Institutional Economics
John R. Commons
[Reprinted from the American Economic Review,
Vol.21, 1931, pp.648-657]
The difficulty in defining a field for the so-called institutional
economics is the uncertainty of meaning of an institution. Sometimes
an institution seems to mean a framework of laws or natural rights
within which individuals act like inmates. Sometimes it seems to
mean the behavior of the inmates themselves. Sometimes anything
additional to or critical of the classical or hedonic economics is
deemed to be institutional. Sometimes anything that is "economic
behavior" is institutional. Sometimes anything that is "dynamic"
instead of "static," or a "process" instead of
commodities, or activity instead of feelings, or mass action instead
of individual action, or management instead of equilibrium, or
control instead of laissez faire, seems to be institutional
economics.
All of these notions are doubtless involved in institutional
economics, but they may be said to be metaphors or descriptions,
whereas, a science of economic behavior requires analysis into
similarities of cause, effect or purpose, and a synthesis in a
unified system of principles. And institutional economics,
furthermore, cannot separate itself from the marvelous discoveries
and insight of the classical and psychological economists. It should
incorporate, however, in addition, the equally important insight of
the communistic, anarchistic, syndicalistic, fascistic, co-operative
and unionistic economists. Doubtless it is the effort to cover by
enumeration all of these unco-ordinated activities of the various
schools which gives to the name institutional economics that
reputation of a miscellaneous, nondescript yet merely descriptive,
character of so-called "economic behavior," which has long
since relegated the crude Historical School.
If we endeavor to find a universal circumstance, common to all
behavior known as institutional, we may define an institution as
collective action in control, liberation and expansion of individual
action.
Collective action ranges all the way from unorganized custom to
the many organized going concerns, such as the family, the
corporation, the trade association, the trade union, the reserve
system, the state. The principle common to all of them is greater or
less control, liberation and expansion of individual action by
collective action.
This control of the acts of one individual always results in, and
is intended to result in, a gain or loss to another or other
individuals. If it be the enforcement of a contract, then the debt
is exactly equal to the credit created for the benefit of the other
person. A debt is a duty enforced collectively, while the credit is
a corresponding right created by creating the duty. The resulting
social relation is an economic status, consisting of the
expectations towards which each party is directing his economic
behavior. On the debt and duty side it is the status of conformity
to collective action. On the credit and right side it is a status of
security created by the expectation of the said conformity. This is
known as "incorporeal" property.
Or, the collective control takes the form of a tabu or
prohibition of certain acts, such as acts of interference,
infringement, trespass; and this prohibition creates an economic
status of liberty for the person thus made immune. But the liberty
of one person may be accompanied by prospective gain or loss to a
correlative person, and the economic status thus created is exposure
to the liberty of the other. An employer is exposed to the liberty
of the employee to work or not to work, and the employee is exposed
to the liberty of the employer to hire or fire. The typical case of
liberty and exposure is the goodwill of a business. This is coming
to be distinguished as "intangible" property.
Either the state, or a corporation, or a cartel, or a holding
company, or a co-operative association, or a trade union, or an
employers' association, or a trade association, or a joint trade
agreement of two associations, or a stock exchange, or a board of
trade, may lay down and enforce the rules which determine for
individuals this bundle of correlative and reciprocal economic
relationships. Indeed, these collective acts of economic
organizations are at times more powerful than the collective action
of the political concern, the state.
Stated in the language of ethics and law, to he developed below,
all collective acts establish relations of rights, duties, no rights
and no duties. Stated in the language of individual behavior, what
they require is performance, avoidance, forbearance by individuals.
Stated in the language of the resulting economic status of
individuals, what they provide is security, conformity, liberty and
exposure. Stated in language of cause, effect or purpose, the common
principles running through all of them are the principles of
scarcity, efficiency, futurity, the working rules of collective
action and the limiting and complementary factors of economic
theory. Stated in language of the operation of working rules on
individual action, they are expressed by the auxiliary verbs of what
the individual can, cannot, must, must not, may or may not do. He "can"
or "cannot," because collective action will or will not
come to his aid. He "must" or "must not,"
because collective action will compel him. He "may,"
because collective action will permit him and protect him. He "may
not," because collective action will prevent him.
It is because of these volitional auxiliary verbs that the
familiar term "working rules" is appropriate to indicate
the universal principle of cause, effect or purpose, common to all
collective action. Working rules are continually changing in the
history of an institution, and they differ for different
institutions; but, whatever their differences, they have this
similarity that they indicate what individuals can, must, or may, do
or not do, enforced by collective sanctions.
Analysis of these collective sanctions furnishes that correlation
of economics, jurisprudence and ethics which is prerequisite to a
theory of institutional economics. David Hume found the unity of
these thee social sciences in the principle of scarcity and the
resulting conflict of interests, contra to Adam Smith who isolated
economics from the others on assumptions of divine providence,
earthly abundance and the resulting harmony of interests.
Institutional economics goes back to Hume. Taking our cue from Hume
and the modern use of such a term as "business ethics,"
ethics deals with the rules of conduct arising from conflict of
interests, arising, in turn, from scarcity and enforced by the moral
sanctions of collective opinion; but economics deals with the same
rules of conduct enforced by the collective economic sanctions of
profit or loss in case of obedience or disobedience, while
jurisprudence deals with the same rules enforced by the organized
sanctions of violence. Institutional economics is continually
dealing with the relative merits and efficiency of these three types
of sanctions.
From this universal principle of collective action in control,
liberation and expansion of individual action arise not only the
ethical concepts of rights and duties and the economic concepts of
security, conformity, liberty and exposure, but also of assets and
liabilities. In fact, it is from the field of corporation finance,
with its changeable assets and liabilities, rather than from the
field of wants and labor, or pains and pleasures, or wealth and
happiness, or utility and disutility, that institutional economics
derives a large part of its data and methodology. Institutional
economics is the assets and liabilities of concerns, contrasted with
Adam Smith's Wealth of Nations.
But collective action is even more universal in the unorganized
form of custom than it is in the organized form of concerns. Custom
has not given way to free contract and competition, as was asserted
by Sir Henry Maine. Customs have merely changed with changes in
economic conditions, and they may to-day be even more mandatory than
the decrees of a dictator, who perforce is compelled to conform to
them. The business man who refuses or is unable to make use of the
modern customs of the credit system, by refusing to accept or issue
checks on solvent banks, although they are merely private
arrangements and not legal tender, simply cannot continue in
business by carrying on transactions. These instruments are
customary tender, instead of legal tender, backed by the powerful
sanctions of profit, loss and competition, which compel conformity.
Other mandatory customs might be mentioned, such as coming to work
at seven o'clock and quitting at six.
If disputes arise, then the officers of an organized concern -- a
credit association, the manager of a corporation, a stock exchange,
a board of trade, a commercial or labor arbitrator, or finally the
courts of law up to the Supreme Court of the United States -- reduce
the custom to precision by adding an organized sanction.
This is the common-law method of making law by the decision of
disputes. The decisions, by becoming precedents, become the working
rules, for the time being, of the particular organized concern. The
historic "common law" of Anglo-American jurisprudence is
only a special case of the universal principle common to all
concerns that survive, of making new law by deciding conflicts of
interest, and thus giving greater precision and organized compulsion
to the unorganized working rules of custom. The common-law method is
universal in all collective action, but the technical "common
law" of the lawyers is a body of decisions. In short, the
common-law method is itself a custom, with variabilities, like other
customs. It is the way collective action acts on individual action
in time of conflict.
Thus collective action is more than control of individual action
-- it is, by the very act of control, as indicated by the aforesaid
auxiliary verbs, a liberation of individual action from coercion,
duress, discrimination, or unfair competition by other individuals.
And collective action is more than control and liberation of
individual action -- it is expansion of the will of the individual
far beyond what he can do by his own puny acts. The head of a great
corporation gives orders whose obedience, enforced by collective
action, executes his will at the ends of the earth.
Thus an institution is collective action in control, liberation
and expansion of individual action.
These individual actions are really trans-actions instead of
either individual behavior or the "exchange" of
commodities. It is this shift from commodities and individuals to
transactions and working rules of collective action that marks the
transition from the classical and hedonic schools to the
institutional schools of economic thinking. The shift is a change in
the ultimate unit of economic investigation. The classic and hedonic
economists, with their communistic and anarchistic offshoots,
founded their theories on the relation of man to nature, but
institutionalism is a relation of man to man. The smallest unit of
the classic economists was a commodity produced by labor. The
smallest unit of the hedonic economists was the same or similar
commodity enjoyed by ultimate consumers. One was the objective side,
the other the subjective side, of the same relation between the
individual and the forces of nature. The outcome, in either case,
was the materialistic metaphor of an automatic equilibrium,
analogous to the waves of the ocean, but personified as "seeking
their level." But the smallest unit of the institutional
economists is a unit of activity -- a transaction, with its
participants. Transactions intervene between the labor of the
classic economists and the pleasures of the hedonic economists,
simply because it is society that controls access to the forces of
nature, and transactions are, not the "exchange of commodities,"
but the alienation and acquisition, between individuals, of the
rights of property and liberty created by society, which must
therefore be negotiated between the parties concerned before labor
can produce, or consumers can consume, or commodities be physically
exchanged.
Transactions, as derived from a study of economic theories and of
the decisions of courts, may be reduced to thee economic activities,
distinguishable as bargaining transactions, managerial transactions
and rationing transactions. The participants in each of them are
controlled and liberated by the working rules of the particular type
of moral, economic or political concern in question. The bargaining
transaction derives from the familiar formula of a market, which, at
the time of negotiation, before goods are exchanged, consists of the
best two buyers and the best two sellers on that market. The others
are potential. Out of this formula arise four relations of possible
conflict of interest, on which the decisions of courts have built
four classes of working rules.
(1) The two buyers are competitors and the two sellers are
competitors, from whose competition the courts, guided by custom,
have constructed the long line of rules on fair and unfair
competition.
(2) One of the buyers will buy from one of the sellers, and one
of the sellers will sell to one of the buyers, and, out of this
economic choice of opportunities, both custom and the courts have
constructed the rules of equal or unequal opportunity, which, when
reduced to decisions of disputes, become the collective rules of
reasonable and unreasonable discrimination. (3) At the close of the
negotiations, one of the sellers, by
operation of law, transfers title to one of the buyers, and one
of the buyers transfers title to money or a credit instrument to one
of the sellers. Out of this double alienation and acquisition of
title arises the issue of equality or inequality of bargaining
power, whose decisions create the rules of fair and unfair price, or
reasonable and reasonable value.
(4) But even the decisions themselves on these disputes, or the
legislative or administrative rules prescribed to guide the
decisions, may be called in question, under the American System, by
an appeal to the Supreme Court, on the ground that property or
liberty has been "taken" by the governing or judicial
authority "without due process of law." Due process of law
is the working rule of the Supreme Court for the time being, which
changes with changes in custom and class dominance, or with changes
in judges, or changes in the opinions of judges, or with changes in
the customary meanings of property and liberty.
Hence the four economic issues arising out of that unit of
activity, the bargaining transaction, are competition,
discrimination, economic power and working rules.
The habitual assumption back of the decisions in the foregoing
classes of disputes is the assumption of equality of willing buyers
and willing sellers in the bargaining transactions by which the
ownership of wealth is transferred by operation of law. Here the
universal principle is scarcity.
But the assumption back of managerial transactions, by which the
wealth itself is produced, is that of superior and inferior. Here
the universal principle is efficiency, and the relation is between
two parties, instead of the four parties of the bargaining
transaction. The master, or manager, or foreman, or other executive,
gives orders -- the servant or workman or other subordinate must
obey. Yet a change in working rules, in course of time, as modified
by the new collective action of court decisions, may distinguish
between reasonable and unreasonable commands, willing and unwilling
obedience.
Finally the rationing transactions differ from managerial
transactions in that the superior is a collective superior while the
inferiors are individuals. Familiar instances are the log-rolling
activities of a legislature in matters of taxation and tariff; the
decrees of communist or fascist dictatorships; the budget-making of
a corporate board of directors; even the decisions of a court or
arbitrator; all of which consist in rationing either wealth or
purchasing power to subordinates without bargaining, although the
negotiations are sometimes mistaken for bargaining, and without
managing, which is left to executives. They involve negotiation,
indeed, but in the form of argument, pleading, or eloquence, because
they come under the rule of command and obedience instead of the
rule of equality and liberty. On the borderline are partnership
agreements which ration to the partners the benefits and burdens of
a joint enterprise. These rationing transactions, likewise, in the
American system, are subject finally to the working rules (due
process of law) of the Supreme Court.
In all cases we have variations and hierarchies of the universal
principle of collective action controlling, liberating and expanding
individual action in all the economic transactions of bargaining,
managing and rationing.
Since institutional economics is behavioristic, and the behavior
in question is none other than the behavior of individuals while
participating in transactions, institutional economics must make an
analysis of the economic behavior of individuals. The peculiar
quality of the human will in all its activities, distinguishing
economics from the physical sciences, is that of choosing between
alternatives. The choice may be voluntary, or it may be an
involuntary choice imposed by another individual or by collective
action. In any case the choice is the whole mind and body in action
-- that is, the will -- whether it he physical action and reaction
with nature's forces, or the economic activity of mutually inducing
others in the transaction.
Every choice, on analysis, turns out to be a three-dimensional
act, which, as may be derived from the issues arising in disputes,
is at one and the same time, a performance, an avoidance, and a
forbearance. Performance is the exercise of power over nature or
others; avoidance is its exercise in one direction rather than the
next available direction; while forbearance is the exercise, not of
the total power except at a crisis, but the exercise of a limited
degree of one's possible moral, physical or economic power. Thus
forbearance is the limit placed on performance; performance is the
actual performance; and avoidance is the alternative performance
rejected or avoided -- all at one and the same point of time.
It is from forbearance that the doctrine of reasonableness arises,
while performance means either rendering a service, compelling a
service, or paying a debt, but avoidance is non-interference with
the performance, forbearance or avoidance of others. Each may be a
duty or a liberty, with a corresponding right or exposure of others,
and each may be enforced, permitted, or limited by collective action
according to the then working rules of the particular concern.
If institutional economics is volitional it requires an
institutional psychology to accompany it. This is the psychology of
transactions, which may properly be named negotiational psychology.
Nearly all historic psychologies are individualistic, since they are
concerned with the relation of individuals to nature, or to other
individuals, treated, however, not as citizens with rights, but as
objects of nature without rights or duties. This is true all the way
from Locke's copy psychology, Berkeley's idealistic psychology,
Hume's skeptical psychology, Bentham's pleasure-pain psychology, the
hedonistic marginal utility psychology, James' pragmatism, Watson's
behaviorism, and the recent Gestalt psychology. All are
individualistic. Only Dewey's is socialistic. But the psychology of
transactions is the psychology of negotiations. Each participant is
endeavoring to influence the other towards performance, forbearance
or avoidance. Each modifies the behavior of the other in greater or
less degree. This is the psychology of business, of custom, of
legislatures, of courts, of trade associations, of trade unions. In
popular language it resolves into the persuasions or coercions of
bargaining transactions, the commands and obedience of managerial
transactions, or the arguments and pleadings of rationing
transactions. All of these are negotiational psychology. It may be
observed that they are a behavioristic psychology.
But these are only names and descriptions. A scientific
understanding of negotiational psychology resolves it into the
smallest number of general principles, that is, similarities of
cause, effect or purpose, to be found in all transactions, but in
varying degree. First is the personality of participants, which,
instead of the assumed equality of economic theory, is all the
differences among individuals in their powers of inducement and
their responses to inducements and sanctions.
Then are the similarities and differences of circumstance in
which personalities are placed. First is scarcity or abundance of
alternatives. This is inseparable from efficiency, or the capacity
to bring events to happen. In all cases negotiations are directed
towards future time, the universal principle of futurity. Working
rules are always taken into account, since they are the expectations
of what the participants can, must or may do or not do, as
controlled, liberated or expanded by collective action. Then, in
each transaction is always a limiting factor whose control by the
sagacious negotiator, salesman, manager or politician, will
determine the outcome of complementary factors in the immediate or
remote future.
Thus negotiational psychology is the transactional psychology
which offers inducements and sanctions according to the variable
personalities and the present circumstances of scarcity, efficiency,
expectation, working rules and limiting factors.
Historically this transactional psychology may he seen to have
changed, and is changing continuously, so that the whole
philosophies of capitalism, fascism or communism are variabilities
of it. In the common-law decisions it is the changing distinctions
between persuasion and coercion or duress, persuasion being
considered the outcome of a reasonable status of either equality of
opportunity, or fair competition, or equality of bargaining power,
or due process of law. But economic coercion and physical duress are
denials of these economic ideals, and nearly every case of economic
conflict becomes an assumption or investigation, under its own
circumstances, of the negotiational psychology of persuasion and
coercion. Even the managerial and rationing negotiations come under
this rule of institutional change, for the psychology of command and
obedience is changed with changes in the status of conformity,
security, liberty or exposure. The modern "personnel"
management is an illustration of this kind of change in
negotiational psychology.
All of this rests on what may he distinguished as three social
relations implicit in every transaction, the relations of conflict,
dependence and order. The parties are involved in a conflict of
interests on account of the universal principle of scarcity. Yet
they depend on each other for reciprocal alienation and acquisition
of what the other wants but does not own. Then the working rule is
not a foreordained harmony of interests, as assumed in the
hypotheses of natural rights or mechanical equilibrium of the
classical and hedonic schools, but it actually creates, out of
conflict of interests, a workable mutuality and orderly expectation
of property and liberty. Thus conflict, dependence and order become
the field of institutional economics, builded upon the principles of
scarcity, efficiency, futurity and limiting factors derived from the
older schools, but correlated under the modern notions of working
rules of collective action controlling, liberating and expanding
individual action.
What then becomes of the "exchange" of physical
commodities and the production of wealth, as well as the consumption
of wealth and satisfaction of wants by consumers, which furnished
the starting points of the classical, hedonic, communist and other
schools of economists? They are merely transferred to the future.
They become expectations of the immediate or remote future, secured
by the collective action, or "institution," of property
and liberty, and available only after the conclusion of a
transaction. Transactions are the means, under operation of law and
custom, of acquiring and alienating legal control of commodities, or
legal control of the labor and management that will produce and
deliver or exchange the commodities and services, forward to the
ultimate consumers.
Institutional economics is not divorced from the classical and
psychological schools of economists -- it transfers their theories
to the future when goods will be produced or consumed or exchanged
as an outcome of present transactions. That future may be the
engineering economics of production of the classical economists or
the home economics of consumption of the hedonic economists, which
depend on physical control. But institutional economics is legal
control of commodities and labor, where the classical and hedonic
theories dealt only with physical control. legal control is future
physical control. Future physical control is the field of
engineering and home economics.
Thus it may be seen how it was that the natural rights ideas of
the economists and lawyers created the illusion of a framework,
supposed to be constructed in the past, within which present
individuals are supposed to act. It was because they did not
investigate collective action. They assumed the fixity of existing
rights of property and liberty. But if rights, duties, liberties and
exposures are simply the changeable working rules of all kinds of
collective action, looking towards the future, then the framework
analog disappears in the actual collective action of controlling,
liberating and expanding individual action for the immediate or
remote future production, exchange, and consumption of wealth.
Consequently the final social philosophy, or "ism" --
which is usually a belief regarding human nature and its goal --
towards which institutional economics trends is not something
foreordained by divine or natural "right," or
materialistic equilibrium, or "laws of nature" -- it may
he communism, fascism, capitalism. If managerial and rationing
transactions are the starting point of the philosophy, then the end
is the command and obedience of communism or fascism. If bargaining
transactions are the units of investigation then the trend is
towards the equality of opportunity, the fair competition, the
equality of bargaining power, and the due process of law of the
philosophy of liberalism and regulated capitalism. But there may be
all degrees of combination, for the three kinds of transactions are
interdependent and variable in a world of collective action and
perpetual change, which is the uncertain future world of
institutional economics.