The Political Coase Theorem: Identifying Differences between Neoclassical and Critical Institutionalism

Vira, Bhaskar, Journal of Economic Issues

Institutional analysis has traditionally described the comparative performance of different economies and has attempted to explain the dynamics of economic transformation. This paper analyzes issues relating to institutional performance and to the process of institutional change. It reviews some recent institutional literature and draws upon the distinction between the neoclassical approach represented by New Institutional Economics and the more critical tradition associated with old institutionalism.(1) The paper argues, along with the critical institutionalists, that efficiency is not a value-neutral goal for institutional analysis and that it is necessary to discuss the ethical assumptions that are implicit in the choice of evaluative criteria. Furthermore, although neoclassical institutionalists admit the possibility that socially desirable institutional change may not always be forthcoming, this paper suggests that explanations in this tradition pay inadequate attention to understanding the nature of the political process and that such accounts tend to explain institutional failure using the device of high transaction costs in the political market. In contrast to this neoclassical literature, it is argued here that it is difficult to generalize about the potential success of institutional innovations without analyzing the configuration of political forces in society and without explicitly identifying winners and losers from the process of institutional change.

Evaluating Institutional Performance

If one of the objectives of institutional analysis is to compare the performance of economies, it is necessary to discuss the criterion for evaluation. While there may be agreement that the normative goal of public policy should be to promote outcomes deemed to be socially desirable, it has been recognized since the work of Arrow [1951] that it is difficult to define consistent and complete rules for social choice that satisfy fairly "mild-looking conditions of reasonableness" [Sen 1987, 34n]. The choice of any evaluative criterion inevitably involves making ethical and moral judgments. An important difference between neoclassical and critical institutionalists is the extent to which they recognize and discuss these value judgments, which are implicit in the choice of performance indicators. Critical institutional literature is concerned as much with the normative content of institutional arrangements as it is with the positive analysis of institutional change.

Efficiency is a commonly used indicator of institutional performance, defined in terms of Pareto optimality. For instance, Binger and Hoffman [1989, 69] suggest that "we can view more or less efficient institutions as being more or less effective at exhausting the public gains from exchange." Introducing a volume on Rethinking Institutional Analysis and Development, Nicholson [1993, 4] argues that "institutional innovation contributes to economic development by providing more efficient ways of organizing economic activity" and goes on to suggest that the collected essays "serve to elucidate strategies that will improve the efficiency of institutional choices" [1993, 6]. Furubotn and Richter [1989, 3], however, warn that the use of Pareto-optimality as a criterion confronts the "well-known problems of welfare economics," since there are multiple Pareto-optimal points on the welfare frontier, and these cannot be compared without making value judgments. The non-uniqueness of the Pareto-optimum reflects alternative initial endowments.(2) Furthermore, as Samuels [1992, 65] points out: "There are an infinite number of Pareto-optima reflecting the many other assumptions and the multiplicity of substantive contents of each of them. Pareto-optimum varies, for example, with income and wealth distribution, with the power structure and, most significantly for policy issues, with the law." Then, what needs to be recognized is that since it is the institutional structure that defines what is Pareto optimal, it is meaningless to use this as an evaluative criterion for institutional analysis.

A distinction made by Demsetz [1969], Dahlman [1979], and De Alessi [1983] is that between efficiency with reference to an ideal (or nirvana state) and that which is attainable with given constraints, and they suggest that comparative institutional analysis should concentrate upon the latter. For De Alessi [1983, 60], "a system's solutions are always efficient if they meet the constraints that characterize it." However, such a conception of efficiency is not without problems; as Furubotn and Richter [1989, 3; emphasis added] comment, "the assumptions about which constraints are operative take on critical significance." If all existing restrictions are taken as constraints, it is trivial to argue that every solution is efficient; such a flexible definition of efficiency is not particularly useful. If some restrictions are viewed as subject to change while others are fixed, this choice becomes arbitrary and may generate a significant bias in favor of the status quo [Batie 1984, 816; Samuels 1992, 68-79].

In the context of institutional analysis, such a conception of efficiency is devoid of any analytical significance, since institutions structure human interaction by taking the form of constraints within which individuals pursue their interests. The notion of efficiency relative to constraints is meaningless since the object of analysis is the set of constraints itself. For Bromley [1989, 5], this is the "fundamental circularity between the institutional structure of an economy and the efficiency judgments that can be inferred therefrom." Schmid [1987, 243-5] argues that efficiency calculations are relevant only at that level of decision making that refers to choices about combinations of inputs and outputs within given institutional rules. Efficiency derives from the prior choice of the content of the input and output categories and cannot be a guide to the choice of alternative sets of categories. To argue that efficiency is defined with respect to the existing set of constraints (as suggested by Dahlman [1979, 153]) is to assume the social optimality of the status quo allocation and thereby to ignore the basic question at the heart of the comparative study of institutions [Bromley 1989, 3]. As Schmid [1987, 248] puts it, "Efficiency calculations always depend on where you start, but they cannot validate that starting place."

North [1989a, 243] recognizes problems with the use of the concept of efficiency for evaluating institutional performance, and he argues that "the term must be used very carefully - if at all - when analyzing institutions." North draws a distinction between Pareto efficiency and adaptive efficiency (which he equates with "institutions conducive to economic growth"), and he suggests that the latter is a more useful analytical criterion. Thus, for North [1989b, 665n] inefficiency "is simply meant to specify the development of a set of constraints that will not lead to economic growth."

Aggregate economic growth seems to be a widely accepted indicator of institutional efficiency and is frequently used for comparative analysis. Thus, although the focus of his analysis is the process of bargaining that underlies the creation and modification of institutions, the proposition that a successful institutional structure is one that promotes growth is implicit in Libecap's [1989a; 1989b] work and accepted uncritically.(3) Eggertson [1990, 12] is more circumspect and discusses the choice of criteria briefly, but then he argues that "ultimately, we are interested in the impact of various structures of property rights on (maximizing) the wealth of nations."

The intention here is not to question the validity of aggregate growth as a legitimate objective for development policy and, consequently, as an important subject of inquiry for political economy. However, it must be recognized that the use of aggregate growth to evaluate institutional performance is not a value-neutral choice, and it is important that this be made explicit. Net social benefit cannot be defined unambiguously if interests conflict in the face of scarcity [Schmid 1987, 245]. What is included in output, and what is considered growth, is partly determined by public choice. Costs, and the value of net output, are defined by the institutional structure and thus cannot be used as a criterion for the normative evaluation of alternative institutional structures [Bromley 1989, 115].(4) Who has the initial rights determines whose entitlements are considered as costs - but the initial rights cannot be justified by their ability to reduce costs. Since these costs are a function of the chosen institutional structure, using aggregate economic growth as a criterion for institutional comparison is to use the same circular reasoning as that which suggests the use of Pareto efficiency. The constraints that are operative may be redefined under new institutional arrangements, and this may alter the feasible output vector.(5)

A further justification for the use of aggregate growth derives from the …

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Publication information: Article title: The Political Coase Theorem: Identifying Differences between Neoclassical and Critical Institutionalism. Contributors: Vira, Bhaskar - Author. Journal title: Journal of Economic Issues. Volume: 31. Issue: 3 Publication date: September 1997. Page number: 761+. © 1999 Association for Evolutionary Economics. COPYRIGHT 1997 Gale Group.

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