A Journey in Explaining Differences in Development (part-4)

by Rizal K.

From part-1 to part-3, we have reviewed several economic theories that derive its explanation based on the assumption of perfect rationality. Although those explanations are stemmed from the same assumption of perfect rationality, they predict a totally different outcome. While classical growth theories predict a balance economic outcome in the long run, Marxist economics predicts otherwise.

Between those two extreme positions of neoclassical and Marxist economics, there are a variety of alternative approaches that attempt to explain the economic processes and their spatial implications but reject the assumptions of perfect rationality, i.e. the self-interested atomic, perfectly informed economic agents pursuing profit maximization. Instead, these alternative paradigms embrace the fact that economic agents have bounded rationality and base their actions not merely on economic considerations but importantly on social-political context within which they take their economic actions. Within this line of arguments, three approaches are worth to discuss, namely new institutional economics (North, 1990), new economic sociology (Granovetter, 1985), and evolutionary economics (Nelson and Winter, 1982). Enjoy the reading!

New Institutional Economics (NIE)

North (1990) provides a good foundation for understanding institutional economics. He put forward some underlying arguments on which he develops his concept of institutions.

First, he identified theoretical problems in explaining human coordination and cooperation in neoclassical economic theory and other social sciences. This problem of coordination and cooperation can be addressed through iterated games through which participants may explore each other’s motivations. Institutions emerge from prolonged iterated interactions that make one’s motivations predictable for others.

Second, acknowledging the limitation of rational choice theory of neoclassical economics,  North (1990) revealed two human characteristics that are crucial to be incorporated in a theory explaining economic outcomes, which are human motivations and human abilities to process information (bounded rationality). Again, institutions (formal and informal) may constrain human behaviours, thus provide predictable motivations that shape choices and help individuals to decipher the complexity of the environment.

Third, institutions reduce uncertainty by providing structure for exchange, thus reducing the costs of transactions. Further, North acknowledged embeddedness of institutions into social and cultural situations that change incrementally even though formal institutions may change overnight as a result of political or judicial decisions (p. 6). He also stressed that institutions may provide stable structures but that these structures are not necessarily efficient. Differences in economic outcome therefore hinge on the efficiency of institutions in reducing transaction and transformation costs that exist in society within local, regional and national levels.

It is important to note that despite North’s tendency to tie institutions to the economic analysis of transaction costs, his line of argument is in fact built on bounded rationality of human behaviour and embeddedness of institutions into social-cultural contexts which are in contradiction with the basic assumptions of neoclassical economics. Embeddedness itself is an important concept in economic sociology introduced by Granovetter (1985).

Economic sociology

Granovetter (1985) distinguishes two extreme views on the relation between economic actions and social context. One view is what he labelled as oversocialized which is held by most sociologists who emphasize the deterministic influences of social and political structure on individuals’ economic actions. “The conception of ‘social influences’ is oversocialized because it assumes that people follow customs, habits or norms automatically and unconditionally” (Granovetter, 1992, p. 6).

In contrast, an undersocialized view is based on the utilitarian tradition that views economic actions in an atomistic way, neglecting other social influences on economic actions. As Granovetter (1992) put it: “The detail of their social relations are irrelevant (p. 5)”.

Taking on an in-between stand between these two extremes, Granovetter (1985) builds his economic sociology concept by putting forward the notion of ‘embeddedness’: how economic behaviour is attached in real, on-going systems of social relations. The simple example is the existence of firms, industries or other economic institutions. In the case of firms, within the neoclassical transaction cost theory, firms emerge if it reduces transaction costs. In contrast, economic sociology contends that firms are constructed by individuals whose actions are facilitated and constrained by social relations within which they are embedded. This embeddedness in social networks enables the delegation of tasks and coordination among individuals that are supported by some degree of trust.

This embeddedness of individuals and firms in local social networks is the reason why routines organizing the production process in firms (Nelson and Winter, 1982) differ across space and time. Therefore, the prediction of this theory for regional paths is likely to diverge.How routines change and evolve over time is actually the main concern of one branch of evolutionary economics.

Evolutionary economics

In the beginning of the 1980s, Nelson and Winter (1982) published their seminal work: “An Evolutionary Theory of Economic Change”. Contesting orthodox neoclassical economics, they argue that to develop a more realistic theory of economic change one should put aside the assumptions of perfect rationality and equilibrium. Alternatively, they proposed the term ‘routine’ as decision rules used by firms to deal with temporal complex situations they are facing. These routines, which are also defined as operating characteristic of firms, play crucial roles in evolutionary theory particularly in determining the behaviour and inheritance capacity of firms as objects on which selection forces work.

The core concern of evolutionary theory is the presence of variety (in this case the firms’ routines), inheritance (temporary persistence of routines) and selection of firm routines. These key principles of evolutionary theory (variety, inheritance, selection) then termed by many scholars as Universal or Generalized Darwinism (Dawkins, 1983; Hodgson, 2002; Hodgson and Knudsen, 2012). Generalized Darwinism operates at high level of abstraction so that the basic principles of variety, inheritance/retention, and selection can be applied to a wide range of phenomena that need to be supplemented with domain-specific explanations to explain empirical phenomenon and causal processes operating in those domains (Hodgson, 2002).

Another important notion introduced by Nelson and Winter (1982) is the notion of ‘search’ for new routines. Searching for new routines is equivalent to mutation in biological evolutionary theory, which in part is determined by gens. Thus, by applying these two notions to the dynamic process of firms and its market environments, they developed their evolutionary theory of which ‘firms behavior patterns and market outcomes are jointly determined over time (p. 18)’.

In terms of regional paths, divergence is likely the predicted outcomes of evolutionary economic theory.

References

Dawkins, R 1983, Universal Darwinism, in Bendall, DS (ed.), Evolution from Molecules to Man, Cambridge University Press, Cambridge.

Granovetter, M 1985, Economic action and social structure: the problem of embeddedness, American Journal of Sociology, vol. 91, p. 481-510.

Granovetter, M 1992, Economic institutions as social constructions: a framework for analysis, Acta Sociologica, vol. 35, p. 3-11.

Hodgson, GM 2002, Darwinism in economics: from analogy to ontology, Journal of Evolutionary Economics, vol. 12, p. 259-281.

Hodgson, GM & Knudsen, T 2012, Agreeing on generalised Darwinism: a response to Pavel Pelikan, Journal of Evolution Economics, vol. 22, p. 9-18.

Nelson, RR & Winter SG 1982, An Evolutionary Theory of Economic Change, Harvard University Press, Cambridge. North, DC 1990, Institutions, Institutional Change and Economic Performance, Cambridge University Press, Cambridge.

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