Friday, October 18, 2019


445. The dogma of efficiency

The good thing about institutional economics is that it does not take markets for granted but investigates how institutions may enable, disable or pervert markets.

Institutions can be formal and written, such as property rights, access to markets (competition law), and a variety of government regulations (for the environment, advertising, labour conditions, etc.). There are also unwritten, informal, cultural effects, such as norms and customs of behaviour, with underlying ethics and values. Language is an institution that enables communication.

There still is, even among institutional economists, the dogma that all institutional analysis should be based on the assumption of efficiency, as recently propounded by Douglas Allen, in a book ‘Research agenda for New Institutional Economics’.[i] Allen defined efficiency as the outcome of the maximization of a utility function under constraints. If an institution appears inefficient, that is because one has neglected some part of he utility function or some side condition

This is in itself an institution, stating the rule of the game for institutional economists to belong to the tribe.

Here, Allen quotes Coase, one of the founding fathers of institutional economics as saying that ‘.. to not appreciate that institutions are efficiently chosen is to end up doing welfare economics that “ultimately dissolves into a study of aesthetics and morals”’.

Now, I would not claim aesthetics as a basis for the study of institutions, but I would certainly include morals as perhaps the most important aspect of the role of culture in the making of institutions. Trust, for example is based, in part, on morals. It is risible to denigrate morals in the way that Coase did.

There are two problems with the dogma. The first is methodological. The claim that institutions are efficient is taken to be true by definition, therefore is not falsifiable and therefore not scientific.

The second problem is substantive. The assumption of efficiency appears to ignore the vast evidence that people routinely make decisions out of ignorance, mistake, impulse and irrational shortcuts to decisions (called ‘heuristics’). Developed in social psychology, all this is now part of behavioural economics.

Now, the response to this criticism of the dogmatic economist would be that this conduct only seems irrational, inefficient, because one has not included the proper goals or constraints of conduct. But that only confirms, or deepens, the methodological problem. All conduct becomes rational even if it is not rational.

The solution of the dogmatist would be to rationalize the heuristics by including in the objective function the cost of mental effort and delay of rational analysis. In this way one can rationalize any conduct, no matter how absurd, by including the assumption that this what people want. The point is, of course that no matter how you twist it, the fact remains that the conduct is irrational.

A whole industry of ‘nudging’ is developing, where policymakers or business strategists develop ways to improve the rationality of conduct, by affecting (‘nudging’) preferences and habits, the way heuristics work, to improve their optimality, by showing how choice can be improved, or by sheer manipulation.

This requires the recognition of inefficiency and irrationality.  
      


[i] Douglas Allen, ‘Recognizing and solving institutional puzzles’, in: Claude Menard & Mary H. Shirley, A research agenda for New Institutional Economics, Cheltenham UK: Edward Elgar, 2018, p. 269-277.

445. The dogma of efficiency



The good thing about institutional economics is that it does not take markets for granted but investigates how institutions may enable, disable or pervert markets.



Institutions can be formal and written, such as property rights, access to markets (competition law), and a variety of government regulations (for the environment, advertising, labour conditions, etc.). There are also unwritten, informal, cultural effects, such as norms and customs of behaviour, with underlying ethics and values. Language is an institution that enables communication.



There still is, even among institutional economists, the dogma that all institutional analysis should be based on the assumption of efficiency, as recently propounded by Douglas Allen, in a book ‘Research agenda for New Institutional Economics’.[i] Allen defined efficiency as the outcome of the maximization of a utility function under constraints. If an institution appears inefficient, that is because one has neglected some part of he utility function or some side condition.



This is in itself an institution, stating the rule of the game for institutional economists to belong to the tribe.



Here, Allen quotes Coase, one of the founding fathers of institutional economics as saying that ‘.. to not appreciate that institutions are efficiently chosen is to end up doing welfare economics that “ultimately dissolves into a study of aesthetics and morals”’.



Now, I would not claim aesthetics as a basis for the study of institutions, but I would certainly include morals as perhaps the most important aspect of the role of culture in the making of institutions. Trust, for example is based, in part, on morals. It is risible to denigrate morals in the way that Coase did.



There are two problems with the dogma. The first is methodological. The claim that institutions are efficient is taken to be true by definition, therefore is not falsifiable and therefore not scientific.



The second problem is substantive. The assumption of efficiency appears to ignore the vast evidence that people routinely make decisions out of ignorance, mistake, impulse and irrational shortcuts to decisions (called ‘heuristics’). Developed in social psychology, all this is now part of behavioural economics.



Now, the response to this criticism of the dogmatic economist would be that this conduct only seems irrational, inefficient, because one has not included the proper goals or constraints of conduct. But that only confirms, or deepens, the methodological problem. All conduct becomes rational even if it is not rational.



The solution of the dogmatist would be to rationalize the heuristics by including in the objective function the cost of mental effort and delay of rational analysis. In this way one can rationalize any conduct, no matter how absurd, by including the assumption that this what people want. The point is, of course that no matter how you twist it, the fact remains that the conduct is irrational.



A whole industry of ‘nudging’ is developing, where policymakers or business strategists develop ways to improve the rationality of conduct, by affecting (‘nudging’) preferences and habits, the way heuristics work, to improve their optimality, by showing how choice can be improved, or by sheer manipulation.



This requires the recognition of inefficiency and irrationality.  

       



[i] Douglas Allen, ‘Recognizing and solving institutional puzzles’, in: Claude Menard & Mary H. Shirley, A research agenda for New Institutional Economics, Cheltenham UK: Edward Elgar, 2018, p. 269-277.

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