Neoclassical Economics As A Theory Of Politics And

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NEOCLASSICAL ECONOMICS AS A THEORY OF
        POLITICS AND INSTITUTIONS
                         Anton D. Lowenberg

Introduction
   There are essentially two types of social science explanations
of politics and institutions. One approach is to focus on the behav-
ior of the rational individual agent and treat macrostates as outcomes
of interaction between individual agents. This is the methodology of
neoclassical economics. An alternative approach is to start with social
structures and historical context, and to view the individual as merely
a passive reflection ofthese. In economics, this "agentless" emphasis
on social structure is characteristic of Marxian, radical, and institu-
tionalist theory.
   Ultimately, the usefulness of any research program is to be judged
on its ability to explain an increasing number ofhitherto unexplained
phenomena.' A "progressive" research program, to borrow the termi-
nology of Lakatos (1978), possesses an expanding empirical content.
Theories within a progressive research program are able to explain
novel facts or regularities that were previously unexplained. Con-
versely, a "regressive" research program is one whose theories require
continuous ad hoc changes in order to shore up the fundamental
axioms upon which they are based. The theories in a regressive
research program continually confrontempirical refutation, and they
must be amended accordingly.
   My purpose is to argue that neoclassical economics encompasses
a progressive research program, whereas Marxism, institutionalism,

  Cato Journal, Vol. 9, No. 3 (Winter 1990). Copyright  Cato Institute. All rights
reserved.
  The author is Associate Professor of Economics at the University of Colorado at
Denver.
`A research program (or paradigm) is a cluster of theories all of which are based on a
common "hard core" set of axioms, assumptions, or beliefs. The notion of a research
program in this sense is due to Lakatos's rational reconstruction of the growth of
scientific knowledge (Lakatos 1978).


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and other "holistic" methodologies in economics2 suffer important
drawbacks that impede their explanatory power. I use the term "neo-
classical" here very broadly; it includes all theories that are based
on the economizing behavior ofindividual value-maximizing agents.
This term would embrace standard textbook theories of production
and consumption; the property rights and transaction costs approach
to industrial organization, law, history, and social institutions; public
choice theories of politics and constitutional arrangements; and even
Austrian economics.3 By contrast, nonneoclassical theories are those
that posit the primacy of social structure and assign little role to the
individual agent. In addition to Marxian economics, nonneoclassical
theories include institutionalism--a theory that regards market
exchange as a function of underlying power relations in society.4
   In this paper, I will start by showing that neoclassical rational
choice theory has rapidly expanded its empirical content and explan-
atory power. Recent theoretical developments have brought many
aspects of collective and institutional choice explicitly into the
domain of economic theory. Therefore, in the next section I will
demonstrate that the typical criticisms leveled against neoclassical
economics by radical and institutionalist detractors no longer have
much validity. Following that section I will examine some of the
weaknesses inherent in structuralist and functionalist theories, and
then I will show how some practitioners ofmodern radical economics
have attempted to rescue their paradigm by injecting elements ofthe
neoclassical method. This discussion is offered as evidence of the
regressiveness of the structuralist research program when compared
to the rational individual choice approach.

The Extension of Neoclassical Economic Theory
  In addition to the standard price-theoretic analysis of market
exchange and production, neoclassical economics now also provides
testable theories of institutions and nonmarket interactions. The
extension of the scope of economic theory into this area is evidence

2See Boland (1982) on the distinction between methodological individualism and meth-
odological holism.
3This is not to deny the substantial differences between these various subprograms. As
long as they share some crucial hard-core axioms, different paradigms can be viewed
as belonging to the same overall research program even if they contain conflicting
propositions or theories. On the relationship between subprograms and the larger
research program, see Rernenyi (1979), Cross (1982), Weintraub (1985), and Heijdra
and Lowenberg (1988).
4For a good brief summary of the major differences among neoclassical economics,
Marxism, and institutionalism, see Mederna (1989).


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                                                 POLITICS AND INSTITUTIONS


of the progressivity of the neoclassical research program. It also
debunks the claims of Marxians, post-Keynesians, institutionalists,
and other nonneoclassical economists that only their respective
schools are able to deal adequately with institutions. Orthodox Marx-
ians, for example, have traditionally rejected the methodology of
neoclassical economics on the grounds that it is based on an atomistic
isolated individual and is, therefore, unable to supply a theory of
history, social institutions, collective behavior, or anything else that
lies outside the realm ofnarrow market exchange (Hunt and Schwartz
 1972, p. 8).
   It is certainly true that the basis of neoclassical economics is method-
ological individualism. The individual is modeled as an evaluating,
choosing, and acting agent (Buchanan 1987, p. 244). Aggregate social
phenomena (of both the market and nonmarket variety) are then
explained in terms of individual actions and their interrelations (Van-
berg 1986, p. 80). Every observed social outcome is treated as an
endogenons product ofa process of individual choice and exchange, in
the context ofperceived constraints. The much touted (and thoroughly
misunderstood) assumption of "individual rationality" is really quite
innocuous, It simply means that individuals strive to make themselves
as well off as possible, given their tastes and the resources and knowl-
edge that they possess.5 This assumption does not imply that the rational
actor of neoclassical economics pursues only pecuniary wealth. Any-
thing that is valued by the individual is a legitimate source of utility.
Whether something is valued depends on whether individuals reveal
by their behavior that they are willing to sacrifice some other object of
utility in order to attain more of the "good" in question. This good
might be a marketed commodity like apples or oranges, but it could
also be a less-tangible form of satisfaction like charitable giving or
the propagation of some ideological or religious belief. The minimal
assumption required for this economic theory of human behavior is
simply that identifiable self-interest (for example, net wealth, social
position, fairness, altruism, etc.) motivates the choosing individual.
Note that this assumption does not give primacy to the pursuit of
narrowly conceived economic interests, nor does it impute any mali-


5The method of neoclassical economics is, in fact, a variant of what Karl Popper calls
"situation analysis"--individuals' actions are dictated by the logic of a situation in
which they find themselves, assuming that they will use only those actions that are
most appropriate to their situation. See Hands (1985, p. 84); Boland (1982, p. 32); and
Latsis (1976). Langlois (1986, p.236) points out thatthe advantage ofsituational analysis
isthat it renders unnecessary a detailed psychologistic study ofthe internal mechanisms
ofhuman decisionmaking. A knowledge of the agent's environment (including institu-
tions) serves as a substitute for a detailed knowledge of his or her psychology.


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cious or selfish motives to the individual agent.6 Furthermore, it obvi-
ates the oft-repeated complaint of nonneoclassicals that the rational
choice framework cannot explain altruism.7
   One of the great discoveries of such 18th-century political econo-
mists as Mandeville, Hume, Tucker, Ferguson, and Adam Smith is
that self-interested individual behavior can have unintended, but
nevertheless beneficial, consequences for society. Unrestricted indi-
vidual exchange will ensure that scarce resources flow to their high-
est valued uses. This efficient outcome--what Hayek (1976, p. 99)
calls "the spontaneous order of the market"--is not, and indeed
cannot be, brought about through the design of any person or group.
Individuals are driven primarily by their own self-interest, and no
single individual or group ofindividuals can possibly possess enough
information to implement the kind of massive coordination that is
effected by market prices.8 This view does not by any means preclude
the existence of benevolent motives, but benevolence is scarce (it
usually does not extend very far beyond close family and acquain-
tances). Therefore, a rationally organized society will economize on
its use, rather than rely upon it to achieve an efficient allocation of
resources.9
   Apart from market resource allocation, many aggregate social out-
comes can be modeled by means of so-called "invisible hand" expla-
nations. Institutions, rules, mores, culture, tradition, and other
behavioral regularities are often explained by economists as products
of evolutionary-competitive processes.' This explanation is what
Menger originally referred to as "organic" evolution ofsocial conven-
tions (Schotter 1986, p. 118). In the Mengerian research program,
institutions are treated as the explananda of invisible hand theories
(Langlois 1986, p. 247). The latter theories characterize institutions
and rules as the products of a process involving the separate actions
of individuals who do not deliberately intend to bring about the
outcomes in question, but whose collective pursuit of individual
interests is sufficient to ensure those outcomes (Vanberg 1986, pp.
80--81). This notion of a spontaneous social order emerging as an
unintended consequence out of a catallaxy of individual exchanges
has been formulated most explicitly by the Austrian school, although
its intellectual heritage includes earlier ideas such as Mandeville's

6See Buchanan (1987, p. 245).
7See, for example, Dearlove (1989, p. 225) for a recentstatement of this mistaken view.
5See Vanberg (1986, p. 78) and Lavoie (1989, p. 627).
9See Coase (1976),
`SeeGray (1984, pp. 33--34) and Wift (1989).


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                                             POLITICS AND INSTITUTIONS


"Private Vices, Public Virtues" and Adam Smith's own conception
of the invisible hand ofthe market." Contemporary examples of the
invisible hand type ofexplanations include Douglass North's theory
of economic history (1981), the property rights and transaction costs
theory of industrial organization (Demsetz 1967 and Williamson
1985), the economic theory ofthe common law and the family (Posner
1977 and Becker 1976), and the economic theory of constitutions and
rules (Brennan and Buchanan 1985). Common to all of these is the
axiom that rational individuals will seek to exploit profit opportuni-
ties (broadly conceived) whenever they arise, which in turn ensures
that welfare enhancing institutional innovations will occur whenever
the net benefits are positive. Again, the term "benefit" is to be inter-
preted to include more than just pecuniary gains.
   However, the economic theory of political and social institutions
does not treat all institutional forms as spontaneous, socially desir-
able products of a catallaxy of individual wealth maximization.
Within the broad rubric of neoclassical economics there has devel-
oped the field of public choice, which provides an economic theory
of politics on the basis of the same methodological individualism
that underpins other branches of neoclassical economics. Central to
public choice theory is the recognition that optimal resource alloca-
tion does not always arise spontaneously out of individual optimizing
behavior, because of various prisoner dilemma problems associated
with the pursuit of collective outcomes. This theory makes it neces-
sary to study the political processes through which individual prefer-
ences are translated into social structures. Public choice theory is
informed by several converging strands of scholarly inquiry. These
strands include most importantly Wicksell and Buchanan's approach
to the economics ofrule making; Duncan Black's work on collective
choice exercized through committees and voting (a work that draws
on earlier insights on social choice by the Marquis de Condorcet
and Lewis Carroll); Anthony Downs' economic model of political
exchange under democracy; Gordon Tullock's analysis ofthe welfare
costs of rent seeking; Stigler and Peltzman's "capture" theory of
regulation; and the theory of interest groups, which starts with the
political scientists Truman and Bentley, and which is further devel-
oped by Olson and more recently formalized by Becker.
   While there are important differences that separate some of these
schools, there are considerable areas ofoverlap. For example, Chica-
go-style politicaleconomy generalizes the economic theory ofregula-
tion into a theory of politics that has much similarity to the Virginia

"See Heijdra, Lowenberg, and Mallick (1988, pp. 298--99).


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