It may seem odd to begin a discussion about institutional economics by talking about people. When it comes to economics, we are accustomed referring to abstract entities like companies, governments, and, occasionally, somewhere far off, there are also people, usually disguised as “households.” However, I’d like to start with a somewhat heterodox view of economics: there are neither companies, nor governments, nor households – there are only different groups of people. With a statement like “This is essential to the company’s interests,” one only needs to scratch the surface to get to the real question: whose interests are actually at stake? These might be the interests of senior managers, shareholders, factions of employees, parties holding controlling or even minority stakes. Whatever the case, there is no such thing as the interests of the firm per se, only the interests of individuals. The same applies to a statement like “A household gained income.” Isn’t this when the most interesting part begins? Every family has its own complicated distribution of wealth. There are a number of sophisticated tasks to be resolved within this type of unit that involve a multitude of negotiating parties, children, grandchildren, grandparents.

Thus, the discussion of human nature cannot be avoided when talking about economics. This is referred to as “the principle of methodological individualism.” However, this designation is imprecise because the question of whether human beings are individualists or not is totally beside the point. The issue is that every phenomenon in the social world is comprised of diverse individual interests. For this reason, it is important to figure out who these humans we are dealing with are.

Man vs Homo Economicus

Adam Smith, the founding father of political economy, is known as the originator of the idea of man as Homo economicus, and for many decades this model has been ubiquitous in economics textbooks. I’d like to say a few words in defense of our great intellectual forerunner. Adam Smith could not teach at a political economy department, as there was no such discipline in his time. Instead, he taught in the philosophy department, and while his course on political economy focused on the selfish man, in his moral philosophy course, he expounded on the altruistic one. And these were not two different men, but one and the same.

Meanwhile, Smith’s students and followers would not be teaching in philosophy departments. As a result, the discipline inherited a rather odd and flawed foundational construct: Homo economicus. This concept underlies all classical economic analysis of human behavior. The development of this concept was influenced by the 18^th century French Enlightenment thought, with its claims of a limitless human consciousness, the omnipotence of reason, and the fundamental goodness of human beings, and that if they were liberated, everything would flourish. The interplay of Adam Smith’s philosophical and economic ideas with those of the French Enlightenment thinkers produced Ноmo economicus, a real selfish bastard armed with super-rational thoughts and utility maximization.

This model persists in economics texts to this day. However, the notion of human beings pursuing exclusively selfish goals without any limitation is just not realistic. New institutional economic theory refines this concept by introducing two propositions that are essential for all subsequent reasoning and model-building. One of these propositions asserts the bounded rationality of humans; the other expounds on their proclivity toward opportunistic behavior.

Man vs Rationality

The Enlightenment notion that humans possess a boundless capacity for rational thought is challenged by our own life experience, which demonstrates that human rationality is limited. Economist and psychologist Herbert Simon won a Nobel Prize for his analysis of how bounded rationality manifests itself, namely accounting for why humans are capable of solving a multitude of problems although they don't possess the boundless capacity for gathering and processing information.

Let’s imagine how a person would spend their morning according to a standard economics textbook. As soon as they wake up, they have to solve a minimal optimization problem in order to eat breakfast, that is, they have to consider all the possible combinations of yogurt, cheese, eggs, ham, and so on in terms of how they are made, where they are located, and how much they cost. After making all the relevant calculations, that person will be able to make the optimal decision of purchasing eggs (rather than avocados) in Moscow (rather than in Singapore), at a particular store for a particular price. One suspects that unless that person draws upon a couple of rules of thumb or institutions in order to make these calculations, not only will they fail to get breakfast, they’ll miss their dinner, as well. So how on earth do they solve this problem?

Herbert Simon said that the decision-making process is based on a more simplified principle. When someone is selecting a spouse, he or she does not enter billions of individuals of the opposite sex into a computer program. Instead, they makes a couple of random trials, determine a pattern to follow and decide what they are going to persue. Then, when the first person that fits these criteria comes along, they become their spouse (after which, of course, the marriage is consummated in heaven). The task of getting a breakfast or, for example, picking a suit is solved in exactly the same way: through random trials upon establishing one’s demands. Therefore, the idea of a limited rational capacity does not imply that people are stupid. It merely implies that people lack the capacity to process the totality of information available, and yet they can develop simple algorithms for resolving a host of problems.

Man vs Good Intentions

Human beings are no angels. They frequently attempt to circumvent rules and conditions. Oliver Williamson, who drew attention to the role of human opportunism in economics (and received the Nobel Prize in 2009), defined this behavior as involving the use of cunning and disguise. In other words, opportunistic behavior is not affected by moral standards. Again, this hardly requires special proof, but Williamson’s innovation was providing a conceptual framework that enables us to explain how people circumvent various restrictions. One of the most spectacular examples is the market for “lemons” model that economist Joseph Akerlof won a Nobel Prize for in 2002.

The “lemons” model describes pre-contractual opportunistic behavior. It is based on a real-life issue, the used car trade in the United States. Imagine someone who goes to a dealership to buy a used car. All of the cars look good, they’re shiny and clean, but there is no indication whether any one of them will break down after the first 500 meters or if they will run for another 100,000 km. So what are the buyer’s selection criteria? By and large, there are two: how the car looks and its price. But all the cars look the same. As for the price, guess who can offer a better price, someone who is selling a good car or someone selling a bad one?  The latter is more likely. As a result, once the buyer makes their decision on the basis of how good the car looks and how much it costs, the person selling the lemon, i.e. the least conscientious competitor, out-competes everybody else. Meanwhile, plums, i.e. decent cars, get squeezed out of the market.

At first glance, it may seem that the “lemons” model describes a morally irreproachable situation: this is just normal competition, without any interference from outside, or any monopolies. However, because the buyer’s rationality is limited and they cannot know everything, while the seller conceals information, behaving opportunistically, competition in this case does not lead to economic prosperity. Moreover, it may simply lead to the implosion of this market due to the continuous decline in quality.

The solution lies in fairly simple rules. For example, the introduction of a seller’s warranty. The seller guarantees that any malfunctioning within one year will be repaired at their own expense. This kind of guarantee immediately leads to a flattening of prices. In this case, the problem is resolved through the introduction of certain rules, that is, institutions. In the absence of such rules, we end up with negative selection. It’s worth noting that what Akerlof proved using the example of used cars also works, for example, for Russian bureaucracy. If you have no idea what kinds of public goods are produced by the Russian government and for whose benefit, then the selection criteria for officials are connected to superiors’ assessment of whomever they are in charge of. Consequently, the people that will advance their careers will not be the ones who produce the best results; wherever consumers are incapable of evaluating the quality of the product, negative selection is at work.

Opportunistic behavior can also extend to consumers. It may result from weakness and vulnerability. If a consumer believes that they are up against a team with specialized knowledge, they may resort to cunning and deception. Here is a classic example of “consumer opportunism”: someone takes out a loan, knowing in advance that he or she is not going to repay it. In the early 1990s, there were two popular maxims circulating in Russia: “it's easy to get rich, just take a loan out and keep it,” and “in Russia, only wimps pay back loans.” These principles laid the foundation for many individual fortunes. For fairness’ sake, I’d also like to remind the reader that many Russian cemeteries are filled with the remains of people who didn’t pay back their loans.