Institutions are the humanly devised constraints that structure human interaction. They are made up of formal constraints (rules, laws, constitutions), informal constraints (norms of behavior, conventions, and self-imposed codes of conduct), and their enforcement characteristics. Together they define the incentive structure of societies and specifically economies. 

– Douglass North, Nobel Prize Acceptance Speech (1993)

Developing an economic theory has always been a path-dependent exercise. That is, the evolution of the theory is greatly influenced by the trajectory of historical events. Karl Marx’s historic materialism and stages of development that tried to explain human history starting from the interpretation of Industrial Age in Victorian England, Adam Smith’s invisible hand with its four stages of history trying to explain the transition from Feudalism to Capitalism in Europe, Keynes’ theory of aggregate demand aimed at understanding the Great Depression and finding a solution to mitigate the worst of any future depression (or recession), Austrian economics’ tool of methodological individualism and methodological subjectivism to understand the Great Depression, rise of Capitalism in Europe and even the rise and fall of Communism in the erstwhile USSR etc- all these approaches started either with the individual or the collective as the fundamental unit of analysis. For example, individual entrepreneurs and their pursuit of profit through innovation were said to be the source of knowledge discovery in economies. But the evolution of enterprises in itself wasn’t accorded due attention till Ronald Coase wrote his famous ‘The Nature of the firm’. Entrepreneurship helped in understanding the economic dimension of human activity whereas the political and social dimensions remained distinct sub-disciplines of research. But there was difficulty in analyzing them separately. The difficulty for theorists was that the human action involves elements of social, political and economic decision-making. Decision-making in one sphere is influenced, to varying degrees, by those from the other two. This called for a deeper understanding of the dynamics among these three. As a beginning, the Virginia School of Political Economy led to the economic analysis of politics in the form of public choice theory through the works of James Buchanan, Gordon Tullock etc. Further developments needed not just a revision of primary assumptions but the epistemology of ‘theory’ itself.

Every theory has a prescriptive and descriptive component to it. While the descriptive component helps in deciphering the events of the past, the prescriptive component helps in making predictions to facilitate future course of action. Starting from the Great Depression to the recent financial crisis, the prescriptive component of major theories and models has come under heavy criticism. The inability of these models to make predictions can be ascribed to the assumptions behind the theories themselves. In the individual-centric theories it was assumed that an individual is omniscient and in the collective-centric theories it was assumed that the society/group/tribe is omniscient. The theories had to make improbable assumptions to facilitate analysis such as the perfect competition and rationality in neo-classical economics and theory of alienation & class struggle (for social development) in Marxism etc. The deficit in the theories was either due to neglect of heuristic nature of human evolution or the in-sufficient treatment of the same. Descriptive component of the theory shares a similar fate. While Adam Smith’s invisible hand attempted to explain the boons of industrialization, Marx’s class struggle tried to explain the banes of industrialization through class conflicts. While economics presumed man to be rational, understanding political expediency or voter-mindset couldn’t afford the assumption of homo economicus. What was neglected in all former analyses were the rules or institutions developed by humans to facilitate the conduct of their affairs. The evolution of institutions was merely seen as a corrective action aimed at making the transaction costs zero. But what happens when the transaction costs do not become zero? That was the basis for Ronald Coase’s paper explaining the formation of firms and organization in an economy. Study of institutions in an economy is different, according to Douglass North because, ‘The analytical framework is a modification of neo-classical theory. What it retains is the fundamental assumption of scarcity and hence competition and the analytical tools of micro-economic theory. What it modifies is the rationality assumption. What it adds is the dimension of time.”

According to Douglass North ‘The analytical framework is a modification of neo-classical theory. What it retains is the fundamental assumption of scarcity and hence competition and the analytical tools of micro-economic theory. What it modifies is the rationality assumption. What it adds is the dimension of time.”

Humans in a society survive by transacting with each other. When the cost of transaction is not zero, they try to minimize it. Institutions are conceived and subsequently evolve to facilitate this minimization. It’s possible that most of the transacting partners of the institutions could be alienated from critical decision-making. This was why aristocracy, meritocracy, plutocracy, oligarchy etc. eventually lead to class struggles. What democracy has achieved is to provide a voice for every transacting individual in the design of the institutions under which they function. This has its own perils as reflected in the work of Malcur Olson, James Buchanan, Gordon Tullock, Elinor Olstrom etc. But ultimately, institutions form the incentive structure of any society. Unless we strive to understand institutions as a means of politico-economic organization, our understanding of economic history will be incomplete and hence by the path-dependent nature of theory-evolution, we will continue to develop insufficient theories which in turn will be utilized to make misinformed policy decisions. Therein rests the motivation to pay more attention to the idea of institutions.

The article first appeared on Spontaneous Order.

Posted by The Indian Economist