Evolutionary Change in Institutions and Markets

1. Evolutionary Change in Institutions and Markets Chris Mantzavinos Paris, December 9, 2008

2. I would like to formulate first the three main questions to which I am going to provide an answer in my talk today.

3. My book is - broadly speaking - on Economics • But why is Economics useful?

4. Economics is extremely useful as a form of employment for economists“ John Kenneth Galbraith and…

5. „The only function of economic forecasting is to make astrology look respectable“ John Kenneth Galbraith

6. 2. Since we are all Institutional Economists nowadays. Why is Institutional Economics useful?

7. One of the reasons that it is useful is that it deals with governments and their economic policies. • But what is the government`s view of the economy?

8. „Government`s view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it.“ Ronald Reagan

9. 3. My talk today will have as a subject matter how assumptions about human behavior and institutional economics are interrelated. Why is dealing with this subject matter useful?

10. „Most economists make the assumption that man is a rational utility maximiser. This seems to me both unnecessary and misleading. I have said that in modern institutional economics we should start with real institutions. Let us also start with man as he is. I am not calling into question that more is demanded if something becomes easier to get or that more is supplied if the price is raised. But what is being maximized? Some of my colleagues quote a statement of Bentham`s to the effect that madmen also calculate. This is a correct and, I believe, very important statement. But I would stop there. I do not think that we should draw the conclusion that madmen are also rational.“ Ronald Coase

11. Evolutionary Change in Institutions and Markets • Introduction • Individual Learning • Collective Learning and Change • Path Dependence: Cognitive, Institutional and Economic • Conclusion

12. 1. Introduction • One of the greatest challenges in the social sciences is to explain change, more specifically: social, political, economic and organizational change • Starting point should be an account of human learning as the fundamental prerequisite for explaining such change • Methodological individualism # Rational Choice Theory

13. 2. Individual Learning • Cognitive science: relationships among brain, mind and behavior • Many competing explanations for perception, learning, memory, and attention • For our own explanatory purposes as social scientists, we want to use a theory that satisfies the following three criteria:

14. An empirically testable account of individual learning • A satisfactory account of choice processes • A foundation for explaining the processes of social learning, since the ultimate phenomena of interest are economic and political change

15. In light of these criteria I propose to view the mind as a complex structure that actively interprets and at the same time classifies the varied signals received by the senses. • Pragmatic notion of mental models • They are typically formed in pragmatic response to a problem situation in order to explain and interpret the environment • Learning is the complex modification of the mental models according to the feedback received by the environment

16. When environmental feedback confirms the same mental model many times, it becomes stabilized in a way. I call this relatively crystallized mental model a “belief”. • The interconnection of beliefs (which can be either consistent or inconsistent) I call a “belief system”. • Old Problems Rule-following • New Problems Choice

18. 3. Collective Learning, Institutions and Markets • Learning at the societal level can be best conceptualized as a process of collective learning. Two aspects: • Static: Formation of Shared Mental Models as a result of communication • Evolutionary: Evolution of Shared Mental Models over time • Theoretical Knowledge (expressible in linguistic terms): Science • Practical Knowledge (not expressible in linguistic terms): driving a car, typing a paper etc.

19. As collective learning takes place at the societal level, the problem-solving capacity of the society, encompassing both theoretical and practical knowledge grows and is transmitted over time. • What we are most interested in here is a subcategory of practical knowledge – the knowledge concerning the solution of social problems of human interaction • Starting from the distinction between the rules of the game and the economic games (markets) that take place within the rules, the question is how institutions and markets change and evolve over time.

20. Evolutionary Change takes place at both levels: • Evolution of rules and evolution of markets within rules • That the institutions matter for economic outcomes is a common theme in every theory of political economy • Beyond that: Institutions come first • This should be proved rather than only (implicitly) assumed • The fundamental proposition of Institutional Analysis is that institutions can act as the rules of the game. In a static context this is probably unproblematic. In an evolutionary context, however, one has to demonstrate theoretically why institutions can show a relative stability vis-à-vis markets. Since only if institutions are relatively stable can they ever play the role of the rules of the game.

21. From an external point of view, institutions are shared behavioral regularities or shared routines within a population. • From an internal point of view, they are nothing more than shared solutions to recurrent problems of social interaction. Only because they are anchored in people’s minds do they ever become behaviorally relevant the elucidation of the internal aspect is the crucial step that makes for the qualitative difference between a congnitive approach to institutions and other approaches

22. Difference between markets and institutions • The knowledge concerning institutions is shared among all (or nearly all) participants • The fact that people classify the recurrent stylized situations of social conflict as old problems allowing for already known solutions means that they do not consciously attend to them. The classification of institutions as old problems at the cognitive level is concomitant with the unconscious following of routines at the behavioral level • In markets understood here as exchange processes there is a division of labor that goes hand in hand with a division of knowledge

23. Process of institutional change is completed only when all interacting individuals have formed the same mental models in their minds. • Therefore the tempo of change in rules will be slower than the tempo of change in markets → Institutions come first even if one adopts an evolutionary perspective Conclusion: relative stability of institutions due to cognitive reasons

24. Since institutions are relatively stable, they can act as the selection environment of evolutionary market processes → channeling of the innovative potential of the agents

25. The main characteristic of problems emerging in the market is that they are temporary. The diversity of exchange acts is immensely greater and more temporary than any recurrent social problem solved by social institutions. Accordingly, economic agents perceive in market settings a large number of problems as new ones • This means that the economic agents concentrate their innovative potential only on those problems that arise in the markets and are not dealt with by institutions. These problems are subjectively interpreted as novel and allow for creative solutions that lead to monetary profits • The channeling of the market process via institutions is founded in this dual classification in the minds of the economic agents

26. 4. Path Dependence: Cognitive, Institutional, and Economic • “reality”>beliefs>institutions>specific policies>outcomes (and, thus, altered “reality”) • Mantzavinos, North, Shariq (2004)

27. 5. Conclusion • What I have provided here is only a first, crude and very imperfect approximation of the role that learning plays in the formation of institutions and in the economic games unfolded within them. • The questions that are open are many more than the answers provided, but this could be a good start for further work.

28. „It is better to be roughly right than precisely wrong“ John Maynard Keynes

29. Work inspired by the presented framework • Empirical Work: • Ghecham (2005) on formal and informal constraints and firm strategies in Egypt • Rhee (2005) on judicial review and market institutions in Korea • Okazaki and Sawada (2003) and Okazaki (2004), econometric studies of the Bank System in Japan • Mendoza (2006) dissertation in process on indigenous people in Guatemala • Ben-Porat and Mizrahi (2005) on foreign policies in Israel • Chabaud, Parthenay and Perez (2005) on electric industry

30. Applications • Christian Joerges (2005) on European Constitution • Bleischwitz (2005) on Environmental Economics • Saam (2005) Simulation model on Evolutionary Competition • Engel (2005) Psychology and Law