Evolutionary Change in Evolutionary Change in Institutions and MarketsInstitutions and Markets

Chris MantzavinosChris Mantzavinos

Paris, December 9, 2008Paris, December 9, 2008

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

My book is - broadly speaking - on My book is - broadly speaking - on EconomicsEconomics

But why is Economics useful?But why is Economics useful?

Economics is extremely useful as a form of Economics is extremely useful as a form of employment for economists“employment for economists“

John Kenneth GalbraithJohn Kenneth Galbraith

and…and…

„„The only function of economic forecasting The only function of economic forecasting is to make astrology look respectable“is to make astrology look respectable“

John Kenneth GalbraithJohn Kenneth Galbraith

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

One of the reasons that it is useful is that it One of the reasons that it is useful is that it deals with governments and their economic deals with governments and their economic policies.policies.

But what is the government`s view of the But what is the government`s view of the economy?economy?

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

Ronald ReaganRonald Reagan

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

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

Ronald CoaseRonald Coase

Evolutionary Change in Evolutionary Change in Institutions and MarketsInstitutions and Markets

1.1. IntroductionIntroduction

2.2. Individual LearningIndividual Learning

3.3. Collective Learning and ChangeCollective Learning and Change

4.4. Path Dependence: Cognitive, Institutional Path Dependence: Cognitive, Institutional and Economicand Economic

5.5. ConclusionConclusion

1. Introduction1. Introduction One of the greatest challenges in the social One of the greatest challenges in the social

sciences is to explain change, more sciences is to explain change, more specifically: social, political, economic and specifically: social, political, economic and organizational changeorganizational change

Starting point should be an account of Starting point should be an account of human learning as the fundamental human learning as the fundamental prerequisite for explaining such changeprerequisite for explaining such change

Methodological individualism Methodological individualism # Rational # Rational Choice TheoryChoice Theory

2. Individual Learning2. Individual Learning

Cognitive science: relationships among Cognitive science: relationships among brain, mind and behaviorbrain, mind and behavior

Many competing explanations for Many competing explanations for perception, learning, memory, and attentionperception, learning, memory, and attention

For our own explanatory purposes as social For our own explanatory purposes as social scientists, we want to use a theory that scientists, we want to use a theory that satisfies the following three criteria:satisfies the following three criteria:

An empirically testable account of An empirically testable account of individual learningindividual learning

A satisfactory account of choice processesA satisfactory account of choice processes

A foundation for explaining the processes of A foundation for explaining the processes of social learning, since the ultimate social learning, since the ultimate phenomena of interest are economic and phenomena of interest are economic and political changepolitical change

In light of these criteria I propose to view In light of these criteria I propose to view the mind as a complex structure that the mind as a complex structure that actively interprets and at the same time actively interprets and at the same time classifies the varied signals received by classifies the varied signals received by the senses.the senses.

Pragmatic notion of mental modelsPragmatic notion of mental models– They are typically formed in pragmatic They are typically formed in pragmatic

response to a problem situation in order to response to a problem situation in order to explain and interpret the environmentexplain and interpret the environment

– Learning is the complex modification of the Learning is the complex modification of the mental models according to the feedback mental models according to the feedback received by the environmentreceived by the environment

When environmental feedback confirms the When environmental feedback confirms the same mental model many times, it becomes same mental model many times, it becomes stabilized in a way. I call this relatively stabilized in a way. I call this relatively crystallized mental model a “belief”.crystallized mental model a “belief”.

The interconnection of beliefs (which can The interconnection of beliefs (which can be either consistent or inconsistent) I call a be either consistent or inconsistent) I call a “belief system”.“belief system”.

Old ProblemsOld Problems Rule-followingRule-following New ProblemsNew Problems ChoiceChoice

General Motivational Aspect: Increase of One`s Own Utility

Pragmatic Cognition According to Rules

Forming of Mental Models of the Problem Space

Similar or identical to Dissimilar to any available class one stored in human mind Interpretation as an Old Problem 1st stage: Employment of Inferential Strategies Unconscious employment Success Failure of solutions as designated in the respective class: 2nd stage: Process of Choice routines Success Failure Acquisition of ready- Creation made solutions from of new the environment alternatives with the aid of imagination

A1 A2 A3 A4...

Chosen Alternative Success Failure

Interpretation as a New Problem

Interpretation as a New Problem

Interpretation as a New Problem

3. Collective Learning, 3. Collective Learning, Institutions and MarketsInstitutions and Markets

Learning at the societal level can be best Learning at the societal level can be best conceptualized as a process of collective conceptualized as a process of collective learning. Two aspects:learning. Two aspects:– Static: Formation of Shared Mental Models as a Static: Formation of Shared Mental Models as a

result of communicationresult of communication– Evolutionary: Evolution of Shared Mental Models Evolutionary: Evolution of Shared Mental Models

over timeover time» Theoretical Knowledge (expressible in linguistic Theoretical Knowledge (expressible in linguistic

terms): Scienceterms): Science» Practical Knowledge (not expressible in linguistic Practical Knowledge (not expressible in linguistic

terms): driving a car, typing a paper etc.terms): driving a car, typing a paper etc.

As collective learning takes place at the societal As collective learning takes place at the societal level, the problem-solving capacity of the society, level, the problem-solving capacity of the society, encompassing both theoretical and practical encompassing both theoretical and practical knowledge grows and is transmitted over time.knowledge grows and is transmitted over time.

What we are most interested in here is a subcategory What we are most interested in here is a subcategory of practical knowledge – the knowledge concerning of practical knowledge – the knowledge concerning the solution of social problems of human interactionthe solution of social problems of human interaction

Starting from the distinction between the rules of the Starting from the distinction between the rules of the game and the economic games (markets) that take game and the economic games (markets) that take place within the rules, the question is how place within the rules, the question is how institutions and markets change and evolve over institutions and markets change and evolve over time.time.

Evolutionary Change takes place at both levels:Evolutionary Change takes place at both levels:– Evolution of rules and evolution of markets within rulesEvolution of rules and evolution of markets within rules

That the institutions matter for economic outcomes is That the institutions matter for economic outcomes is a common theme in every theory of political a common theme in every theory of political economyeconomy– Beyond that: Beyond that: Institutions come firstInstitutions come first

» This should be proved rather than only (implicitly) assumedThis should be proved rather than only (implicitly) assumed

The fundamental proposition of Institutional Analysis The fundamental proposition of Institutional Analysis is that institutions can act as the rules of the game. In is that institutions can act as the rules of the game. In a static context this is probably unproblematic. In an a static context this is probably unproblematic. In an evolutionary context, however, one has to evolutionary context, however, one has to demonstrate theoretically why institutions can show a demonstrate theoretically why institutions can show a relative stabilityrelative stability vis-à-vis markets. Since only if vis-à-vis markets. Since only if institutions are relatively stable can they ever play the institutions are relatively stable can they ever play the role of the rules of the game.role of the rules of the game.

From an external point of view, institutions are From an external point of view, institutions are shared behavioral regularities or shared shared behavioral regularities or shared routines within a population.routines within a population.

From an internal point of view, they are From an internal point of view, they are nothing more than shared solutions to nothing more than shared solutions to recurrent problems of social interaction. Only recurrent problems of social interaction. Only because they are anchored in people’s minds because they are anchored in people’s minds do they ever become behaviorally relevantdo they ever become behaviorally relevant

the elucidation of the internal aspect the elucidation of the internal aspect is the is the crucial step that makes for the crucial step that makes for the qualitative qualitative difference between a difference between a congnitive approach congnitive approach to institutions and to institutions and other approachesother approaches

Difference between markets and Difference between markets and institutionsinstitutions

The knowledge concerning institutions is The knowledge concerning institutions is sharedshared among all (or nearly all) participantsamong all (or nearly all) participants

The fact that people classify the recurrent stylized The fact that people classify the recurrent stylized situations of social conflict as situations of social conflict as old problemsold problems allowing for already known solutions means that allowing for already known solutions means that they do not consciously attend to them. The they do not consciously attend to them. The classification of institutions as old problems at the classification of institutions as old problems at the cognitive level is concomitant with the cognitive level is concomitant with the unconscious following of routines at the behavioral unconscious following of routines at the behavioral levellevel

In markets understood here as exchange processes In markets understood here as exchange processes there is a division of labor that goes hand in hand there is a division of labor that goes hand in hand with a with a division of knowledgedivision of knowledge

Process of institutional change is completed Process of institutional change is completed only when all interacting individuals have only when all interacting individuals have formed the same mental models in their formed the same mental models in their minds.minds.

Therefore the tempo of change in rules will Therefore the tempo of change in rules will be be slower than the tempo of change in slower than the tempo of change in markets → Institutions come first even if one markets → Institutions come first even if one adopts an evolutionary perspectiveadopts an evolutionary perspective

Conclusion:Conclusion: relative stability of institutions relative stability of institutions due to due to cognitive reasonscognitive reasons

Since institutions are Since institutions are relativelyrelatively stable, they stable, they can act as the can act as the selection environment of selection environment of evolutionary market processesevolutionary market processes

→ → channeling of the innovative potential of the channeling of the innovative potential of the agentsagents

The main characteristic of problems emerging in The main characteristic of problems emerging in the market is that they are temporary. The diversity the market is that they are temporary. The diversity of exchange acts is immensely greater and more of exchange acts is immensely greater and more temporary than any recurrent social problem solved temporary than any recurrent social problem solved by social institutions. Accordingly, economic by social institutions. Accordingly, economic agents perceive in market settings a large number agents perceive in market settings a large number of of problems as new onesproblems as new ones

This means that the economic agents concentrate This means that the economic agents concentrate their innovative potential only on those problems their innovative potential only on those problems that arise in the markets and are not dealt with by that arise in the markets and are not dealt with by institutions. These problems are subjectively institutions. These problems are subjectively interpreted as novel and allow for creative solutions interpreted as novel and allow for creative solutions that lead to monetary profits that lead to monetary profits

The channeling of the market process via The channeling of the market process via institutions is founded in this dual classification in institutions is founded in this dual classification in the minds of the economic agents the minds of the economic agents

4. Path Dependence: Cognitive, 4. Path Dependence: Cognitive, Institutional, and EconomicInstitutional, and Economic

““reality”>beliefs>institutions>specific reality”>beliefs>institutions>specific policies>outcomes (and, thus, altered policies>outcomes (and, thus, altered “reality”)“reality”)

» Mantzavinos, North, Shariq (2004)Mantzavinos, North, Shariq (2004)

5. Conclusion5. Conclusion

What I have provided here is only a first, What I have provided here is only a first, crude and very imperfect approximation of crude and very imperfect approximation of the role that learning plays in the formation the role that learning plays in the formation of institutions and in the economic games of institutions and in the economic games unfolded within them.unfolded within them.

The questions that are open are many more The questions that are open are many more than the answers provided, but this could be than the answers provided, but this could be a good start for further work.a good start for further work.

„„It is better to be roughly right than It is better to be roughly right than precisely wrong“precisely wrong“

John Maynard KeynesJohn Maynard Keynes

Work inspired by the presented Work inspired by the presented frameworkframework

Empirical Work:Empirical Work:– Ghecham (2005) on formal and informal constraints and Ghecham (2005) on formal and informal constraints and

firm strategies in Egyptfirm strategies in Egypt

– Rhee (2005) on judicial review and market institutions in Rhee (2005) on judicial review and market institutions in KoreaKorea

– Okazaki and Sawada (2003) and Okazaki (2004), Okazaki and Sawada (2003) and Okazaki (2004), econometric studies of the Bank System in Japaneconometric studies of the Bank System in Japan

– Mendoza (2006) dissertation in process on indigenous Mendoza (2006) dissertation in process on indigenous people in Guatemalapeople in Guatemala

– Ben-Porat and Mizrahi (2005) on foreign policies in IsraelBen-Porat and Mizrahi (2005) on foreign policies in Israel

– Chabaud, Parthenay and Perez (2005) on electric industryChabaud, Parthenay and Perez (2005) on electric industry

ApplicationsApplications– Christian Joerges (2005) on European Christian Joerges (2005) on European

ConstitutionConstitution– Bleischwitz (2005) on Environmental Bleischwitz (2005) on Environmental

EconomicsEconomics– Saam (2005) Simulation model on Evolutionary Saam (2005) Simulation model on Evolutionary

CompetitionCompetition– Engel (2005) Psychology and LawEngel (2005) Psychology and Law