Pathway to development
Using New Institutional Economics to explain different growth trajectories of various nations
Ever since man organised himself into geographical entities such as city-states and nation-states, we have seen different nations having different experiences of development and economic growth. In the present series of papers, we will examine how nations experience different growth trajectories. We will examine whether institutions explain variations in economic growth or there are other competing explanations. But before that, I would like to explore how the Neoclassical model has failed to explain such variations and how it has been modified and challenged over the years. To my mind, the Neoclassical paradigm has been challenged to take it into three directions: a) New Institutional Economics, b) Public/Social Choice and c) Behavioural Economics. These three are not mutually exclusive and overlap in a number of areas. Let us see how.
Neoclassical Paradigm and New Institutional Economics (NIE)
As we know, New Institutional Economics developed by calling into question various assumptions of the Neoclassical model. In other words, it did not transplant Neoclassical economics but modified it by introducing more real-life concepts into the model such as institutions, transaction costs, bounded rationality, property rights and asymmetric information.
One reason why Neoclassical economics did not do a good job of explaining how markets function better in certain places and fail in others or why some nations succeed and others fail was because of the nature of its development. We may recall that Neoclassical economics was born at the end of the 19th century by displacing the established wisdom of Classical economics. While Classical economics included the works of Adam Smith and David Ricardo, where costs determine the value of the product, in Neoclassical economics, the value of a product was determined by the utility to the consumer. The Neoclassical paradigm marched forward with the marginal revolution, which basically stated that economic actors (producers and consumers) made decisions based on marginal values such as marginal cost, marginal production, marginal revenues, etc. The initial proponents of the marginal revolution were Jevons, Menger and Walras. Their work was taken forward by well-known economists like Marshall (Principles of Economics), Hicks (Value and Capital), Pareto and others.
It is apparent that the Neoclassical model developed mainly in Western Europe and the United States. These countries had already achieved a fair degree of development, the markets here were firmly established and the 'efficient market hypothesis' was firmly in play. Issues such as provisions of public goods came up only rarely when a discussion of market failure was undertaken. Only after the Great Depression, the limits of the 'efficient market hypothesis' and the Neoclassical model began to be realised. The familiar assumptions that markets are always available to exploit 'gains from trade' proved to be illusive. Issues such as lack of governance and absence of institutions began coming to the fore.
In the 1950s and 1960s, many countries under colonial rule became independent and later, many of the Communist nations collapsed in the 1980s and 1990s. The issues of economic development, building up of institutions, provisioning of public goods, eradication of poverty, etc., became more salient only after these events. Most economic policy at the time was driven by the Washington Consensus which essentially spoke of free-market policies with minimal government intervention and free trade. However, when development challenges became more complex and even developed countries witnessed instability (bouts of 'stagflation' in the 1970s in developed countries where inflation coexisted with stagnant growth) the Neoclassical model started being questioned.
We may recall that in the immediate aftermath of the Great Depression, Keynes had proposed a greater role for the government. Most of the macroeconomic thinking of Keynes was absorbed into Neoclassical economics by Paul Samuelson and was referred to as the 'Neoclassical synthesis'. The Neoclassical model never really went out of fashion. It was only after the challenges of governance and development in newly independent and erstwhile communist countries mentioned above that the assumptions of these models began to be questioned. Some of the assumptions that were relaxed were perfect and complete information, rationality, zero transaction costs, absence of institutions etc. This led to a body of work called the New Institutional Economics whose main proponents were Ronald Coase, Elinor Ostrom, Douglass North, Oliver Williamsons and Mancur Olson. As seen above and in my earlier articles, the NIE essentially incorporated institutions into the Neoclassical model.
Neo-classical Paradigm and Public Choice/Social Choice
The body of work called Social Choice theory did not challenge Neoclassical economics but pushed its boundary outwards to analyse collective decisions. It went into the realm of voting choices, which was basically the subject of political science. While Condorcet is considered as the father of social choice, it was Kenneth Arrow, the Nobel Prize winner in 1972, who, with his Impossibility Theorem, popularised this stream of economics. As I have discussed in these columns, Arrow basically proved that individual preferences cannot be aggregated into collective preferences under certain conditions. Other economists and political scientists took Arrow's result into areas such as voting choices, social choices, legislative design, collective decision making and welfare economics. We have discussed the works of such scholars in these columns earlier (William Riker, Gordon, Tullock, Mckelvey, Duncan Black, Anthony Downs etc.)
Neoclassical Paradigm and Behavioural Economics
While the New Institutional Economics and Public/Social choice theory did not supplant Neoclassical economics, Behavioural economics proposes an alternative to Neoclassical economics. It provides a different explanation of decision making by individuals and institutions. It basically challenged one of the main assumptions of neoclassical economics viz., rationality. In a sense, Behavioural economics is reaching out to Classical economists such as Adam Smith who had proposed that individual behaviour is driven by psychological factors and concerns about equity and justice. Similarly, Jeremy Bentham had invoked psychological foundations of utility. It was, however, Herbert Simon who can be regarded as the father of Behavioural economics. In fact, he was one of the first to question the rationality assumption of Neoclassical economics. Simon had proposed two ideas viz., bounded rationality and satisficing. By bounded rationality, Simon had said that an individual has cognitive limitations and cannot comprehend all the possible alternatives in his mind and then rank these in order of his preference. Accordingly, decision-makers do not reach for optimal solutions; rather they 'satisfice', meaning that they seek a satisfactory solution.
In more recent times, Behavioural economics has been popularised by the work of Daniel Kahneman and Amos Tversky who were the winners of the Nobel Prize in 2002 (Daniel Kahneman is also the author of the famous book, Thinking Fast and Slow). Loss Aversion was another concept popularised by Kahneman and Tversky whereby people preferred avoiding loss as compared to acquiring equivalent gains. For example, people prefer not to lose Rs 1,000 as compared to not finding Rs 1,000. Way back in 1979, Kahneman and Tversky had published a book on Prospect Theory that had challenged the Neoclassical paradigm and used cooperative psychology to explain economic decision making. In the same book, Kahneman and Tversky had propounded that individuals use 'heuristics' or simple references or 'rule of thumb' to make decisions under complex situations.
Robert Shiller, the Nobel Prize winner in 2013, worked on explaining why decision-makers make irrational systematic errors in the world of finance. Richard Thaler who got the Nobel Prize for economics in 2017 also contributed to integrating the economic and psychological aspects of individual decision making. His famous works include the Nudge Theory, which basically says that human beings are not supercomputers while taking decisions but make predictable mistakes because of the use of 'heuristics'. He also popularised Behavioural economics through books like Quasi-Rational Economics and The Winner's Curse where he has propounded that there is a limit on human beings' rationality and that humans do not always have self-control.
Coming back to the question which I raised in the first paragraph above, I believe that out of three different directions in which Neoclassical economics has developed, New Institutional Economics is most suited to explain the variations in the development trajectories of various nations. This is in contrast with Public/Social Choice theory, which can be of use in certain aspects of economic growth such as the distribution of income or legislative design but would perhaps fall short in explaining why some nations see remarkable growth and others fail. Similarly, Behavioural economics can help us understand individual decision making better but may not be able to explain the differential performances of various economies.
In the next few articles, we will attempt to answer the question 'Why some nations fail and why some succeed' using tools of New Institutional Economics and attempt to explain the variations in the development experience of various countries.
The writer is an IAS officer, working as Principal Resident Commissioner, Government of West Bengal. Views expressed are strictly personal