The Institute of Modern Russia begins publishing a series of selections from economist Aleksandr Auzan's 'Institutional Economics for Dummies.' Articles from this book first appeared in the Russian edition of 'Esquire.' For many years, Dr. Auzan has been tackling the issues of civil society and modernization in Russia. He recently discussed these topics in an exclusive interview with IMR's Olga Khvostunova.



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 18th 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.

Man vs Contracts

These examples illustrate what is called pre-contractual opportunistic behavior, although the behavior I will describe can also be post-contractual. I think that many of us, if not everyone,  has been through the misfortune of changing their dentist. Almost always, the first sentence out of the new dentist’s mouth will be  “Who in the world did these terrible fillings?” You always become dependent on your dentist because they always let you know that everything has to be redone, and when the makeover begins, requiring additional expenses, it becomes very difficult to judge where it should end. And if you go to another doctor, you will just end up with the same problem.



This situation is all too familiar to those who work in construction field. When I first visited the U.S. in 1991, I was struck by the following contrast: while in Soviet Union, construction was held in high esteem while business was frowned upon, in America, I discovered the opposite – business was held in high esteem while construction was not. Such attitudes are partly justified by the mafia’s much stronger affinity with construction over business. This is because in business, stealing a third of the net worth would lead to collapse, while in construction, even if a third of all the money was stolen, the building would still stand. Even more importantly, in construction, there is a lot of room for scams. According to the Cheops principle, which was developed in management theory, “Never since the Pyramid of Cheops was there a building that was completed on time and within the budget.” Having involved oneself in this undertaking, one has to muddle through it.

Shirking is another obvious example of a post-contractual opportunistic behavior. Employers and employees alike know all about it. If an employee is in full compliance with their contract, shows up at 9 AM, turns on the computer, sits down and stares at the monitor, it is by no means guaranteed that they are working and not surfing the web or watching porn. The employee may abide by all the formal requirements of their contract but without the outcome expected by the employer. Then the employer has to seek out other ways of implementing the contract, for example, by striking bargains with the employee, such as “I will let you early on Friday if you finish your work on time.” What makes this reframing of the contract possible? Shirking, as a form of opportunistic behavior.

Why would one say all these unpleasant things about people? The point is that if we want to have realistic economic theories, we need to populate economics with human beings that behave like real people do. However, real people are also very different from one another, and thus, theory needs to account for those differences, as well. We cannot say that everybody around us is a thief. Nonetheless, stealing is fairly widespread, which is to say that people may behave selfishly while remaining within normal moral boundaries. Finally, people may even not behave selfishly. This is known as “weak” behavior, which happens when an individual identifies with a certain community such as a village or a clan. Usually, “weak” behavior is characteristic of patriarchal societies. Incidentally, this is precisely why ancient Greeks did not view slaves as humans. In their novel Monday Begins on Saturday, Arkady and Boris Strugatsky present an image of the future. Two people are playing kitharas and, in hexametric verse, expounding on their lives in a magnificent society where everybody is free, everybody is equal, and everybody has two slaves. For us, this is a huge contradiction, but it isn’t one for them. A person torn out of their community is like a severed hand, finger, or ear. In many ways, humans can only truly be said to live within a certain communal network, and when a person is taken out of their network and transplanted into another, they become an instrument, a “speaking tool,” as ancient Romans would say.

Sometimes the networks provided by a traditional society are used very efficiently even today, in the context of the international markets. Thus, South Korea relied upon traditional family ties to build its system of chaebols – huge business conglomerates consisting of separate, formally-autonomous companies. Koreans ended up with very low management costs, by relying upon “weak” behavior, their society members’ traditional recognition of being parts of some bigger units. In Russia, this would be impossible. It has been long since we’ve had any traditional communities. Consequently, people have no bigger units other than themselves to identify with. Take, for example, the institution of peasant society. It started getting rooted out during the reign of Peter I, but the process wasn’t completed until the Bolshevik modernization. Having lost their familiar communal networks, people on the one hand were surrendering their relatives to agents of government-imposed terror virtually without any resistance, while on the other hand, they began identifying with non-existent communities such as the European proletariat or starving Africans. The peasant stereotype of the identification of the individual with the larger group continued to manifest itself but not on the scale of a village or other common geographic origin, but rather on the scale of national or even global solidarity.

Man vs the System

The framework of bounded rationality and opportunism doesn’t just apply to interpersonal relationships, it also applies to the relationship between the individual and the state. On its own, the idea of the state is rather abstract.  Just like “the people,” it is the subject of manipulation by human beings, individually and as groups. This is why institutional economists do not use “government” as a concept; instead, they speak about rulers and their subjects. Here, it is fitting to remember the famous Russian saying, “do not fear, do not hope, do not ask,” a motto imbued with the understanding of  bounded rationality and opportunistic behavior gained through the tragic experience of the Soviet prison system.

Why “do not fear”? Because people have a strong tendency to exaggerate certain kinds of threats. Let’s take organized crime, for example. The notion that the mafia is watching your every move is the product of our bounded rationality. Any capacity for violence is limited – this is a scarce resource that needs to be used sparingly. Another example is the idea that the government is recording our every conversation. Have you ever tried to estimate the costs of this level of surveillance?

Some ten years ago I visited a German agency housing the archives of the Stasi, the East German political police. It has an entire room filled with tapes, wiretaps of dissidents’ phones from the 1970s, that were never transcribed. In the forty years of its existence, the Stasi managed about a million of individual surveillance cases (far from all of them led to arrests, let alone sentencing). These cases were overseen by 7 million employees, seven people per individual case. Thus you should curb your estimates of the material value of your persona against the costs of government surveillance—and have no fear. Just calculate the cost of a hypothetical struggle against you personally and be assured that many of your fears are overstated.

But do not be hopeful, either. Strikingly, in the 1970s, brilliant Soviet economists developed a framework of the optimal functioning of the economy based the works of Leonid Kantorovich, one of Russia’s two Nobel Prize winners in this field. They realized that the country was ruled by a Politburo with its own internal differences of interests, competition, and filled with people some of whom had never graduated from high school. Nonetheless, according to these economists, there was such a thing as “the state,” a reasonable and well-intentioned actor, and it would implement the results of their work.

These kinds of expectations are still alive and well. The issue with them is that government’s rationality is not boundless; indeed, its rationality, that is, the rationality of individuals that make up the government, is considerably limited. Expectations of the authorities’ omnipotence are based on the idea of their divine nature. The reality is different.

The state is not always motivated by considerations of public good and this is addressed in the “do not ask” portion of the motto. Obviously, opportunistic behavior is possible both outside and inside the government. If, on top of that, the composition of the government reflects the effects of negative selection, it is quite plausible that government officials will not be bounded by moral restraints.

Is it possible to live in the world determined by these grim outlines?  Yes it is. One simply has to realize that we can hardly rely on hopes for some powerful and well-intentioned entity’s benevolence. We should rather rely upon the rules that we can use in communicating with each other. And we should rely on institutions.