Uncertainty in Economic Theory from the Perspective of New Institutional Economics

Keynes accused “… classical economic theory of being itself one of these pretty, polite technique which tries to deal with the present by abstracting from the fact that we know very little about the future.”¹ Keynes concedes classical economics would not rule out change; they would assume, however that risks are “capable of an exact actuarial computation.” As a result, the calculus of probability would “…be capable of reducing uncertainty to the same calculable status as that of certainty itself; …” (loc. cit. 112 f.). Arrow (1953) with his time-state-preference theory, developed a model of this type, which Debreu (1959) later integrated into his axiomatic presentation of general equilibrium theory. In the perfect futures economy of Arrow and Debreu, each can maximize the present value of its expected utility.² Assumed is perfect foresight, meaning all individuals know from now on to the Last Day all possible states of the economy and their stochastic properties. No surprises can happen. Of course, these are extreme assumptions.

We mean by uncertainty that we don’t know all variables of future states (not to speak of their stochastic properties) and for that reason are even not able to form subjective probability distributions of future “states of the economy”; thus, “…there is not scientific basis on which to form any calculable probability whatever. We simply do not know.” (Keynes loc. cit. 114) Macroeconomists or politicians, who are used to thinking in terms of large aggregates (national product, unemployment rate, rate of inflation etc.), have to do a giant step backwards into the realm of microeconomic life, to recognize the problem of uncertainty as understood in this paper. They have to put themselves into the position of, e.g., young people choosing their professional training (their investment in human wealth); or of entrepreneurs planning to produce new goods, i. e., of people who have little or nothing to do with thinking in aggregates. The neoclassical concept of efficiency—constrained maximization of some target function—does not help much in this case, also not its more refined forms like stochastic dynamic programming (Dixit and Pindyck 1994) or flexible planning (Dinkelbach 1989). Still, prudent individuals or firms have to solve their investment problems subject to the ability to reasonably adapt to unforeseen events. On this much wider problem of “adaptive efficiency,” North (1990, p. 80)³ focuses the new institutional economics. Williamson’s transaction cost economics aims exactly at the uncertainties of business life that is to be seen as “adaptive, sequential decision problem” (Williamson 1985, p. 79). Open-ended long-term relationships between people or firms become relevant. Opportunistic behaviour of contractual partners after contract conclusion (ex post opportunism) must be taken into consideration. Due to the limits of court ordering it demands agreement on contractual safeguards ex ante. We are lead to the role of custom⁴ and law in economic analysis—generally to the problem of social order and its stability.

About the time Ronald Coase’s article on “The Nature of the Firm” appeared in Economica (1937), members of the Freiburg School in Germany, with Walter Eucken⁵ as the leader of their economic wing, turned their attention also to the pre-Ricardian theory of social order. However, they concentrated their attention on the effect of state made law, while a large group of new institutional economists also deal with the effects of privately made law, viz., the impact of governance structures of contracts between individuals.

David Hume, an important figure among pre-Ricardian economists, deals with the problem of uncertainty with the help of at his time widely used fiction of a state of nature of human society. He writes⁶:

Of all animals, with which this globe is peopled, there is none towards whom nature seems, at first sight, to have exercis’d more cruelty than towards man, …

‘Tis by society alone he is able to supply his defects, and raise himself up to equality with his fellow-creatures, … By society all his infirmities are compensated; … ‘Tis by this additional force, ability, and security, that society becomes advantageous [for each individual].

But in order to form society, ‘tis requisite not only that it be advantageous, but also that men be sensible of these advantages; and ‘tis impossible, in their wild uncultivated state, that by study and reflection alone, they should ever be able to attain this knowledge.

[The fact that] each person loves himself better than any other single person, and his love to others bears the greatest affection to his relations and acquaintance, [what yet is not true for large societies, this]…must necessarily produce an opposition of passions, and a consequent opposition of actions; which cannot but be dangerous to the new-establish’d union. (p. 539)

The remedy to this is not derived from nature, “but from artifice; …[because men] from their early education in society, have become sensible of the infinite advantages that result from [belonging to society],…” (p. 540). In effect, this can only be achieved by “a convention enter’d into by all the members of the society to bestow stability on the possession of … goods, and leave every one in the peaceable enjoyment of what he may acquire by his fortune and industry.” (p. 541, emphasis added) Hume explains this by example of individual ownership:

I observe it will be for my interest to leave another in the possession of his goods, provided he will act in the same manner with regard to me. He is sensible of a like interest in the regulation of his conduct. When this common sense of interest is mutually express’d, and is known to both, it produces a suitable resolution and behaviour. And this may properly enough be called a convention or agreement betwixt us, tho’ without the interposition of a promise; …⁷

This mutual agreement, Hume continues, does not have the characteristics of a promise but is simply performed on the general awareness of common interest among members of society.⁸ This is no natural or innate insight,⁹ “…but moral, and founded on justice.”

Taken together Hume explains the well-known three “fundamental laws of nature”, viz.,

…that of the stability of possession, of its transference by consent, and of the performance of promises (p. 578, italics in the original).

However, reflections on the role of social order were soon pushed into the background by the emergence of “strong cases” (Ricardo) in economic theory—and even more so with the emergence of marginal analysis and its emphasis on methodological individualism. As a consequence, economic theory—in its form of “pure” theory—became an easy target for critics like Gustav Schmoller (1900) who simply reduced it to a theory of selfish, their utility maximizing humans. It required, somewhat exaggerated, the evolution of game theory and game theoretic experiments like the ultimatum game by Werner Güth et al. (1982) to remind micro economists that evolution shaped humans differently from the bleak image of the self-seeking homo oeconomicus, and that, in fact, men are quite willing to cooperate with strangers.¹⁰

As for game theory, its language and concepts are of interest for new institutional economics. Still, there is a major problem in that game theory demands very detailed information about what can happen. In other words, there exists no uncertainty or uncertain future, as understood in this paper. Still, we may use its language and concepts at least in a metaphorical sense as is done in the institutions-as-an-equilibrium-of-a-game aspect of institutional economics. It has been initiated by Schotter (1981) and continued by Aoki (2001) and Greif (1997). One also finds some of its basic terminology and ideas in the work of Williamson (1985) or North (1990). Take Williamson’s transaction cost approach. His transaction cost analysis provides a nice illustration for game theoretic style of analysis of contractual agreements. He explains, among others, how to overcome the problem of incentive incompatibility in the case of long-term contracts that demand specific investments and argues that if contract specific investments are required, the parties to the contract must negotiate not only on the price but also on the contractual governance structure of their contract to protect themselves against ex post opportunistic behaviour of the other side. Williamson simplifies matters by itemizing a short list of real-world governance structures (with firms and markets as the extremes); their choice is assumed to depend on the frequency of transactions and the characteristics of specific investments—assuming uncertainty to be given “in a sufficient degree to pose an adaptive, sequential decision problem” (Williamson 1985, p. 79). A vast amount of empirical studies supports the propositions of Williamson’s transaction cost economics (overview: Shelanski and Klein 1995).

Of particular interest to social scientists is the game-theoretic concept of Nash Equilibrium. Strictly understood it describes an n-tuple of strategies such that each player’s strategy is an optimal response to the other players’ strategies (Nash 1951). To deviate from it would not be rational for anyone. The concept of Nash Equilibrium underlies in above-mentioned institutions-as-an-equilibrium-of-a-game view and defines an institution as a self-sustaining system of shared beliefs of all members of society.¹¹ As was mentioned, it is understood in this paper only in a metaphorical sense. The problem with Nash equilibria is that, as a rule, non-cooperative games have many such Equilibria not all of which are particular to be sought. Therefore, Schelling (1960) suggests assuming that players tacitly agree on choosing some salient equilibrium, like the precedence. In any case, Nash Equilibria describe durable social states that no single actor would voluntarily give up out of concern to change to the worse. They help understanding the durability of social equilibria—be they good or bad ones.

Legal restriction of liability is an instrument that allows a broad diversification of uninsurable economic investment risks. It can make highly uncertain investments attractive to individual investors.¹² However, restrictions of liability interrupt the chain of personal liabilities and thus tear a hole in the chain of the social control mechanism of the capitalist economy. Obviously this hole must be closed, e.g., by the legal establishment of boards of directors, public regulation, bankruptcy law, law of obligations, etc. “Corporate governance” is to be seen in this light (see Zingales 1998). Unfortunately, interventions into the control mechanism of the economy tend to create wrong incentives as did, e.g., the balance sheet oriented banking regulation that tempted banks to establish Special Purpose Vehicles, which enabled them to hide their failure rate of outstanding loans.¹³

Not only the costs of using the market (transaction costs) hamper the coordination of individual economic plans by the market and can be used to explain the nature of the firm as did Coase (1937). Instead, the nature of the firm can also be traced back to the uncertainties of the future in the sense of this paper, that is to uncertainties that cannot even be bought off against all wealth of the world. As a consequence of uncertainty, there are not many futures markets for goods.¹⁴ Certainly both, uncertainties of what the future will bring and costs of using the market help explain why markets are interspersed by “non-markets” like firms. In an uncertain world, the management of firms—the “entrepreneur”—takes over the position of forward traders. Managers have the advantage over forward traders in that they are permitted by law to influence their sales opportunities by advertising, quality variation, reorganizing their sales chain etc. Different from gamblers, entrepreneurs are not only allowed to corriger la fortune ¹⁵ but even expected to do that.¹⁶ The same applies to managers of financial intermediaries as banks, insurance companies, stock exchanges, etc.—organizations that exist only in a world of uncertain expectations.¹⁷ In the ideal neoclassical model of Arrow and Debreu with perfect foresight and zero transaction costs is no room at all for financial intermediaries or financial markets.¹⁸ But exactly this is the model world economists assumed for a long time as a basis, i.a., for their provisions on competition policy. In fact, financial markets and financial intermediaries attracted rather late the interest of professional economists (basically not before the second half of the last century). Still, the neoclassical style of reasoning appears again in the theory of the banking firm in the form of mathematical contract theory—again a form of constrained optimization of some target function with the assumption of perfect information having returned through the back door. Competition policy, for example, seems to be left to banking regulators (like in case of the European Libor scandal of 2013 that was fined by the EU). To a degree, the “too-big-to-fail” problem may bear the brunt—a problem that could be answered by suitable bankruptcy legislation.¹⁹

Not only firms replace missing futures markets, but also mixtures of markets and firms—“hybrid forms” as Williamson calls them.²⁰ Meant are those long-term contractual relationships like franchises, collective agreements, log-term supply agreements and more besides (see Calamari and Perillo 1987, p. 13; Macaulay 1996, 110 ff.). Williamson (1985) describes such contracts also as relational contracts (Macneil 1974), other authors prefer the more specific term “incomplete contracts” (Hart 1987, p. 752). Relational contracts are long-term agreements that take into account the fact of incomplete foresight or uncertainty and establish contractual provisions to accommodate unforeseen contingencies. They are characterized by

“relatively deep and extensive communication by a variety of modes” between contracting parties (Macneil 1974, p. 752).

The parties agree to deal with problems as they arise by following an ex-ante agreed upon procedure (see Richter and Furubotn 2010, 156 ff.). Since such contracts usually require specific investments, those parties with smaller specific investments may be tempted to dare an ex-post “hold-up” on its counterparty by threatening to breach their contract if he/she does not give him/her a greater share of their gain than ex-ante agreed to. Williamson calls such behaviour “ex-post opportunism”. Farsighted parties will agree ex-ante on an appropriate governance structure of their contract to protect themselves against possible ex-post opportunism of their counterparty. That is basically the starting point of Williamson’s transaction cost economics.²¹