Institutional economics

Based on Wikipedia: Institutional economics

The Invisible Architecture of Economic Life

Here's a puzzle that classical economics never quite solved: why do some societies prosper while others stagnate, even when they have access to the same technologies and resources? The answer, according to a rebellious tradition in economic thought, has almost nothing to do with supply curves or rational actors maximizing utility. It has everything to do with something far messier and more human: institutions.

Not institutions in the sense of buildings or organizations, though those matter too. Institutions as the unwritten rules, habits, legal frameworks, and social expectations that shape how people actually behave when they go about the business of making and exchanging things.

This is the domain of institutional economics, a school of thought that emerged in the early twentieth century as a direct challenge to the elegant but bloodless abstractions of mainstream economic theory. Its founders looked at the textbook model of the economy—populated by perfectly rational individuals making optimal choices in perfectly competitive markets—and asked a simple question: have you ever actually met a human being?

The Rebellion Begins

The story properly begins with Thorstein Veblen, one of the strangest and most original minds in the history of economic thought. Born in 1857 to Norwegian immigrant farmers in Wisconsin, Veblen never quite fit into polite academic society. He dressed poorly, spoke with a thick accent, conducted scandalous affairs, and wrote prose of such elaborate irony that readers sometimes couldn't tell when he was serious.

But he saw things that other economists missed entirely.

In 1899, while teaching at the University of Chicago, Veblen published The Theory of the Leisure Class, a book that introduced a concept now so familiar we forget how revolutionary it once was: conspicuous consumption. Veblen noticed that wealthy people didn't just buy expensive things because those things were useful. They bought expensive things precisely because they were expensive—to signal their status, to demonstrate that they could afford to waste money.

This was heresy. Classical economics assumed people spent money to maximize their utility, their satisfaction. Veblen suggested they spent money to impress their neighbors, and that this seemingly irrational behavior followed its own logic, shaped by the institutions and habits of the society around them.

He didn't stop there. In The Theory of Business Enterprise, published in 1904, Veblen drew a sharp distinction between two ways of thinking about economic activity. On one side stood industrial production—engineers and workers actually making useful things. On the other stood business enterprise—financiers and executives manipulating industrial assets for profit. These two logics, Veblen argued, often worked at cross-purposes. Business didn't always want more production; sometimes it wanted less, if scarcity meant higher prices. Sometimes it wanted to restrict new technologies that might disrupt existing investments.

When the Wall Street crash of 1929 plunged America into depression, Veblen's warnings about reckless finance and wasteful consumption suddenly seemed prophetic. He had died just two months before the crash, but his ideas were about to find a much wider audience.

What Makes Economics Evolutionary

In 1898, Veblen had asked a question that still reverberates through economic thought: "Why is economics not an evolutionary science?"

By this he meant something specific. The natural sciences had embraced Darwin. They understood that species weren't fixed categories but constantly evolving entities, shaped by their environments over time. Economics, by contrast, still treated human preferences and institutions as essentially static—things you could take as given and then analyze mathematically.

Veblen thought this was backwards. Economic institutions weren't natural facts like gravity. They were human creations, products of history, habit, and power. They changed over time, sometimes dramatically. And they shaped the very preferences that economists liked to treat as independent inputs.

Think about what this means. Standard economics starts with individuals who have fixed preferences—they want what they want, and markets exist to help them get it efficiently. Institutional economics suggests something more unsettling: what you want is itself shaped by the institutions you live within. Work at a corporation for twenty years and you'll think differently than someone who spent those years as an independent craftsman. Grow up in a society with strong unions and you'll have different expectations about fair wages than someone from a society without them.

Institutions don't just facilitate exchange. They constitute the people doing the exchanging.

The Mediator

While Veblen provided the critique, another economist provided a more constructive vision of what institutional economics might look like in practice. John R. Commons, born in 1862 in Ohio, spent his career at the University of Wisconsin, where he developed ideas that would quietly reshape American labor law and government policy.

Commons saw the economy not as a harmonious machine tending toward equilibrium, but as a web of relationships between people with genuinely conflicting interests. Employers and workers, producers and consumers, large corporations and small businesses—these groups didn't have naturally aligned incentives. Their conflicts were real, not the result of some market imperfection that better information would solve.

But Commons wasn't a revolutionary. He didn't want to abolish capitalism. Instead, he saw government as a potential mediator, a neutral party that could help conflicting groups reach workable bargains. This might sound obvious now, but in the early twentieth century it was a significant departure from both laissez-faire orthodoxy (which held that government should stay out of the economy) and socialist theory (which held that class conflict could only be resolved by abolishing capitalism entirely).

Commons didn't just theorize about mediation. He practiced it. He spent years serving on government boards and industrial commissions, helping to craft the legal infrastructure of American labor relations. His influence can still be seen in institutions like the National Labor Relations Board, in the legal frameworks that govern collective bargaining, in the very idea that government might have a legitimate role in refereeing economic disputes.

When the Controllers Are Not the Owners

In 1932, at the depths of the Great Depression, two scholars published a book that would fundamentally change how people thought about corporations. Adolf Berle, a lawyer who had attended the Paris Peace Conference in 1919 as a young diplomat, teamed up with economist Gardiner Means to produce The Modern Corporation and Private Property.

Their argument was deceptively simple: in the large corporations that now dominated the American economy, ownership and control had become separated.

In classical economic theory, the people who owned a business also ran it. They faced the consequences of their decisions directly. If they made wise investments, they prospered; if they made foolish ones, they suffered. This alignment of interests was supposed to keep businesses efficient and responsive to market signals.

But Berle and Means showed that in the modern publicly traded corporation, this alignment had broken down. Thousands or millions of shareholders technically owned the company, but they had almost no real power over its operations. They were too dispersed, too poorly informed, too lacking in means of communication to coordinate effectively. Meanwhile, a small group of professional managers actually controlled the company's resources and decisions.

This created a troubling possibility. The managers might run the company in their own interest rather than in the interest of the owners. They might pay themselves excessive salaries, make decisions that protected their positions rather than maximized value, or simply manage badly with little accountability.

Berle served in Franklin Roosevelt's administration, helping to craft New Deal policies that attempted to address some of these problems through securities regulation and corporate governance reforms. In 1967, he and Means published a revised edition of their book with an even more provocative preface. They questioned not just whether shareholders were getting their fair share, but what the whole corporate structure was supposed to achieve in the first place.

Shareholders, they noted, did nothing to earn their dividends. They simply held a position that entitled them to a share of the profits generated by other people's labor and ingenuity. The only justification for such a system, Berle and Means argued, was social utility—that it somehow served the common good. And that justification only held, they suggested, if share ownership were widely distributed across the population, giving ordinary families a stake in the system rather than concentrating wealth in a few hands.

The Technostructure and the Affluent Society

John Kenneth Galbraith was born in rural Ontario in 1908, eventually becoming perhaps the most publicly influential economist of the twentieth century—not through technical contributions to the discipline, but through a series of bestselling books that challenged how ordinary people thought about the economy.

In The Affluent Society, published in 1958, Galbraith coined the term "conventional wisdom" to describe ideas that persist not because they're true, but because they're familiar and comforting. The conventional wisdom of his time held that economic growth was always good, that markets were essentially self-regulating, and that consumer sovereignty—the idea that producers simply respond to what consumers want—ensured that the economy served human needs.

Galbraith thought this was largely nonsense. In an age of giant corporations with massive advertising budgets, consumers didn't shape production. Production shaped consumers. Companies spent billions creating demand for their products, manipulating tastes and expectations through sophisticated marketing. What people wanted wasn't some independent fact that the economy responded to; it was itself manufactured by the institutions of corporate capitalism.

He called this the "dependence effect." The very wants that the economy purportedly satisfied were created by the economy in the first place. This made the whole edifice of consumer sovereignty—and the claim that market outcomes reflected genuine human preferences—philosophically suspect.

Galbraith's critique went further in The New Industrial State, published in 1967. Here he argued that the large corporations dominating the American economy were no longer really run by their nominal owners or even by their visible executives. They were run by a "technostructure"—a bureaucracy of experts in management, marketing, engineering, and finance who made most of the actual decisions.

This technostructure was self-serving in ways that had nothing to do with profit maximization. Its members wanted stability, predictability, and steady growth that would secure their positions. They feared uncertainty and competition. And they were powerful enough to recruit governments to serve their interests, through fiscal and monetary policies that ensured steady demand and stable markets.

Meanwhile, Galbraith observed, the public realm withered. The private sector produced ever more elaborate luxuries—big cars, fancy appliances, manicured suburban lawns—while public goods like schools, parks, and infrastructure decayed. Americans stepped from air-conditioned homes onto potholed streets, from landscaped private gardens into neglected public spaces.

The New Institutionalism

By the late twentieth century, the original institutionalists had mostly passed from the scene, and mainstream economics had developed in ways that seemed to vindicate the mathematical, model-building approach they had criticized. But institutionalist ideas never entirely disappeared, and in the 1970s and 1980s they experienced something of a revival under the banner of "new institutional economics."

The new institutionalists were less hostile to mainstream economics than their predecessors had been. They tried to integrate institutional analysis with the tools and assumptions of neoclassical theory. They asked questions like: why do firms exist at all, rather than every economic transaction occurring through markets? Why do some contracts take certain forms rather than others? How do property rights emerge and evolve?

One key insight was that transactions themselves have costs. It takes time and effort to find someone to trade with, to negotiate terms, to write and enforce contracts, to monitor compliance. These "transaction costs" help explain many institutional arrangements that seem puzzling from a pure market perspective. Firms exist because sometimes it's cheaper to organize production through hierarchy than through repeated market transactions. Contracts take the forms they do because those forms minimize the costs of negotiation and enforcement given the information available to the parties.

Scholars like Elinor Ostrom, who won the Nobel Prize in Economics in 2009, showed how communities often develop sophisticated institutional arrangements to manage common resources—fisheries, forests, irrigation systems—without either private property or government regulation. These arrangements worked because they had evolved to fit local circumstances and because they embedded enforcement mechanisms in social relationships and community norms.

The new institutional economics influenced fields far beyond economics proper. Organizational theory, management studies, industrial relations, public administration—all incorporated insights about how institutions shape behavior and how transaction costs influence organizational form.

The Concept That Means Everything and Nothing

Institutional economics has its critics, and their main objection is fundamental. What exactly is an "institution"? The term gets applied to everything from legal codes to informal norms to organizations to habitual patterns of thought. If institutions are everything that shapes economic behavior beyond individual preferences and technology, then institutions are essentially everything. And a theory of everything is a theory of nothing in particular.

Critics argue that the concept has become a buzzword, a label that obscures more than it reveals. Calling oneself an "institutionalist" doesn't specify any particular theory or methodology; it just signals skepticism about mainstream economics without committing to any alternative. Endless debates about who counts as a true institutionalist, and what the essential features of institutional analysis really are, suggest that the tradition may be more a sensibility than a school of thought.

There's something to this critique. But there's also something to be said for a tradition that insists on asking questions that formal models can't easily answer. Why do some societies develop market economies while others don't? Why do similar policies produce such different results in different contexts? Why do people so often fail to behave as textbook rational actors?

The institutionalists didn't always have good answers to these questions. But they refused to assume the questions away. They insisted that economies are embedded in societies, that human behavior is shaped by history and habit, that the legal and social frameworks within which markets operate are not neutral containers but active forces shaping outcomes.

Beyond Homo Economicus

At the heart of institutional economics lies a different vision of human nature than the one found in most economic textbooks. The textbook vision gives us Homo economicus—rational, self-interested, with stable preferences, maximizing utility through careful calculation. Behavioral economists Richard Thaler and Cass Sunstein, drawing on institutionalist insights, suggest we replace this figure with someone more recognizable: not an "Econ," but a "Human."

Humans are social creatures. We care about what others think of us. We follow habits and conventions without conscious calculation. Our preferences aren't fixed but shaped by our experiences and environments. We make systematic cognitive errors. We are susceptible to framing effects, where the same choice presented differently leads to different decisions. We often don't know what we want until we see what others are choosing.

None of this makes humans irrational in some simple sense. It makes us embedded—in communities, in institutions, in histories. Our rationality is "bounded," to use the term coined by Herbert Simon, another Nobel laureate sympathetic to institutionalist thinking. We don't have infinite information or infinite computational capacity. We satisfice rather than optimize, choosing options that are good enough rather than theoretically best.

This vision of human nature has profound implications for policy. If people don't have fixed preferences but are shaped by their institutional environments, then changing those environments changes people. The question isn't just how to satisfy preferences efficiently but what kinds of preferences different institutional arrangements will cultivate. Markets aren't neutral mechanisms for preference satisfaction; they're educational institutions that teach people to think of themselves as consumers and competitors.

Why It Matters Now

As we navigate an era of institutional crisis—of declining trust in governments, corporations, and traditional sources of authority—the institutionalist tradition offers some hard-won wisdom.

Institutions matter more than policies. You can have the best policies in the world, but without institutions capable of implementing them, they're worthless. Building and maintaining institutions is slow, unglamorous work, and destroying them is much easier than creating them. This is why political instability is so costly: not because of the immediate disruption, but because of the institutional capital that gets squandered.

Institutions are also self-reinforcing. They create the people who then perpetuate them. Workers in hierarchical organizations internalize hierarchical norms. Citizens in democratic societies develop democratic habits. This is why rapid institutional change is so disorienting: people suddenly find that the skills and dispositions they developed no longer fit their environment.

And institutions are path-dependent. History matters. The choices made at one moment constrain the choices available at the next. This is why some societies seem stuck in dysfunctional patterns while others maintain virtuous cycles. Breaking out of a bad institutional equilibrium is possible, but it's rarely easy and often requires moments of crisis that open windows for fundamental change.

The institutionalists didn't solve economics. They raised questions that the discipline is still grappling with, often awkwardly. But they remind us of something that formal models tend to obscure: economies are made by people, embedded in societies, shaped by history, and changeable by collective action. That's not the whole truth about economic life, but it's an important part of it—and one that elegant equations can easily make us forget.