Walton H. Hamilton

The logical place to begin is with Hamilton since he officially launched institutional economics with his paper at the 1918 AEA meeting (Hamilton Reference Hamilton1919). Hamilton was trained as an economist but later shifted to law.

In 1917 Hamilton (Reference Hamilton1917) notes that economists dissatisfied with the neoclassical system are “demanding a newer institutional economics” (p. 239; emphasis added) and his 1918 paper is its manifesto. However, many of the themes are contained in earlier articles (e.g., Hamilton Reference Hamilton1915).

Hamilton opens the paper with this sentence: “An explanation of the ‘institutional approach’ to economic theory is a plea for a particular kind of theory” (p. 310). He notes there are a multiplicity of schools of thought in economics but only “two bodies of doctrine have developed which aspire to the dignity of ‘economic theory.’” Hamilton identifies them as, respectively, value economics and institutional economics. Other synonyms he uses for “value economics” are “price economics,” “neoclassical economics,” and “orthodox economics.”

Hamilton describes value theory as “an explanation of the nature of economic value and the forms of income in which it expresses itself” (p. 317). In price economics, Hamilton says, the theories of value and income distribution are mechanical formulas derived from the principle of free competition in an individualist “Crusoe-infested” economy. Hamilton states that neoclassical theory “has no concern with the organization of that market, the nature of the transactions which occur there, or the less immediate facts of the distribution of opportunity, property, and leisure upon which these shares rest” (p. 313).

On policy, Hamilton says that while value economics for much of the nineteenth century was used as a “defense of laissez-faire,” and even though in the previous two decades neoclassical theorists had endeavored to strip out any formal association with non-intervention, “it still lingers implicitly in terms and the statement of propositions” (ibid.). As a result, neoclassical economics serves as a theoretical/ideological roadblock to social reform, rationalizes economic problems as either an inherent part of the natural order or places blame on defects in human character or government-sanctioned interferences, and provides little constructive guidance for policy or social reform.

Hamilton also points out a major paradox about value economics. Even though over a century’s time the structure of the economy had transformed from small-scale, labor-intensive, and local-based competitive enterprise to large-scale, capital-intensive, and cross-national corporations and trusts, the competitive model of economic organization not only remained in place but was reformulated by neoclassical economists into a more pure and abstract form. The result was a large and growing theory-reality gap. And, even as value economics was becoming increasingly divorced from reality in the early twentieth century, it nonetheless consolidated its positon as the dominant paradigm.

Hamilton then describes institutional economics. He begins by noting that “institutional and value economics have many things in common” (p. 310), and the latter contains useful tools, concepts, and insights, albeit for a delimited range of analysis. From Hamilton’s perspective, therefore, institutional economics (IE, used interchangeably with OIE) subsumes value, or neoclassical, economics (NE) as a special case; however, for analysis of real life economies, the approaches of the two theories are substantially opposed.

The fundamental differences between OIE and NE are “what economic theory is all about” (1919, p. 309) and their alternative “conceptions of the nature of the economic order” (p. 310). Hamilton says that every paradigm needs a “unifying agent” (p. 312), and in IE this agent is the concept of economic order. He defines “economic order” as the economy’s “scheme of arrangements” and “modes of doing” (p. 311), and uses the term “institution” as equivalent to a scheme of arrangements (formal and informal), and the terms “economic organization” and “economic system” as equivalent to economic order. ^{Footnote 2}

Neoclassical economics, says Hamilton, has one conception of the economic order and institutional economics has another. The key differentiation is that he uses the terms ‘scheme of arrangement’ and ‘mode of doing’ in the singular to describe neoclassical economics but in the plural to describe institutional economics. Neoclassical economics, in pure form, is a uni-institutional economic order, and is a closed and informationally complete system. The sole ordering mechanism is the market, human agents are rational individualists with predetermined motives and purposes, the legal regime is an exogenous system of natural liberty, and the social welfare goal is maximum goods satisfaction for consumers. Its perspective is a smooth and continuous mechanical order, static equilibrium, comparative static movements in equilibrium, equilibrium growth paths through time, outcomes balanced and fair with respect to individual contributions, and a spontaneously emergent equilibrium social order needing government only as a neutral rule enforcer.

Hamilton says that OIE, by contrast, is a multi-institutional order. It is an open system with fundamental uncertainty about the future, thus allowing for positive forces, such as entrepreneurial innovation and risk taking, but also negative forces, such as exploitation and opportunism. It contains different and partially conflicting modes of coordination, such as firms, markets, and custom, which price cannot jointly equilibrate. He particularly objects to the neoclassical model of the human agent (economic man), and says it needs to be reconstructed with principles from social psychology. Hamilton devotes a section of the paper to social welfare criteria and measurement, argues that market prices fail to capture many aspects of social value, and approvingly cites the work of several English ‘welfare economists’ (e.g., John Hobson, Richard Tawney, and Sidney and Beatrice Webb).

In Hamilton’s conception, therefore, institutional economics is more general because it encompasses all parts of the economic system (not just the market) and the separate institutions that comprise it. Thus, he uses the term “industrial economy,” not “market economy,” because the former is more general and descriptive. For economic theory, institutions are a crucial analytical device because their scheme of arrangements determines the structures within which production, exchange, distribution, and consumption take place; defines the existence and properties of commodities, production functions, markets, firms, money, and other concepts; determines the boundaries of markets and whether they are competitive or monopolistic; and explains price/quantity outcomes by determining where in economic space the demand/supply curves intersect. Thus, it is more appropriate to talk about institutional determination of price, rather than market determination, and context-specific institutional laws of economics, rather than universal neoclassical laws. In empirical research, variation in institutional attributes explains variation in economic outcomes—say, across industries in a country or across countries—and likewise change in institutional attributes explains dynamic patterns of growth and development over time.

Institutional theory, as Hamilton envisions it, has important methodological implications. An economist can say, “assume a competitive market,” and solve N demand/supply equations to get the equilibrium solution, but this is a purely formalistic exercise without also identifying, first, the determinants of the exogenous variables and, second, that the economy’s economic structure reasonably approximates the abstraction. Thus, Hamilton argues that assumptions must be empirically verified so they are not at great variance with the facts—a position critics lampoon as a myopic quest for descriptive realism but which is more fairly described as a demand for empirically informed priors. A downside, however, is that economic behavior “cannot properly be answered in formulas” and OIE will “lack the clear-cut, definite, and articulate character of neo-classical theory” (p. 318).

Hamilton also emphasizes that institutional economics provides an analytical framework more relevant and useful for solving economic problems and guiding policy. Neoclassical price theory leads to conclusions that inhibit or obfuscate problem solving and policy. Economic problems, for example, disappear if people and governments act in line with natural laws and the economist’s model. Also, the self-correcting property of markets, and efficiency outcomes of demand/supply, point to a government policy of non-interference. As a result, Hamilton says, price theory’s “explanatory terms [preferences, technology, endowments] are not matters subject to control” (p. 313). Institutional economics, on the other hand, explains why economic problems are an inevitable and inherent product of economic activity, given imperfect people, imperfect institutional arrangements, and inevitable conflicts of interest. Although parts of human and physical nature are beyond control, the institutional arrangements of society are all human-made and therefore capable of change. Thus, OIE suggests a constructive program of reform in which empirical research locates the institutional source of the problem and decision makers alter institutional arrangements to fix it.

Next, consider what Hamilton says regarding IE origins. Although he coined the term, Hamilton argues that institutional economics sui generis long antedates him. Hamilton contends that starting from Adam Smith, economics has separated into two alternative paradigm visions, generically considered as value economics and institutional economics. He states (p. 310):

In a follow-up statement, Hamilton indicates that Adam Smith, or a portion of Smith, is the root stem of OIE, observing “Adam Smith’s point of departure was the relationship of economic organization to national wealth” (p. 312; emphasis added). ^{Footnote 3}

Hamilton offers three other observations on OIE’s origin and development. First, he lists as leaders of the institutional paradigm Adams, Cooley, Veblen, and Mitchell (p. 318). Adams is noteworthy because he comes from the 1880s generation of progressive economists. Cooley is also noteworthy because he was an economist-sociologist who depicted the social organization as an organic and functionally related whole. Into the first decade of the twentieth century, economics and sociology were often combined in the same university department and a number of pre-World War I (WWI) writers on economic institutions were sociologists or economists with a sociology background. Examples are Ely and Commons, the Webbs, and Max Weber.

Second, Hamilton suggests that the institutionalism of Progressive-era economists dwindled on account of an adverse pincer movement of developments. The first factor is the rise to dominance of marginalism, described as “the most subtle, the most general, and the most articulate body of thought in economics” (p. 310). Even though the early institutionalists did not reject marginalism per se (Veblen and Hobson exceptions), it was much less suited to their world of social structure, evolutionary change, and indeterminism. Hamilton cites J. B. Clark’s Distribution of Wealth (1899) as the crowning success of American marginalism, and, with it, “value theory passed into the inheritance” (p. 310). Then, on the other side of the pincer, Hamilton notes that contemporaneously, “the older system of institutional theory was dissipated” (p. 310; emphasis added). He does not identify who or what represents the older system but does observe “American thought has lagged largely because efforts which in England have taken a constructive bent [e.g., Marshall] here have been spent in criticism of neo-classical doctrine” (p. 318). The most straightforward inference is that Hamilton is referring to Veblen and associates.

Third, Hamilton nonetheless optimistically expects unfolding developments to play in OIE’s favor. For example, WWI led to large-scale collective reorganization of the economy, extensive government regulation of the price system, and advent of economic planning. Hamilton knew that the wartime programs would be substantially cut back but, nonetheless, thought there was no going back to the pre-war order. Also, Hamilton observed that while economists are attracted to the precision and beauty of neoclassical price theory, they would nonetheless come face-to-face with its unreality and irrelevance when called on by current events to grapple with the great economic problems left in the war’s aftermath. Hamilton tempered his optimism, however, with the prescient caution, “But survival [of IE] will be assisted by the development of a theory of the economic order vital, true, and relevant to the problems of the times” (p. 318).

Finally, regarding Veblen, Hamilton’s only explicit mention of Veblen in his manifesto paper is where he names Veblen as one of four leaders from the pre-war period. Also, in his paper Hamilton only tangentially references several Veblenian concepts, such as ‘habits of thought,’ ‘machine process,’ and ‘instincts,’ while giving no mention to Darwinism. Hamilton does equate OIE with the genetic method (p. 315), but the genetic method, as a generic concept (i.e., sequential causal analysis), is not specifically Veblenian but broadly historicist/organicist (Ross Reference Ross1991). Hamilton also gives no attention to the anthropological-cultural sides of the economic order important in Veblen, perhaps because they are not readily accessible levers of social control. Instead, Hamilton highlights the foundation of OIE in law, property relations, and “the nature of the transactions,” which are central to the Ely–Commons tradition (and legal realism in jurisprudence, in which Hamilton became a leading figure). Equally noteworthy, the key term “institution” is defined by Hamilton in social structural terms (e.g., economic organization, scheme of arrangements) while Veblen defined it largely in terms of habituated ways of thinking and doing.

John M. Clark

John Maurice Clark, son of John Bates Clark, helped Hamilton organize the 1918 AEA session and also delivered one of the papers. In the 1920s and 1930s he was considered one of America’s leading economists and practitioners of institutional economics (Rutherford Reference Rutherford2011). Clark wrote two particularly substantial review papers on economic theory and history of thought (Clark Reference Clark and Tugwell1924, Reference Clark1936a). I let the latter structure the summary that follows, but with input from two of Clark’s early books, Studies in the Economics of Overhead Costs (1923) and Social Control of Business (1926), and other articles reprinted in Preface to Social Economics (1936b).

Clark locates the starting point of economic science in America in the mid-1880s. Before then, Clark says, economics was a relatively rote and dogmatic version of English classical economics with emphasis on the virtues of free competition and laissez-faire—depicted as “final truths” and logical deductions from “absolute natural laws” (1936b, p. 418). Clark then divides the following half-century of American economics into a starting point and four phases, identifies two contending types of economics, and describes their development and juxtaposition.

Clark uses various labels to identify the two contending paradigms. Examples for the traditional paradigm are: orthodox economics, neoclassical economics, abstract economics, price economics, static economics, and value economics. Labels for the challenger are: social economics, institutional economics, genetic economics, dynamic economics, realistic economics, business economics, descriptive economics (quantitative-statistical), and (non-utilitarian) welfare economics. To indicate the core non-commensurability of the two paradigms, he also uses the terms “Euclidian” and “non-Euclidian” economics. (Note that John Maynard Keynes [1936] also uses the Euclidean/non-Euclidean contrast to mark off his work from the orthodox and, as OIE fades in the early 1930s, his work becomes the ‘new economics.’) Among all of these labels, Clark’s preferred term is “social economics”—connoting ideas of social man, social value, social interest, social organization, social wealth, social justice, and social control, as opposed to neoclassical analogs of economic man, exchange value, self-interest, market organization, commodity wealth, property justice, and laissez-faire. Ely (Reference Ely1893) earlier suggested the term “social economics” as a substitute for “political economy” (society ≈ nation), perhaps following Roscher (1878, p. 87) who cites the French version, economie sociale (said to go back to Jean-Baptiste Say), as an approximation of the German nationalökonomie.

Both Roscher (Reference Roscher1878) and Cliffe Leslie (1888, ch. 3), leaders of the (old) German and English historical schools, argue that Adam Smith has been mistakenly identified as a one-sided proponent of competitive self-interest and static equilibrium economics when, in fact, Smith employed the historical method and made social processes and structures a central component in his work (e.g., perfect liberty must be complemented by perfect justice). Clark does not reference Roscher or Cliffe Leslie but takes the same perspective. He (1924; 1936a, ch. 5) says Smith synthesized from both the price theory and social economics paradigms but with the former embedded within the latter. For example, Clark says Smith used the genetic method, was in his era a progressive/radical reformer, recognized that the laws of economics are institutionally and culturally contingent, regarded demand/supply forces as slow and imperfect, and pointed to the one-sided economic and political domination of the capitalist and landlord classes. David Ricardo, on the other hand, stripped out the social, institutional, and comparative historical parts of Smith.

After Smith and Ricardo, Clark turns his attention to development of economic science in America. He calls the first phase “The Starting-Point” (1936b, p. 417) and locates it in the late 1870s and early 1880s when German-trained Adams, Clark Sr., Ely, et al. returned to America determined to reconstruct economic orthodoxy. Clark says, “They went to Germany for advanced study … conscious of defects of traditional method and shortcomings of traditional doctrine—and we now delight to honor them as the Pilgrim Fathers of the new movement” (p. 418; emphasis added).

The second phase is “Preparation, Orientation, and Gestation.” The most important events were formation of the AEA and publication of several foundational books. Clark observes that “these Pilgrim Fathers were individuals, independent-minded, differing from one another, and no more prepared to accept uncritically the more extreme forms of German [state-centered] doctrines than those of their own country…. They genuinely wished a broader groundwork of historical fact to put system theory on a proper basis, but not to displace it entirely” (pp. 419–420). Important books he cites are Adams’s Relation of the State to Industrial Action (1887) and his father’s The Philosophy of Wealth (1885). In the latter, Clark highlights the chapter “Non-Competitive Economics” as a forerunner of his own approach.

The third phase is “Systematic Marginal Economics.” Clark does not date this phase but it is clear he is referencing publication of his father’s Distribution of Wealth (1899). In this book Clark Sr. does what appears to be a major about-face from his earlier Philosophy of Wealth (1885). In it he unites the model of perfect competition with the marginal productivity principle to demonstrate that all factors of production receive payment equal to their marginal value contribution. Clark Sr. added the last refinement needed to integrate all markets and the triplet of consumption, production, and distribution into a unified Walrasian-type demand/supply framework. Clark Jr. reconciles his father’s apparent paradigm shift on two grounds. He claims, first, that Clark Sr. had not abandoned his earlier book but was seeking to highlight the rarified and unrealistic nature of the assumptions needed to produce a competitive-determined income distribution, and, second, that Clark Sr.’s ethical concern for achieving social justice showcased in the early book is equally evident in the latter book and explains why, in the eyes of critics, he attached too much ethical significance to the conclusion that factor owners get income returns equal to their value marginal product. ^{Footnote 4}

The fourth phase is “The Critical Movement.” Clark says that in the fifteen or so years before WWI the marginalist-based price economics was the supreme orthodoxy, yet remained the target of much criticism. Among the critics the most vocal and erudite was Veblen, although “for some time he made little impression on those inside the citadel, save one of irritated puzzlement as to what he was driving at and why” (p. 422). Clark concludes the pre-war criticism made telling points but “did not drive out ‘orthodoxy’ from the field of theory, partly because nature abhors a vacuum” and partly because neoclassical economists withdrew into “psychological agnosticism” (pp. 424, 423).

The fifth phase, starting with WWI and extending to the early 1930s, is “Positive Inquiry of Diverse Types.” Clark says that American entry into the war shifted the attention of economists to “more urgent positive needs.” All of these problems called conventional equilibrium theory into question and opened the door for rejuvenation of the social-institutional-empirical type of economics. The biggest shift, says Clark, was in the new-found interest and respectability of quantitative studies, particularly as pioneered by Mitchell on business cycles. He comments that before Mitchell’s landmark Business Cycles (1913), the study of booms and depressions ran so counter to the preconceptions of equilibrium theory that it was regarded as unscientific speculation and “associated with socialistic doctrines which were beyond the pale” (p. 425).

Clark next considers institutionalism. He observes (p. 426):

It appears that Clark’s view on the status of institutional theory shifted between his 1924 and 1936 articles because in 1924 (p. 101) he states IE is an alternative to neoclassical theory, but in 1936 it has become an elusive movement built on certain common themes. He appears to shift, therefore, from what Gruchy (1990) calls the ‘paradigm’ to ‘thematic’ camp. Whatever the case, Clark remarks that the institutional perspective is “something vastly different from the nineteenth century conception of progress within an institutional framework [i.e., free market economy] which was expected to remain fixed because it had found its final terminus in the system of individualism and free contract, modified only by piecemeal control of specific abuses” (ibid.).

Hamilton had made the economic order the analytical focal point for OIE, and perhaps one reason the field lost momentum is because leaders such as Clark did not, or could not, follow through on this suggestion. In the quotation just given, Clark uses the term “institutional framework” and in other places refers to the “existing order” and “social organization”; however, he does not go far toward the next step of analytically developing these key concepts. The most important point of progress is in Social Control of Business (1926), where he devotes six chapters to working out the legal framework of social control. Here Clark is exploring the interface between law and economics very much as Commons was contemporaneously doing in Legal Foundations of Capitalism (1924).

Much of what Clark has to say on Veblen is already described above. The most salient addition is in Clark (Reference Clark and Tugwell1924). One section in the paper is titled “The English Tradition” and the next is “Modern Antithesis of the English Tradition.” The antithesis section is devoted completely to Veblen. Clark concludes English classical/neoclassical economics was “one-sided” and “becoming ever more elaborate and more brittle” (p. 84). Then he observes, “Thus it is the most natural thing in the world that Veblen should reverse the classifications of ‘orthodox’ economics” (p. 85; emphasis added). In Clark’s depiction, therefore, Veblen is the ‘antithesis’ because he positions his approach to economics at the opposite end of the neoclassical.

Clark, on the other hand, positions his type of social economics on the institutional side of the paradigm divide, but relatively centrist. To emphasize the point, the title of the next section following “Antithesis” is “Non-Euclidean Economics: An Experiment in the Simultaneous Truth of Opposites” (1924, p. 86; emphasis added). One can reasonably conjecture, therefore, that Clark distinguishes between social and institutional economics, and positions his work in the former, so he can pursue institutional economics writ large, give due recognition to Veblen’s contributions, but also steer toward a more middle course both theoretically and politically.

Wesley C. Mitchell

Wesley Mitchell was widely regarded as America’s most distinguished economist in the 1920s and 1930s (Dorfman Reference Dorfman1959; Rutherford Reference Rutherford2011). He made his reputation on the empirical study of business cycles but also wrote authoritative works on economic theory and history of economic thought. However, Mitchell never succeeded in putting his ideas on institutional economics into a systematic framework and fell victim at the end of his career to the charge of “measurement without theory” (Koopmans Reference Koopmans1947). Mitchell’s most significant papers are collectively published in The Backward Art of Spending Money (1937), and his perspective on the evolution of economic thought is contained in Types of Economic Theory (Mitchell Reference Mitchell1949).

Mitchell (Reference Mitchell and Tugwell1924a) says economics began with Smith, who defines its subject as “making a living and national wealth” and presented the first theoretical system explaining how a market economy solves these problems. Smith’s emphasis on natural liberty was emphatic, says Mitchell, but his system of analysis was eclectic, with a portion in the mold of price economics but the larger part a melding of historical, institutional, legal, and sociological analysis. Mitchell (1949, ch. 2) notes, for example, that Smith began Wealth of Nations with “an analytic description of economic organization” (p. 169), focused the book on dynamics of production and not statics of exchange, included a variety of social interactions (including emulation and vanity, per Veblen, and sympathy/prudence as an offset to unconstrained self-interest), railed against the economic and political rent-seeking activities of the capitalist and landlord classes (again per Veblen), sanctioned a variety of forms of social control of markets, and engaged in historical/comparative institutional analysis in Book III, “Of the Different Progress of Opulence in Different Nations,” and Book IV, “Of Systems of Political Economy,” with roots in European historicist legal philosophers, such as Samuel von Pufendorf and Hugo Grotius.

Several decades after Smith, economics started to split into two paradigm visions separated by method, theory, and politics. The first group Mitchell identifies formed around the deductive, idealist, price theory, natural law, and free trade/laissez-faire portion of Smith. This approach, with Ricardo as chief spokesman, became orthodox English classical economics, and later, with a reformulated marginalist value theory, the neoclassical economics of the early twentieth century. Ricardo’s position, according to Mitchell (1924a, p. 9), is that “[v]arious minor reforms are feasible but the institutional framework of society will remain what it is.”

The second group formed around the inductive/empiricist, realist, social organization, human law, and social reform portion of Smith’s book. Mitchell puts into this group people such as T. Robert Malthus, Jean de Sismondi, Robert Owen, and Henri de Saint-Simon, and says “they sought to devise a new set of institutions which would insure a juster distribution of labor and income” (1924a, p. 18). Since this group lost the battle of theory and policy (in England), they were cast into the netherworld of heterodoxy and marginalized/dismissed as bad economists (Malthus, Sismondi), misguided or utopian reformers (Owen), or dangerous socialists (Saint-Simon). ^{Footnote 5}

Mitchell (Reference Mitchell and Tugwell1924a) spends several pages in getting from Ricardo to the institutionalists. Essential points are five. First, John Stuart Mill at mid-century broadly crafted his Principles of Political Economy (1848) so, like Smith’s Wealth of Nations, it gave representation to the two streams of price-value economics and social-institutional economics, albeit with the former positioned as economic theory and the latter as social philosophy. Second, the marginal revolution initiated by William Jevons, Carl Menger, Léon Walras, and Clark was a revolutionary advance in tools, new concepts, and micro-foundation, but at the same time left the new neoclassical economics mostly unchanged in terms of basic method (deductive, a priori), theory orientation (competitive markets with focus on value, price, and distribution), and policy orientation (predisposition to non-intervention). Third, Marshall in his Principles of Economics (1890) followed Mill’s two-tier approach and made price economics the theoretical foundation, but added, for purposes of context, dynamics, welfare evaluation, and disciplinary unity, a largely unintegrated overlay of historical, institutional, and social material. Fourth, at the same time as orthodox economics (diverse from within) was being strengthened by marginalism, stripped of association with hedonism and laissez-faire, and broadened by Marshall, the various non-orthodox rivals, such as Marxian economics and German historical economics, were in sharp decline. Fifth, among the numerous critics and dissenters, Mitchell cites Veblen as the most effective and influential, with Sidney Webb and Werner Sombart also mentioned. ^{Footnote 6}

At this point Mitchell (Reference Mitchell and Tugwell1924a) gets to institutional economics. Names of economists that he associates with institutional economics include those cited above (e.g., Malthus, Sismondi), Richard Jones—cited by Ely (Reference Ely1884) as a pioneer of the institutional ‘look and see’ method—and portions of the work of Mill and Marx. On Marx he says (p. 18), “Doubtless Marx’s alleged science was warped by his passionate desires, his theory shaped to suit a program of research, … [b]ut Marx saw the central problem of economics in the cumulative change of economic institutions.”

According to Mitchell, the events unleashed by WWI were pivotal for institutional economics. He says, with reference to Veblen, “In 1914 the institutional type of economic theory was still a rare form of mental aberration to which few but the young succumbed and from which most victims made a prompt recovery” (p. 26). The outbreak of the war greatly changed the situation, however. Mitchell says “the nations found that economic efficiency was a matter of life and death” (p. 20). In America, wartime pressure soon highlighted the inadequacy of the existing industrial system as prices shot up but production was held back by poor transportation coordination, raw material bottlenecks, factory waste and inefficiency, and breakdown of industrial relations. Thus, the country was forced to put economic dogma and vested interests to the side and think instead about principles of institutional economics, including scientific engineering of the industrial system and strategic economic planning.

The argument of orthodox economists, Mitchell says, is that the wartime mobilization of the economy should be viewed as a temporary political disruption, and when the pre-war order is restored, “Economics … will not change because the kind of theory we had in 1914 proved adequate to the demands made upon it” (p. 20). These economists’ reasoning is that “economic truth had been found and would abide so long as logic lasted” (p. 13). Mitchell responds, “I cannot accept this view.” The reasons are twofold.

First, even before the war a gaping mismatch had emerged between the uni-institutional model of standard theory and the multi-institutional economic order of early twentieth-century capitalism. He cites companies such as Standard Oil and US Steel. The latter, for example, was formed in 1902 as a merger of twelve companies, controlled two-thirds of the market, employed over 100,000 workers on twelve-hour shifts, had billions of capitalized assets, and advanced its interests through a web of connections to large investment banks and political leaders. To Mitchell, it was naive and non-scientific to contend that pre-war neoclassical theory was an appropriate abstraction for this kind of modern industrial economy.

Then, second, in Mitchell’s view the economy is an inherently dynamic, evolving system driven by endogenous forces of structural change, which, in a decentralized capitalist economy of poor information, semi-rational people, and imperfect markets, create business cycles of an equally evolving nature. In his view, the direction of economic evolution was further away from the individualist exchange economy of Smith and toward a more complex, technologically driven, and managed economy, per the label ‘New Era’ of the 1920s. His message to economists, therefore, is that economic theory needs to “take on a quantitative realistic form” so it can “account for cumulative change in economic behavior” and “studies of special institutions become organic parts of a single whole” (1924a, p. 24). Toward this end, Mitchell was a prime mover in the creation of the National Bureau of Economic Research (NBER, est. 1920).

Mitchell’s point of view, then, is that institutions are the central explanatory variable in economic theory. They shape the malleable parts of human psychology (certain instincts and drives are constants of human nature), thus determining people’s motives for action and structure of preferences. They also determine budget constraints and opportunity sets by establishing rules, rights, and endowments; the boundaries and structures of markets and firms; and the distribution of benefits and costs from economic activity; and they give expression to society’s social welfare objectives. In turn, since institutions are human-made entities, they are not exogenous constants but change over time, imparting to economies an evolutionary but non-deterministic trend of growth and development.

Mitchell (1924a, p. 26) followed Veblen and described economic evolution in terms of Darwinism but made it a process of human-crafted institutional evolution rather than nature-determined biological evolution. To explain the dynamics of institutional evolution and, in particular, business cycles, Mitchell turns to Veblen’s Theory of Business Enterprise (1904) and makes Veblen’s dichotomy between the ‘money economy’ and ‘goods economy’ a central analytical concept. The most important application is to business firms. Their money economy side (buying/selling) is to make maximum profit and their goods economy side (production) is to increase output. The two modes are driven by different logics, typified by Veblen as the difference between the financier and engineer. Created here is a serious problem for neoclassical theory because price cannot simultaneously equilibrate these two disjointed processes. The typical pattern, say Veblen and Mitchell, is that making profit comes first so firms deliberately restrict production to raise price. The quest for monopoly profit, therefore, leads to growing concentration of capital (per Marx), rising profits increase the capitalized value of firms, a boom of investment and speculation ensues, eventual overproduction leads to price cuts as profits and capitalized values shrink, and the downward part of the cycle commences. The clash of money vs. goods logics, therefore, creates a structural disequilibrium that the invisible hand cannot reconcile.

Since institutions are human-made and changeable, they provide society and policymakers with instruments of social control—described by Mitchell (1924a, p. 25) as “the alluring possibility of shaping the evolution of economic life to fit the development of the race.” The idea is that every society through its governance institutions practices social control; examples cited by Mitchell include Smith’s call to replace mercantilism with a system of natural liberty, Marx’s call to replace capitalism with socialism through class revolution, and the Webbs’ call to replace industrial monarchy with industrial democracy. Social control then cascades to lower levels of the economic order, such as creation of a Federal Reserve Bank, endowment of corporations with limited liability, legal prohibition of child labor, and public investment in education and infrastructure. Economic and social welfare outcomes are constrained by the laws and limits of nature, but within these constraints is large discretion for countries to shape their futures and control/stabilize their economies.

It is clear that Mitchell was considerably influenced by Veblen and incorporated more of Veblen’s ideas than Hamilton, Clark, or Commons. Particularly important was the ‘making money’ vs. ‘making goods’ duality. Mitchell also shared the substance of Veblen’s critique of the ’economic man’ model. He calls Veblen one of the “champions of institutional theory” (1924a, p. 19), which he characterizes as “an unorthodox type of economic theory … that deals with a range of problems undreamt of in the philosophy of value and distribution” (p. 17).

John R. Commons

Commons is conventionally portrayed as a latecomer to institutional economics (e.g., Rutherford Reference Rutherford2011, pp. 31, 194), having spent the early to mid part of his career as a labor economist at Wisconsin and joining the ranks of OIE only with Legal Foundations of Capitalism (1924). Around Commons developed a Wisconsin wing of OIE and also an institutional approach to labor economics known as industrial relations (Kaufman Reference Kaufman2004). His theory books are notoriously difficult reading, and several reviewers of Institutional Economics (1934) confessed they could not make out what Commons was trying to say (e.g., Knight Reference Knight1935). Some help is provided by a posthumous book (Commons Reference Commons1950) and two perceptive review articles by Mitchell (Reference Mitchell1924b, Reference Mitchell1935).

Commons is the only person from this period to write a book specifically on institutional economics, and in it claims to develop, or contribute toward, a pure theory of IE. He says the subject of economics is how people “make a living and get rich” (1950, p. 1). He defines the subject matter of IE as “collective control of individual transactions” in “producing, acquiring, and rationing wealth by cooperation, conflict, and the rules of the game” (1934a, pp. 6, 121). The central concepts for IE, according to Commons, are property and ownership (without ownership there is no organized economy), and he defines an institution as “collective control, liberation, and expansion of individual action” (1934a, pp. 5, 902). Commons positions OIE as a political economy approach that explains patterns of economic activity at a point in time and over time as a function of imperfect but purposive people interacting competitively and cooperatively in different institutional structures governed by different rule sets and methods of coordination for producing, exchanging, and distributing rights of ownership to economic goods.

Thus, IE generalizes economic theory by considering other coordinating modes besides a price-driven market system and makes the institutional structure an active explanatory force rather than an exogenous datum. In Commons’s viewpoint, IE subsumes price economics as a special case and, as such, utilizes various neoclassical tools, such as marginal analysis, demand/supply, and equilibrium, when appropriate to the problem and institutional context (Commons Reference Commons1934a, p. 680; Biddle and Samuels Reference Biddle, Samuels, Holt and Pressman1998).

The fundamental condition of economic life is scarcity, and to overcome scarcity people must cooperate by participating in a division of labor and activities of production, exchange, and distribution. Neoclassical economists also start from this position but telescope the analysis into how cooperation is organized and efficiently performed in an exogenous competitive market order. But, Commons contends, economics must first consider the determinants of the economic order. He explains (Commons Reference Commons1934a, p. 6; emphasis in original):

The idea is that scarcity creates a natural conflict of interest among individuals as they strive to get enough material goods to survive and enjoy life. This conflict has to be regulated and restrained lest the community of individuals breaks down into anarchy, violence, and plunder. The method of regulation and restraint is a social system of rules, perhaps in the form of informal understandings or a written code of law, created by a king, ruling elite, or parliament, which marks out who owns what, the range of permissible and proscribed actions, and the sanctions for violating the rules. These rules, called “working rules,” thus come from exercise of collective action by people with sovereign rule-making authority, starting at the nation-state level and descending to lower-level units, such as corporations (‘industrial governments’), trade unions, political parties, churches, and families. The working rules of institutions structure how individuals interact in production, consumption, and distribution, and hence shape the resulting outcomes.

At one level, institutional economics is a political economy approach that examines how collective choice in societies determines the distribution of endowments and rules of the game, which neoclassical economics mostly takes for granted. In this sense OIE adds a legal-institutional superstructure to price theory and gives definiteness to NE abstractions. In this regard, Commons (1934a, p. 680) observes, “The waves of the water seek their equilibrium just as naturally when the water is raised ten feet by a dam or sunk ten feet by a drainage canal,” and, in the same way, IE explains whether demand/supply determine a high or low price by considering the institutional structure of rights, rules, and endowments that position the respective curves high or low in price/quantity space.

At another level, however, Commons’s version of IE so expands and restructures analysis of the economic order that it turns into a different paradigm. For example, Commons complements markets and prices with two other modes of economic coordination: organizations and management, and social norms and conventions (custom). Most economic orders utilize a mix of all three, albeit in different proportions, while a few rely on only one or two (e.g., a tribe of Amazon hunter-gatherers; the command economy of North Korea).

For purposes of deeper theorizing, Commons largely takes custom as a given within a country at a point in time so economic coordination reduces to two institutional mechanisms: price coordination in markets and authority coordination in organizations. The former he calls “bargaining” transactions and the latter are the duo of “rationing” and “managerial” transactions. A transaction is broadened by Commons from the physical exchange of goods in price theory to a legally conditioned exchange of property rights, in part to emphasize the inherent nexus among sovereign power, the legal regime, and economic outcomes (Samuels Reference Samuels1989). Bargaining transactions are exchange of property rights through a market between legal equals, while rationing and managerial transactions are exchange of property rights commanded by a superior to a subordinate. Rationing and managerial transactions are authority-based but functionally different; the managerial transaction is used inside organizations to direct labor in production (where workers exchange their right in labor power for a right to money) and the rationing transaction is used by leaders of all institutions to set the working rules that authoritatively distribute rights to participants.

An important feature of this duality is that it separates markets and firms as two distinct ways to organize the division of labor and coordinate cooperation, unlike in neoclassical theory where firms are production functions and passive responders to market price signals. Further, the bargaining vs. managerial transaction distinction highlights that markets and firms are two different types of institutions with different functions—exchange vs. production; operated by different coordinating mechanisms–price competition vs. management direction; and guided by different objectives and internal logics—facilitating trade through competition vs. managing production and sales of goods to make profit. Commons (1950, p. 271) labels the management of firms “administrative economics” and argues that the study of management and production inside firms deserves as much attention as external markets and exchange, per the extensive management research conducted by Commons (e.g., Commons Reference Commons1919) and Wisconsin associates (Kaufman Reference Kaufman2008). Commons regards Frederick Taylor’s program of scientific management as akin to a perfect command analog of the perfect competition model (distinguished in Commons [Reference Commons1919] as ‘machine’ model vs. ‘commodity’ model) in which relations are atomized (through deskilling), desocialized (e.g., individual-based incentive pay), and efficiently coordinated by the visible hand of management.

In Commons’s view, this institutional cleavage between coordination modes is an inherent source of boom/bust cycles (explained in Institutional Economics, ch. 9, with significant but largely unattributed commonality with cycle theories of Mitchell and Veblen), involuntary unemployment, and inefficiency in production because the price signals set in the market are different, and move differently over time, relative to the price signals managers set and use. Commons denies, therefore, that an industrial economy has a self-correcting mechanism, stating, “There is no invisible hand about it, no natural equilibrium of forces of nature that augments the national wealth by mere unguided self-interest” (Commons Reference Commons1923, pp. 116–117). To stabilize capitalism, therefore, the state must act as the ‘visible hand’ and create a “managed equilibrium” (Commons Reference Commons1934a, p. 120).

Like other institutionalists, Commons says economic theory needs an expanded model of the human agent. He anticipates the bounded rationality concept when he says that human behavior is purposeful and guided by reason but nonetheless far from an economic man because of the effects of “passion, stupidity, and ignorance” (1934a, p. 874; Kaufman Reference Kaufman1999). He also points to the idea of strategic interaction in decision making with the concept of “negotiational psychology” (Biddle Reference Biddle1990). Most important, however, is his concept of “reasonable value” (Ramstad Reference Ramstad2001). In addition to self-interest, desires for security and justice are hard-wired into human psychology, and therefore market outcomes that might satisfy everyone’s pure self-interest will nonetheless be rejected if buyers and sellers judge them below the minimally reasonable level in terms of life protection (security) and justice. At a market level, this idea means that reasonable value places upper and lower limits on demand/supply outcomes, and values outside the zone of reasonableness are therefore disequilibrium. Similarly, managers of firms must maintain reasonable security and fairness to earn workers’ goodwill and the discretionary work effort and loyalty that goes with it (Commons Reference Commons1919). At the nation-state level, the government also adjusts the working rules so economic outcomes remain within the zone of reasonable value lest social injustice and insecurity destabilize the order, perhaps to the point of Marxian class struggle and overthrow of capitalism.

Given this theory framework, where did Commons get his ideas and locate the origins of IE? Commons traces his ideas back to David Hume and weaves in contributions from many economists and schools of thought. After Hume, Commons (1924) cites Smith, who “started with a view of the forest” [having defined economics in Wealth of Nations as “the science of the legislator”], but says his classical followers “lost themselves in the woods” (p. 362). He goes on to say that institutional political economy is a “return to the true spirit of Adam Smith,” for Smith’s theory “was set forth in order to indicate the best policy that governments should pursue in proportioning inducements and restraints to individuals” (1924, p. 363). Commons adds, “He [Smith] could not, of course, see the necessity and economy of the mass production brought about afterwards by steam, electricity, chemistry and physics, nor the ways the courts and legislatures have recognized and endowed with power and immunity the industrial governments which organize, marshal, and manage armies of producers.” Thus, the fact that Smith’s economic model of competitive individualism suitable for a 1776 farm/handicraft economy was still the model used by orthodox economists for a 1920s mass-production economy is not Smith’s fault but the modern economists’ fault for refusing to adjust their theory to match an economic order transformed by technological and legal change.

However, Commons locates the specific origin of his conceptualization of institutional economics with his teacher Richard Ely. He says in the preface to Legal Foundations of Capitalism (1924, p. vii), “The aim of this volume is to work out an evolutionary and behavioristic, or rather volitional, theory of value. It was commenced thirty-five years ago at Johns Hopkins University under my stimulating teacher, Richard T. Ely.” In the next sentence, Commons states that his first formulation of this new theory was in his first book, Distribution of Wealth (1893), but that it fell short because “I tried to mix things that will not mix,” identified as the hedonic psychology of marginalist value theory and the reasonable value of law and social relations.

A possible interpretation of this statement is that, in his mature view, Commons regarded marginal and institutional analysis as separate and non-commensurable. However, in Institutional Economics he states a number of times (e.g., pp. 8, 680) that IE subsumes price economics and thus incorporates marginal analysis (a position also held by Ely). The resolution is that marginal analysis is presumed universally applicable in price economics—because its uni-institutional and rule-unconstrained representation creates an unstructured economic space where functional relations have unrestricted continuity—but applicable in IE only within a specific institution or rule set, since to cross from one to another introduces structural breaks, discontinuities, and corner solutions. An implication, represented by Commons’s distinction between bargaining vs. managerial transactions and associated jural relations (1934a, p. 78), is that markets and firms are distinct institutional entities and rule sets and, contra Ronald Coase (Reference Coase1937) and Oliver Williamson (Reference Williamson1985), their respective domains in economic space cannot be reduced to marginal adjustment along a continuous transaction cost function (Kaufman Reference Kaufman2013a).

The only writers I have discovered who locate Commons’s Distribution of Wealth (1893) in the line of development of institutional economics are Joseph Dorfman (Reference Dorfman and Commons1963) and Mark Perlman and Charles McCann (1998). Dorfman states the book is “an ingenuous combination of the modern types of economic theory that he [Commons] had imbibed at Johns Hopkins. It attempted to fuse the Austrian utility theory with an abundance of diagrams and the techniques of the German historical school with its emphasis on the role of law and the use of statistics” (p. xi). He concludes, “The Distribution of Wealth contains the foundations of Commons’ economics” (p. xv).

Dorfman’s observation, along with independent reading of the book, suggests a reconstructed line of development for OIE. By this account, Commons’s institutional thought started in 1893, then continued with A Sociological View of Sovereignty (1899), which Samuels (Reference Samuels and Samuels1998) has selected as a starting date for OIE (along with Veblen’s Theory of the Leisure Class [1899]), but which is then interrupted by a twenty-five-year break until Legal Foundations of Capitalism (1924). So viewed, Commons is not the conventionally portrayed OIE latecomer of the mid-1920s but, instead, the first founder who preceded both Veblen and Mitchell. Unfortunately for Commons, the Distribution of Wealth quickly sank out of sight (it was published at a time of conservative reaction and was panned as bad economics driven by a socialist political agenda) and has ever since so remained. What also needs to be factored in is that Commons’s early theory career was abruptly ended when he was terminated by Syracuse University in 1899 and blackballed at other universities for radical-socialist views, forcing him into five years of academic exile and then rebirth at Wisconsin (thanks to Ely) as a labor expert.

Based on the evidence presented, one could go further and conclude Commons is only an interior link in the OIE family tree and the root stem goes back to Commons’s teacher Richard Ely. This inference matches Ely’s position (1929) that the beginning of institutional economics in America was in 1885 when he and others founded the AEA, and, also, his observation that “we do have a new economics.… The economics of 1929 is a continuous evolution from 1885” (p. 341). Since Adams and J. B. Clark were also AEA founders and advocates of the ‘new economics,’ one could conclude that the founders of institutional economics, at least writ large, are the triplet of Adams, Clark (Sr.), and Ely.

Regarding Veblen, Commons (1934a, p. 676) identifies him as a “pioneer of institutional economics,” and says in the introduction to Institutional Economics (p. 4), “Thorstein Veblen, to his great credit, was introducing the same idea of intangible property into economics during the period following 1900 [e.g., in Theory of Business Enterprise], and it was mainly on that ground that he became known as an institutional economist.” Commons defines “intangible property” as “ownership of expected opportunities” (1934a, p. 5), and highlights Veblen because he based the market value of the firm on the capitalized value of future earnings (a return on intangible property) and, further, explained the business cycle as a credit-induced swing in firms’ capitalized values and investment expenditures. More generally, Commons takes over and generalizes Veblen’s distinction between making goods and making money into the conflicting business logics of efficiency (‘engineering economy’) and scarcity (‘proprietary economy’). Commons also says “no better demonstration of the reason why the orthodox economist could not develop an evolutionary theory has been given than Veblen’s characterization of the faulty conception of human nature of the Austrian economists” (p. 656).

On the other hand, Commons points to a number of flaws in Veblen’s work and, more generally, suggests that in some respects Veblen is outside IE. Commons argues, for example, that Veblen’s Darwinian-based theory of economic evolution is inappropriate because it relies on an unguided nature-based explanation with the process largely driven by exogenous human instincts and technological change. Commons replaces blind and purposeless natural selection with volitional and purposeful ‘artificial selection’ in which people individually and collectively shape their futures via change in institutions and working rules. According to Commons, the Darwinian nature of Veblen’s process theory means it elides two fundamental parts of economic theory—the human choice process and theory of value—that Commons thought essential to IE and endeavored to theorize. ^{Footnote 7} Also, Commons identifies places where Veblen is Marxian rather than institutional, such as treating technology as an exogenous development rather than an endogenous creation of entrepreneurship (emphasized in Distribution of Wealth, ch. 6) and, also, production as a natural science-engineering phenomenon rather than a human science-management phenomenon. Commons also argues that an important methodological principle of IE is that theory construction is preceded by empirical analysis and field investigation so that theoretical abstractions are grounded in real-life conditions. Veblen was largely non-institutional in this respect because he engaged in grand theorizing with little direct look-and-see empirical investigation.

Finally, Commons thought Veblen let his cynicism and alienation carry him toward extreme and destructive suggestions on reform of the economic order, putting him in what Commons (1934a, ch. 11) identifies as the radical wing of the “Managerial [Planning] School,” which wants to abolish individual bargaining transactions (an inevitable source of exploitation to Marx and Veblen) and operate the entire economy as a collective-coordinated managerial transaction, be it through the dictatorship of the proletariat or soviet of engineers. Commons, on the other hand, places himself and other non-radical institutionalists in the reformist “Bargaining School”; says, “I would regulate but not destroy the system” (1934b, p. 188); and observes, “If the profit motive, in the field of economics, can be enlisted in the program of social welfare, then a dynamic factor, more constructive than all others, is enlisted. It is an appeal to the business man to get rich by making others rich, and, if he does not respond, then to appeal to collective action” (1934a, p. 875). Tilman (Reference Tilman1992), accordingly, concludes that “the criticisms of Veblen by institutionalists themselves provide powerful and compelling evidence of the fact that he held significantly more radical views than most other evolutionary economists of the time” (p. 152).