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The Role of Institutions in Growth and Development of a Country

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Over the last few years, institutions have come to the front of the discussions regarding economic growth. Many researchers, most famously Daron Acemoglu and Jim Robinson, have argued that institutions are key to understand why some nations grow while other stagnate. However, institutions are not fixed over time: they constantly change and adapt. Moreover, economists lack a good theory of institutional change and can offer little advice along those lines. However, it is highly expedient to evaluate the evidence for the importance of institutions and discuss historical examples of deep institutional changes, such as the American Revolution, the Meiji Restoration, or the transition to democracy of Mediterranean countries in the 1970s. How and when do we observe institutional change? How do groups overcome collective action problems? Do institutional changes seed their own demise in the future? What advise can we offer to societies trap in bad institutional arrangements?

Early Contributions

The first important contributions to the economics of social institutions announced a new approach to economics and advanced important criticisms of existing economic thinking. The articles collected in this Part of the book represent five influential statements of what an institutional economic approach involves. The first three are well-known classics; the latter two take stock of early thinking. Together they lay out the main boundaries and commitments of the economics of social institutions. Thorstein Veblen’s famous article defined many of the themes of institutionalism, and has since stood as a defining document for subsequent authors. His charge is straightforward and perhaps still applies to current economics: despite an already long history, economics at the beginning of the twentieth century was ‘helplessly behind the times’, and was not up to the standards of modern science because it had failed to become an evolutionary science. The classical economists saw the laws and principles governing the economy as normal and natural, and accordingly allowed ideals of conduct to serve as their measure of truth. Their taxonomic approach lacked an understanding of the economic process as continuous cumulative change.

The Historical school was a modest advance, but was still pre-Darwinian and barely economic theory. The Austrian marginal utility and subjective value school had a ‘faulty conception of human nature,’ and its ‘hedonistic conception of man’ as ‘a lightning calculator of pleasures and pains’ is incompatible with understanding how the ‘economic life history of the individual is a cumulative process of adaptation of means to ends that cumulatively change as the process goes on’. For Veblen the economic life of any community is constantly shaped and re-shaped by our changing material interests amidst a succession of changing economic institutions.

Economics as an evolutionary science traces this cumulative process. It sees the habits and propensities of human beings as a reflection of their hereditary and cultural antecedents. Knowledge in economics needs to be formulated in terms of causal sequence. This is the case in other sciences, but economics has persisted with its theorems about ‘normal’ cases. This may serve some ceremonial or aesthetic effect, but it neglects the realities of modem industrial life and technological change. Veblen believed this state of affairs to be unsustainable. Walton H. Hamilton’s early influential statement of the ‘institutional approach’ was also instrumental in heralding a new approach to economics. He saw a divide between ‘value’ economics with its focus on utility and the origins and manifestations of value and institutional economics with its emphasis on the customs and conventions of the economic system. The former, he charges, fails to recognize ‘the complexity of the relations which bind human welfare to industry’ a complexity which only increases with time.

Modem industrial society requires an economic theory which is able to explain it. Hamilton gives five tests for such a theory, and defends institutional economics as passing all these tests. First, economic theory needs to be able to unify economic science. Economics appears to be a collection of at best overlapping inquires, and value economics does not bring them together. An institutional economics focus on economic organization can unify economic science. Secondly, economics needs to address the modern problem of control. The change in the nature of the modern economy makes it important to recognize that institutions are social arrangements that can be changed rather than natural phenomena. Thirdly, the subject matter of economics is institutions. The price system, credit, forms of business, contracts, property, and so on are all institutions of modern industrial society. Fourthly, economics is concerned with process. In contrast, value theory approaches phenomena as if they were unchanging physical substances. It cannot deal with a genetic and historical ‘economic dynamics’ and only offers an ‘economic statics’ of mechanical formulas and equilibrium ideas. Fifthly, economics needs to be based on an acceptable theory of human behavior. But neoclassical economics is tied to individualism, rationality, and utilitarianism, and thus ignores what modern psychology has taught us about human behavior.

For all these reasons, then, institutional economics offers a way forward for economic science. Yet, for Hamilton, the future of institutional theory was uncertain. The issue, he believed, was whether institutional theory wou1d fit in with the thought of the time. John R. Commons was an influential leader of the Wisconsin school of institutionalism. He saw that there were competing accounts of what institutions are, and so defined them as being concerned with collective action that aimed at the control, liberation, and expansion of individual action. He believed this conception brought economics, jurisprudence, and ethics together, and determined the overall domain of institutional economics. This then meant that the ultimate unit of economic investigation was not individual behavior or the exchange of commodities, which had been the concern of the classical and ‘hedonic’ economists, but rather transactions between individuals and the working rules that underlie them.

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