explanatory primacyover rational choice. Again this impliesa greater level of generality for the coreinstitutionalist approach.17

In practice, the human agent cannotbe a “lightning calculator” (Veblen1919, p. 73), quickly, effortlessly, andinexplicably finding the optimum just aswe can readily locate the lowest point ofa U-curve in a simple textbook diagram.Even with given and unambiguous in-formation, complex optimization prob-lems typically involve difficulties notonly of specification but of comput-ability. Artificially intelligent systemseven in moderately complex environ-ments require “inherited” framing pro-cedures to structure the incoming infor-mation (Zenon Pylyshyn 1986).

C. Evolution and the Limits to Rationality

Strikingly, recent developments inevolutionary psychology (Cosmides andTooby 1994a, 1994b; Plotkin 1994; Re-ber 1993) give strong support to the“old” institutionalist idea of the primacyof habits. The key argument in this lit-erature is that postulates concerningthe rational capacities of the humanbrain must give an explanation of theirevolution according to established prin-ciples of evolutionary biology.

What may be termed the Principle of

17 Clark (1918, p. 25) also wrote: “a good hedon-ist would stop calculating when it seemed likely toinvolve more trouble than it was worth.” HenceSimon’s concept of satisficing behavior finds aclear precedent in the work of an “old” institu-tional economist.


Evolutionary Explanation demands thatany behavioral assumption in the socialsciences must itself be capable of expla-nation along (Darwinian) evolutionarylines.18 However, the empirical andtheoretical work of modern evolution-ary psychologists suggests that, even inhighly intelligent organisms, global ra-tionality is very unlikely to emergethrough evolution. In other words, thestandard assumption of the rational ac-tor fails to satisfy the Principle of Evo-lutionary Explanation.

In an evolutionary view of intelli-gence it is recognized that tacit knowl-edge and implicit learning of an habit-ual character are ubiquitous even inhigher animals, including humans. Thisis because higher levels of deliberationand consciousness are recent arrivals onthe evolutionary scene, and certainlycame after the development of more ba-sic mechanisms of cognition and learn-ing in organisms. That being the case,many of our evolved cognitive processesmust be able to proceed below the levelof full deliberation and awareness.

Cosmides and Tooby (1994a) postu-late that the mind is riddled with func-tionally specific circuits. This contrastswith what they describe as the “Stan-dard Social Science Model,” where themind harbors general cognitive pro-cesses—such as “reasoning,” “induc-tion,” and “learning”—that are “con-text-independent,” “domain-general,”or “context-free.” They show that thisabstract and generalist view of the mindis difficult to reconcile with modernevolutionary biology, giving experimen-tal evidence to support their argument.

A key argument is that all-purposeoptimizing techniques are difficult toconstruct and utilize. First, what counts

as adaptive or (near) optimal behaviordiffers markedly from situation to situ-ation. Second: “Combinatorial explosionparalyzes even moderately domain-gen-eral systems when encountering real-world complexity. As generality is in-creased by adding new dimensions to aproblem space or new branch points toa decision tree, the computational loadincreases with catastrophic rapidity”(Cosmides and Tooby 1994a, p. 56).Third, the generality of all-purposemechanisms undermines their perfor-mance: “when the environment isclueless, the mechanism will be too.Domain-specific mechanisms are notlimited in this way. They can be con-structed to fill in the blanks when per-ceptual evidence is lacking or difficultto obtain” (p. 57). As a result: “Themind is probably more like a Swiss armyknife than an all-purpose blade” (p. 60).

In evolutionary terms, time does not“hammer logic into men.” Cosmidesand Tooby produced evidence that hu-mans are generally poor at solving gen-eral, logical problems. However, whenthese problems are reformulated interms of social interactions, our abilityto solve them increases markedly, de-spite the fact that the logical structureof the problem has not changed. This isclear evidence of special design inbrain, rather than ability to solve gen-eral logical problems.19

Theories of human behavior must beconsistent with our understanding ofevolutionary origins: “The human braindid not fall out of the sky, an inscruta-ble artefact of unknown origin, andthere is no longer any sensible reasonfor studying it in ignorance of thecausal processes that constructed it”

18 Without giving it a name, Veblen (1934, pp.79–80) clearly made use of this principle, in hisdiscussions of the origins of habits, purposeful be-havior, and so on.

19 Significantly, Plotkin has distanced evolution-ary psychology from genetic reductionism. He ar-gues that intelligent behavior “cannot be reduc-tively explained by genetics or genetics anddevelopment” (Plotkin 1994, p. 176).


(Cosmides and Tooby 1994a, p. 68). Ap-plied to economics itself, this principleestablishes the untenability of theprominent assumption “that rational be-havior is the state of nature, requiringno explanation” (Cosmides and Tooby1994b, p. 327). If rational behavior is tobe assumed, then its evolution has to beexplained.

The reintroduction of the concepts ofhabit and instinct into a theory of hu-man behavior helps to provide a founda-tion upon which a theory of institutionscan be built. We have shown that thegrounding of such a theory on the ideaof the given, rational individual is bothunsuccessful, and untenable in ongoing,evolutionary terms. The introduction ofhabit and instinct provides a consis-tency between the socio-economic andbiotic levels of analysis, and establishesan important link between the socio-economic and the natural world. The in-stitutional action-information loop nolonger hangs in empty space: it has abiotic grounding.

This does not mean that explanationsof socio-economic phenomena have tobe in biological terms. Socio-economicreality has emergent properties thatdefy such a reduction. They are differ-ent levels of analysis, but, ultimately,propositions at one level do have to beconsistent with those at another. This isa key reason why economics has to takeaccount of evolutionary biology (Hodg-son 1993).

VI. Conclusion

By institutions, individuals are notmerely constrained and influenced.Jointly with our natural environmentand our biotic inheritance, as social be-ings we are constituted by institutions.They are given by history and constituteour socio-economic flesh and blood.This proposition must cohabit with the

more widely accepted—and equallyvalid—notion that institutions, know-ingly or unknowingly, are formed andchanged by individuals.

It has been suggested above that thebreakdown of the microfoundationsproject provides institutionalism with asignificant entrée. Its focus on institu-tions as durable and typically self-rein-forcing entities provides a convenientmicro-macro link. To see the role of theindividual in relation to institutions is tofocus on the micro aspect. To take theinstitution as a socially constructed in-variant—or emergent property—is a ba-sis for consideration of macroeconomicdynamics and behavior. Accordingly,“old” institutionalists and mainstreameconomists have a great deal to learnfrom each other.

However, some would dismiss thosescholars that reject the rational actorparadigm as being outside “economics,”and consign them to “sociology.” In re-sponse, these vigilantes of “economiccorrectness” have to face two severeproblems. First, leading economistssuch as Smith, Ricardo, Marx, Keynes,Hayek, Simon, and Coase, all failed toincorporate the standard picture of “ra-tional economic man” in their writingsor expressed profound misgivings abouthis behavior. Second, the problem alsohas to be faced that much of “sociology”has now embraced rational choice (forexample, James Coleman 1990).

Among twentieth century economiststhe prevailing practice has been to re-gard the subject as being defined not asa study of a real object—the economy—but in terms of a single approach andset of core assumptions. If the subject isdefined in this way then not muchtheoretical pluralism within economicsis possible; we are stuck with a singletype of theory or approach. Elsewhere,however, a science is normally definedas the study of a particular aspect of ob-


jective reality: physics is about the na-ture and properties of matter and en-ergy, biology about living things, psy-chology about the psyche, and so on. Itis on the basis of their wish to study andunderstand real world economies thatthe “old” institutionalists can retainclaim to the title of being economists.

In fact, the boundary between eco-nomics and sociology that has enduredby the prevailing consensus for the last60 years or so is now being violated onboth sides. The line of demarcation de-fined by “the science of rational choice”is thus losing its legitimacy, and themost reasonable alternative is to at-tempt once again to redefine economicsas the intellectual discipline concernedwith the study of economic systems. Inother words, it should be defined, as inother sciences, in terms of its object ofanalysis, rather than by any set of priortenets.

It may be conjectured that the loss ofthe reigning twentieth-century bounda-ries between the social sciences fore-shadows a great centennial climactericin these intellectual disciplines. Forlong the butt of the critic from the het-erodox fringes, rational economic manhas increasingly come under challengefrom the mainstream in recent years,partly because of developments in gametheory. It has been suggested by leadingeconomists such as Frank Hahn (1991)that one of the central responses to thedeveloping crisis will be the deconstruc-tion of the rational actor that has longruled economics. Optimizing activitywill be recognized as no more than aspecial case of a larger set of possiblemodes of behavior, with all of them be-ing required to render viable explana-tions of their origin and evolution.

Biology is widely seen as the scienceof the twenty-first century. Followingthis lead—and to conjecture further—inthe renewed social sciences the uniting

and fundamental precepts will be theprinciples of evolution themselves, stilltaking strong inspiration from the meth-odology and approach of Darwin. Weshall thereby take a huge step back intime and visit the evolutionary contro-versies of the 1890s and early 1900s—and the intellectual world of Peirce,James, Veblen, and Commons—and dis-cover that much of what we want to sayhas already been said before. Only thenwill we be able to read the works of the“old” institutionalists and fully appreci-ate their achievement.

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The Approach of Institutional Economics (March 1998)