Organizations vs.

Institutions*

ABSTRACT

The paper draws a sharp distinction between organizations and

institutions. Organizations are agents like households, firms,
and states that have preferences and objectives. Institutions are
formal and informal social constraints (rules, habits,
constitutions, laws, conventions) which apparently reduce the
total scarce resources available. Economists debate whether
organizations are individuals with their own objectives, or
whether they are artificial things created ultimately to serve the
objectives of their members. In contrast, economists debate
whether institutions are deep schemes which define the
cognitive ability of the agent, or whether they are insubstantial
constraints placed by optimization calculus. The paper argues
that--insofar as some institutions are deep schemes--the action
of the agent cannot be dictated by such schemes.

*
An earlier version of this paper appeared in Journal of Institutional and Theoretical
Economics, September 1995, 151:3, pp. 445-466. I would like to thank Ernst Mayr, Niles
Eldredge, David Hull, Stanley Salthe, Michael Ghiselin, Viktor Vanberg, Warren Samuels,
Ekkehart Schlicht (the editor), and two anonymous referees for their comments on earlier
drafts, and also acknowledges the research support received from the Judge Institute of
Management Studies, University of Cambridge, and the Alexander von Humboldt
Foundation. However, none of them should be held responsible for any remaining failing.
1. Introduction
Douglass North commences his comparative study of economic performance by making a
distinction between organizations and institutions:
A crucial distinction in this study is made between
institutions and organizations. ... Conceptually, what must be
clearly differentiated are the rules from the players. The
purpose of the rules is to define the way the game is played.
But the objective of the team within that set of rules is to win
the game--by a combination of skills, strategy, and
coordination; by fair means and sometimes by foul means.
Modeling the strategies and the skills of the team as it develops
is a separate process from modeling the creation, evolution, and
consequences of the rules [North, 1990, pp. 4-5].1

North argues that organizations, in the sense of societies at large, would perform better if they
adopt rules or, more elementally, constitutions which protect property rights as well as
enhance private incentives with regard to activities with high positive externalities. One
primary target of North's [Ibid., ch. 11] investigation is the explanation of why the British-
North American path has succeeded, while the Spanish-Latin American path has failed.
North traces the success of the British path to the institutionalized separation of political
powers which constrained the sovereign from predatory public finance practices.
Such an explanation assumes that the story of the evolution of organization is almost
fully spelled out by the story of the underpinning scheme of institutions. North's thesis
presumes that organizations are passive; organizations merely express the supposedly
unambiguous institutional scheme. Such an assumption means that one could judge the
performance of two organizations by simply examining the merits of the respective
institutional schemes. However, it could be the case that the same institutional scheme is put
to use differently by the same organization at different stages of its development. To wit, the
distinction between organizations and institutions entails that there is no one-to-one
correspondence between the set of institutions and the performance of organization. North's
identification of the two--by attributing the performance of the organization to its institutions-
-indicates that he failed to operationalize the organization/institution distinction.2

1
Earlier, Lance Davis and Douglass North [1971, pp. 6-7] called institutions the
"institutional environment" and organizations the "institutional arrangement." A similarly
awkward lexicon has been suggested recently by Scott Masten [in Williamson & Winter,
1993, pp. 198-199; cf. Khalil, 1995c]. He distinguishes between the "broad sense" of
institutions as conventions/contracts which underpin networks (i.e., coalitions of independent
transactors connected by commercial contracts) as well as organizations (i.e., firms), on one
hand, and the "narrow sense" of institutions as strictly denoting organizations, on the other.
The shorter cut suggested here is to restrict the term "institution" to conventions/contracts and
"organization" to households, firms, and states.

2 Gerald Curtis [1999] seems to make the same critique of North’s institutional thinking—

1
 2

While organizations consist of levels of groups, institutions consist of grades of

conventions and constitutions. A person expresses loyalty to higher groups in which he is a
member like his family, church, firm, and country. The agent as a person, firm, or country
has different grades of institutions. If a family is a Baptist, the grade of Christianity is a
deeper institution than the grade of Protestantism which, in turn, deeper than the grade of
Baptism. Likewise, for a country, the constitution laid down by the fathers, would be a
deeper institutional grade than its regulatory3 statues. The hierarchy of organization has no
relation to the gradation of the institutional scheme.
The distinction should highlight that the evolutionary change of how groups relate to
each other, i.e., division of labor, might not be entailed by the change of institutions at any
level of the hierarchy of organization. It is important to differentiate the two kinds of change
if one wants to locate theoretically which one is the horse and which one is the cart, or
whether both have equal and complementary roles. The rise of productivity, and the ensuing
wealth of a country, insofar as it is caused by change of division of labor may not be related
to change of the underpinning institutional scheme. And change of the institutional scheme
may not engender a new organization of labor.
The paper begins, in section two, with stating the issue and, in section three,
summarizing the difference between the theory of organization and the theory of institution.
Sections four and five clarify conceptual problems surrounding, respectively, the theory of the
firm and competing paradigms in economics in light of the organization/institution
distinction. Section six argues that the works of, inter alios, James Buchanan, Mancur Olson,
and Douglass North suffer from a common failing, viz., the assumption of one-to-one
correspondence between institutions and organizational performance. The last section offers
a summary.

2. What is the Issue?

The organization/institution distinction stems from the basic difference between ends and
means. While ends define the organization, means include--besides material and
technological resources--paradigms and conventions or, in short, institutions. Agents act
according to ends--some of them objective while others entrepreneurial--in light of means--
some of them given while others potential.
Joseph Schumpeter's [1989] approach to human action is a good starting point. He
contrasted familiar ends with entrepreneurial ends which he called "irrational":
Experience teaches ... that typical entrepreneurs retire from the
arena only when and because their strength is spent and they
feel no longer equal to their task. This does not seem to verify
the picture of the economic man, balancing probable results
against disutility of effort and reaching in due course a point of
equilibrium beyond which he is not willing to go. Effort, in our
case, does not seem to weigh at all in the sense of being felt as a
reason to stop ... Hedonistically, therefore, the conduct which

namely North ignores the role of organizations (or what sociologists call “agency”) and how
such organizations may interpret institutions differently
3
Hierarchy of organizations should not be confused with hierarchy of markets, as defined
by geographical scales, from local to regional and international structures [Khalil, 1990a].
 3

we usually observe in individuals of our type would be

irrational [Schumpeter, 1989, p. 92].

Schumpeter probably used the term "irrational" to denote peculiar, but given tastes like for
success, ambition, and fame for their own sake. If this is the case, Schumpeter would not
have really posed a challenge to the optimization agenda. But Schumpeter would have
challenged the optimization notion if the term "irrational" is taken as opposite to "rationality"
defined narrowly as about one kind of end-mean assessment, viz., optimization decision
making as Lionel Robbins [1932] understood the subject of economics to be. So a non-
narrow definition of rationality should include another kind of end-mean assessment, viz.,
entrepreneurial decision making. In this sense, Schumpeter's opposition between
entrepreneurship and rationality could be better expressed as an opposition between,
respectively, "belief rationality" and "optimization rationality."4
In optimization rationality models, ends are assumed as separate of means and, hence,
seen as objective tastes or preferences which could be expressed in a utility function. And
means are assumed as objective resources and so could be symbolized by the budget line. In
these models, institutions amount to conventions which enhance efficiency. Such
conventions include formal ones (rules) which internalizes external costs and censure
opportunistic behavior in order to prevent prisoners' dilemma outcomes. They also include
informal conventions (standards and norms) about unified measures and dress codes in order
to minimize transaction costs.
Belief rationality could be defined as belief in self-capacity in terms of tenacity and
aptitude in order to attain a particular purpose. For belief rationality, ends are not conceived
as separate from means. Ends amount to purposes or ambitions which depend on the
assessed capacity of the means. Belief rationality amounts to the pursuit of goals which the
agent believes to be within his capacity. An observer might disagree and call such a pursuit
"irrational." Experience might not be able to adjudicate clearly between these conflicting
beliefs because the future could always defy past performance. In this sense, goals cannot
easily fit an objective utility function, and means cannot be modeled as objective budget line.
The institutions which cement the resources together are not about conventions of efficiency.
Rather, they are about paradigms in the sense of being necessary guides.5 As Young Choi
has argued [1993], they are necessary because agents need pre-existing categories and
schemes in order to conceive and make sense of the world of resources and assess
opportunities.6 Paradigms could be formal (constitutions and covenants) or informal
4
One of the legacies of Max Weber [1978] is the delineation of the two rationalities
which he called, respectively, Wertrationalität (value rationality) and Zweckrationalität
(instrumental rationality). Weber's delineation is related to the basic difference between ends
and means rather than to the proposed distinction between belief rationality and optimization
rationality.
5
The choice of Thomas Kuhn's term "paradigm"--which is about the scheme of thought
underpinning competing schools in a scientific discipline--to denote one class of institutions
is intentional. As Adam Smith has argued [Khalil, 1989], there is no difference between the
ingrained paradigm of scientific thinking and the convictions or ideologies which persons
hold in everyday life.
6
However, Young Choi [1993] fails to distinguish between optimization rationality and
belief rationality. Thus, he confuses the notion of institutions as efficient conventions with
 4

(ideologies and convictions). An example of institutions in the sense of paradigms is the

reference to the position of a king, president, prophet, parliament, firm, or sports hero as an
"institution." Here the term signifies images, exemplars, and ideologies which identify and
cement the resource capacity of the agent.
The aim of the paper is not to contrast and adjudicate between optimization rationality
and belief rationality, or to explore the corresponding difference between the two senses of
institutions. Although the paradigms/conventions distinction is mentioned below in another
context, it is outside the scope of the paper. The focus is rather on the more general
organization/institution (end/mean) contrast which cuts across the difference between the two
rationalities. The term "organization" denotes the agent as pursing ends--irrespective of
whether the ends are objective tastes or purposes. The term "institution" is about the means
needed to pursue the ends--irrespective of whether the institutions are about efficient
conventions or enabling paradigms. So the paper uses the terms "organizations" and
"institutions" in the broad sense as, respectively, agents with ends and as means to achieve the
ends.
The organization/institution demarcation is certainly tenuous. The scheme of
institutions underpinning a firm, like regulations of working hours and wage structure,
influences the preference function of the firm and vice versa. But to make sense of such
endogenous determination, it is important to keep the standard distinction between the
organization's ends and institutional means. Regardless of how one classifies organizations
(as households, firms, and states), they are ultimately defined by their ends. And irrespective
of how one differentiates institutions (as relating to different levels of hierarchy from the
person to the state), they amount to the means needed to pursue the ends. All that we need to
maintain the organization/institution separation is the end/mean distinction.7

institutions as paradigms. He seems to reject the idea that some institutions are about
optimization. (Incidentally, he employs the term "convention" in the same sense as
"paradigm"; where paradigms are at the level of the person, conventions are at the level of the
culture.)
7
The end/mean distinction is also evident in jurisprudence. In a classic article, Ronald
Dworkin [1977, see also 1972] differentiates clearly between two kinds of laws--rules which
are about means and principles which are about purposes. The difference cuts across the
dichotomy, presented by John Rawls [1955], between binding and non-binding canons of
behavior or what is legally (formally) and morally (informally) obligatory. Rules, like
deadline or "a will is invalid unless signed by three witnesses," are precise canons of action.
In contrast, principles, like "the two-parent family is important for children's growth" or "one
should strive for self-respect," are ambiguous canons because there are usually other
contravening principles. As put by Dworkin:

The difference between legal principles and legal rules

is a logical distinction.... Rules are applicable in all-or-nothing
fashion. If the facts a rule stipulates are given, then either the
rule is valid, in which case the answer it supplies must be
accepted, or it is not, in which case it contributes nothing to the
decision [Dworkin, 1977, p. 45].
 5

But still, why should we stress the organization/institution distinction? Institutions,

insofar as they are about means, do not spell out the ends which actors must adopt. We could
have two societies with identical institutions or twin brothers with identical genetic make-up
but who do not share similar ends. This is so evident that it is surprising to find so many
economists--like North, Buchanan, and Olson--think that desired societal goals (i.e.,
successful economic performance) is guaranteed if the correct institutions--i.e., which protect
property rights--are in place. The correct institutions specify only the necessary conditions of
successful economic performance--not the sufficient conditions. Researchers must resort to
normative economics and specify the correct tastes and entrepreneurial purposes of the
organization in order to fulfill the sufficient conditions. We might have property rights
protected and externalities correctly internalized by institutions, but that would not make
agents favor income over leisure or prefer a low discount rate of future streams of income.

3. Two Problem Areas

The organization/institution distinction should clarify many theoretical controversies. It is
usually the case that controversies pertaining to the theory of organization is conflated with
issues regarding the theory of institution. Before showing this with regard to the theory of the
firm, the issue of comparing competing paradigms in economics, and evaluation of
performance grand-scale organizations, it is fruitful to mark how the theory of organization
differs from the theory of institution.

A principle like `No man may profit from his own

wrong' does not even purport to set out conditions that make its
application necessary. Rather, it states a reason that argues in
one direction, but does not necessitate a particular decision. If
a man has or is about to receive something, as a direct result of
something illegal he did to get it, then that is a reason which the
law will take into account in deciding whether he should keep
it. There may be other principles or policies arguing in the
other direction--a policy of securing title, for example, or a
principle limiting punishment to what the legislature has
stipulated. If so, our principle may not prevail, but that does
not mean that it is not a principle of our legal system, because
in the next case, when these contravening considerations are
absent or less weighty, the principle may be decisive. All that
is meant, when we say that a particular principle is a principle
of our law, is that the principle is one which officials must take
into account, if it is relevant, as a consideration inclining in one
direction or another [Dworkin, 1977, p. 47].

It is true that rules are not ironclad like principles. However, the exceptions to a rule
could be, at least theoretically, listed, while counter-instances to a principle cannot be listed
even theoretically. In fact, exceptions to the rule, like in the case of emergency vehicles not
obeying traffic rules, make the rule complete. In contrast, counter-instances do not make the
principle complete; there are no possible lists of exceptions for the principle of honesty,
reciprocity, free speech, justice, and so on.
 6

Aside from the ends, the theory of organization is concerned with the nature of intra-
organization relations. Such relations reflect the division of labor as expressed by the
lengthening of roundabout methods of production, the rise of amount of tools relative to
labor, the increase of complexity as measured by differentiation of functions in society, or the
multiplication of tasks within the organization of labor. Institutions should be seen as
complementing the organization of division of labor. In this sense, they change as the
division of labor changes. The focus on institutions and how they change is legitimate. But it
is only half of the story, and certainly becomes the wrong story if it claims to be the whole
story. One simply cannot discuss the wealth of a country--which is the most important
economic policy topic--without discussing the productivity of its organization of division of
labor. The concern with organization of labor rightly occupies the first chapter of Adam
Smith's Wealth of Nations. The performance of the organization of labor depends on its
history of development and, hence, cannot be specified even if we know in detail all the
formal and informal institutions which complement it.
To capture the division of labor, the theory of organization is concerned with whether
the behavior of the group could be explained by the supposed pre-constituted strategies of the
members who undertake the divided tasks. It is about how to model behavior and
performance of the group in light of the preference and constraint functions of the members.
Could the group's preference function afford the conception of the organization as an
individual in a substantial sense? The conception of organization as an individual entails that
the organization or its preference function cannot be fully reduced to the utility functions of
the members. That is, the organization would not be merely an artificial construct. Rather,
the organization would be a natural, self-constitutive individual in its own right. Or, on the
contrary, is the organization a "vehicle" which lacks autonomy and individuality--i.e.,
designed only to fulfill the separate utility functions of the members? The question of the
naturalness or artificiality of organization, called the "ontological" question, raises the issue
of the merits of functional-holist vs. reductionist conceptions of organization.
In contrast, the theory of institution asks how persisting institutions regulating the
action of an agent relate to the hypothesized optimal rationality of the agent? The question
crosses the issue of whether institutions are formal, in the sense of being backed by explicit
punishment, or informal, in the sense of being only socially expected [Khalil, 1994]. Also,
the debate applies to institutions as habits and binding commitments at the level of the
household, and also to institutions as norms, regulations, practices, laws, and constitutions at
the level of higher-level organizations. The question raises the issue of whether institutions
are conventional in the sense of being a convenient set of constraints which can be shed away
according to the optimization calculus. Or are they deep cognitive scheme in the sense of
being constitutive of the identity (essence) of the agent and, hence, off limits to optimization
rationality? Such a question over the substantiality of institutions, named the "phenomenist"
question, invokes the issue of the merits of essentialism as opposed to anti-essentialism views
of institutions [Khalil, 1996].
The debate over the status of institutions centers on whether they should be seen as no
different from other resource constraints, as advocated by the anti-essentialist neoclassical
view. Or should they be seen as ossified to the extent that they have become part of the utility
function of the agent, as advocated by the essentialist or socioculturalist perspective of old
institutionalism à la Veblen [Khalil, 1995d]. The main thrust of new institutional economics
is to relegate the range of habits and norms to the domain of external constraints. In
 7

comparison, the main thrust of old institutionalist economics is the modelling of institutions
as determinants of the agent's cognitive ability and, hence, constitutive of the agent's
preference function.8 The essay does not attempt to answer whether institutions are essences
or conventions exteraneous to the identity of the agent. Neither does the essay try to resolve
the debate between functionalist and reductionist analyses over whether organization is a
natural individual or an artificial thing. The paper has a more modest aim. It attempts to
draw, at least at the theoretical level, a sharp distinction between institutions and
organizations--irrespective of the theory which one subscribes concerning the character of
institutions and the status of organizations.

4. Theory of the Firm

The conjectured organization/institution distinction is crucial for clarifying some issues
regarding the theory of the firm. The proposed demarcation should not be confused with
Oliver Williamson's [e.g., 1990] differentiation between the governance of the firm and the
institutional environment of the economic society at large. The governance of the firm is also
about the institutional scheme--but at a lower level than the one which underpins the
economic society at large. That is, Williamson is making the distinction between the
governance of the firm as opposed to the governance of the larger organization. In contrast,
the point stressed here is that, at each level of hierarchy, there is a difference between the
organizational actor, on one side, and its institutional scheme of norms, on the other.
Although there are some overlaps, the debate over whether intra-firm exchange differs
from inter-firm exchange is separate from the debate over the nature of institutions. The
theory of organization controversy asks whether the firm is an individual or is it simply a
vehicle of independent entities and, hence, merely an epiphenomenon or, to use Richard
Dawkins's [1982] concept, an extended phenotype of pre-existing individuals? The vehicle
idea allows investigators to conceive the firm as ultimately a convenient network of pre-
constituted agents who meet and exchange through avenues other than the market. The
classic paper of Armen Alchian and Harold Demsetz [1972] champions such a view by
explaining command within the firm as the outcome of shirking, which is endemic to
cooperation.
In reaction to Alchian and Demsetz's theory of authority, economists went on
searching for some grounds for the treatment of the firm as a natural, self-constituted
individual, rather than as an artifact. Along one track, the theory of organization became
entangled with the theory of institution controversy. This occurred when, as advanced inter
alios by Williamson [1985, 1990], the thesis of the firm as an individual became justified on
the grounds that the firm is underpinned by a nexus of treaties. The nexus idea amounts to a
pre-committed set of rules designed to constrain future options, specify duties, and how
rewards are distributed. Viktor Vanberg [1992] advances an explicit institutional theory of
the firm which he calls the "constitutional paradigm." He argues that the firm is an
organizational individual because it is underpinned by constitutional contract which specifies
the set of rules concerning duties and distribution [Khalil, 1995a].
Similarly, Richard Nelson and Sidney Winter [982] have thrown away the idea of the
firm as an organizational individual along with the optimization notion advanced by the

8
For different views of the contrast between new and old institutionalism, see Geoffrey
Hodgson [1989], Richard Langlois [1989], Malcolm Rutherford [1989].
 8

transaction-cost approach. Winter maintains that the firm is merely an amalgamation of

routines evolving through time:
In the evolutionary view--perhaps in contrast to the transaction
cost view--the size of a large firm at a particular time is not to
be understood as the solution to some organizational problem.
General Motors does not sit atop the Fortune 500 ... because
some set of contemporary cost minimization imperatives ...
require a certain chunk of the U.S. economy to be organized in
this way. Its position at the top reflects the cumulative effect of
a long string of happenings stretching back into the past, among
which were the achievement of relatively good solutions to
various technological and organizational problems, the success
of its ancestral companies in establishing strong positions in a
young market that turned out to be a big one, and of course the
creation by merger of the company itself [in Williamson &
Winter, 1993, p. 192].

Jack Vromen has insightfully capsulated the point: "What evolves in Nelson and Winter's
evolutionary theory ... [are] routines and not organization forms [Vromen, 1994, p. 84-85].
Winter even refuses to define the nature of organization. Winter [in Williamson & Winter,
1993, p. 190] rather likens it to the forest. The firm and the forest supposedly lack
boundaries, and they could be analyzed as a repository of routinized competence which
replicates/evolves through time. It is true that the forest does not "know" its mission; it just
grows. But the firm's behavior is more-or-less purposeful or end-directed. It is true that the
firm learns from experience. Nonetheless, it has some goals at any point in time. The
inappropriateness of the "forest" metaphor is indicative of the failure to differentiate the
organization from its institutional routines.
This failure surfaces in other institutional theories of the firm [Khalil, 1995a, 1995c].
Institutions are about routines and habits and, hence, cannot provide the ground to qualify
firms as organizational individuals. Otherwise, it would mean that associations of mutual
interests--like a network of traders, industrial cartels, and inter-locked firms (e.g., Japan's
Keiretsu network)--which are underpinned by institutions are, therefore, organizational
individuals. Hardly anyone considers such associations as organizational individuals in the
same sense as firms are. This suggests that a theory of organization needs something more
than a theory of institutions.
Thus, the theory of institutions cannot fulfill the role of the theory of organization. It
seems that as long as the theory of the firm is exclusively about institutions, as evident in the
transaction cost approach, it would remain incomplete. If the proposed
organization/institution distinction is granted, the common view of the firm as a nexus of
institutions could not be a substitute for a theory of organization.

5. Paradigms in Economics
The proposed organization/institution distinction should lead to the proposition that a
particular theory of institutions should not entail a particular theory of organization. Figure 1
ventures and outlines the possible matrix of paradigms in economics in light of the suggested
organization/institution differentiation. The purpose of Figure 1 is not to provide a systematic
 9

comparison of paradigms [Khalil, 1995b], which would shift the focus of the paper. The
purpose is rather to illustrate the suggested organization/institution distinction. As a result,
the richness of detail and the diversity of ideas within each paradigm are sacrificed. It shows
broadly how the neoclassical perceives the Austrian, as not sceintific, and how the Austrian
sees the neoclassical, as stripped from meaning, exactly parallel the perceptions of the
Sraffian and Marxist of each other.
With regard to the first and second column of Figure 1, neoclassical and Sraffian
economics differ greatly with regard to the theory of organization. There are a variety of
theories of the firm in the neoclassical tradition. But most of them share one important
assumption which makes the exchange theory of teams offered by Alchian and Demsetz
[1972] typical, viz., the idea that organization is an artificial entity composed of
preconstituted agents. In Alchian and Demsetz's theory, cooperation among agents
necessitates
the appearance
of managers
who are Theory of Organization
rewarded with
a residue Reductionist Functionalist
(profit) in +--------------------------------+
return for Theory | | |
combating Anti-Essentialist | Neoclassical | Sraffian |
shirking of +--------------+-----------------|
among the rest | | Marxian & |
of the agents. Institution Essentialist | Austrian | Veblenian |
In order for the +--------------------------------+
reward Figure 1: Organization, Institution, and Paradigms in Economics
mechanism to
work, it is
assumed that the contribution of each agent is defined independently from the others. The
assumption of definite productivity of each agent raises a problem which differs from the
problem of measurement. Namely, the assumption entails that work environment, the effort
intensity of others, or in short the context of the work place, which Harvey Leibenstein [1987]
has tried to highlight, is negligible. In such a neoclassical view, the organization is ultimately
reducible to the supposedly pre-constituted preference functions of the owners of factors of
production.
In contrast, in Piero Sraffa's [1960] system, there is little if any behavioral mechanism
at the micro level. The production of all commodities operates according to fixed coefficients
among the factors of production. That is, the production of any commodity would definitely
decrease in the same proportion as the decline of one factor because no other factor could
substitute for it. The production unit in the Sraffian system operates dutifully, i.e., fulfilling
its function towards the collective goal of the reproduction of the system as a whole.
However, with regard to the first row in Figure 1, one could find a common thread
running through the neoclassical approach and the Sraffian system. Namely, both approaches
view relative prices as a surface phenomenon, i.e., denying at first approximation the
relevance of some deep institutions (i.e., paradigms in the sense of constitutions and
ideologies) regulating the behavior of agents. That is, both perspectives extend more-or-less
 10

their anti-essentialist stand with regard to market exchange to the analysis of the behavior of
agents as mainly adjusting quantities in response to prices or demand forces. For the
neoclassical approach, price is simply the product of supply and demand forces, rather than
also the expression of capacities, opportunities, and beliefs. Likewise, according to the
Sraffian approach, prices are simply technical ratios between inputs and outputs. To wit, Ian
Steedman [1977] extends the Sraffian theory of value to criticize Karl Marx's superfluous
detour into the labor theory of value and commodity fetishism intended to reveal some hidden
nature of capitalist exchange.
The anti-essentialist underpinning of neoclassical and Sraffian systems does not mean
they do not recognize the role of institutions. In fact, Sraffa regards distribution as a datum
given by social forces outside the economy, while economic theory could account only for
prices. In this manner, the institution of distribution is taken as an external constraint on the
input-output system, rather than as an informing, determining essence of such a system.
Likewise, neoclassical economists, known as new institutionalists, treat institutions as
conventions only (ranging from formal rules to informal standards and norms) to enhance
efficiency. For instance, Nicholas Rowe [1989; see also Ault & Ekelund, 1988] carefully
attempts to explain apparently non-optimizing behavior: Why does an agent pay back a loan
even when the other party does not have a recourse to a legal or any other action? According
to Rowe, rational agents do not maximize returns at each instant. Rather, they constrain their
behavior with rules in order to convey to other actors that they are trustworthy and, hence,
secure beneficial transactions in the future. Such rules are not physical constraints, such as
the budget endowment. Rather, they are social constraints which arise endogenously among
agents involved in exchange.
Robert Axelrod [1984] and other theorists have shown that in iterative games, even
egoists tend to abide by so-called ethical constraints out of concern for reputation. In this
fashion, norms are proposed to be constructed in society out of the calculative efficiency of
agents or, according to other theories, constructed out of negotiation and relative political
power of agents. Irrespective of the particular theory, the view that agents consciously choose
their institutions implies that institutions, irrespective of their importance, could be equally
(after allowing for transaction cost or inertia) dispensed with.
The neoclassical view restricts institutions to the function of optimization (by
preventing prisoners' dilemma outcomes and reducing transaction costs). It ignores another
set of institutions, paradigms (ranging from formal constitutions and covenants to informal
ideologies), which are necessary and intrinsic to any act of assessing one's capacity and
opportunities in order to formulate one's purposes. The neoclassical approach views all
institutions as ultimately dispensable (i.e., insofar as allowed by the transaction cost of
change) because it narrowly defines rationality as optimization rationality à la Robbins
[1932]--ignoring belief rationality. As a result, it fails to capture the difference between
paradigms and conventions.
The treatment of paradigms as no different from optimizing conventions entails that
cultural traits lie vis-à-vis each other on the same grade, i.e., occupy a surface phenomenon
with no depth. So the character of an agent as a Christian would be equivalent to his
character as a Protestant and, in turn, as a Quaker. They are, if the optimization view is
unqualified, supposedly symmetrical traits, i.e., belong to a single institutional grade. One is
not seen as presupposing the other and, hence, one cannot conceive that changing one
institution is more difficult the deeper it is. The optimization view entails that all cultural
 11

traits are, at first theoretical approximation, are supposedly subject to adjustment with no
difference in difficulty. This amounts to the view that institutions amount to a mosaic of
colors painted symmetrically on a poster. Such a "coloring-poster" view of traits or
institutions leads to the idea that there is no necessary interconnection among traits, where
one underpins a host of others. In other words, institutions as paradigms could be altered
with equal ease as a result of the optimization mechanism as if they are not multi-textured or
composed of different grades.
To comprehend better such an anti-essentialist perspective, it is helpful to compare it
to the essentialist/socioculturalist theories of institutions advocated by the Austrian, Marxian,
and Veblenian approaches. As Figure 1 shows, with regard to the theory of organization, the
second row sets the Austrian tradition apart from the other two. This needs to be clarified
first. With respect to the theory of organization, the Marxian and Veblenian approaches
reject ontological individualism, while the Austrian tradition embraces it. Marx [1973, pp.
83-84; cf. Khalil, 1990b] explicitly criticizes the "Independent" or "Natural" notion of
individuality underpinning the approaches of Adam Smith and David Ricardo. Instead, he
argues that the agent is greatly a product of the social and historical situation. Likewise,
Thorstein Veblen [1898, pp. 389-390; see also Mayhew, 1987] ridicules the neoclassical
notion of equilibrium which portrays the agent as "isolated, definitive human datum." In its
place, he advocates a functionalist view where the agent's set of tastes are greatly determined,
through imitation and status seeking, by the sociocultural context.
With regard to Carl Menger and Friedrich Hayek, as is well known, they advocated
ontological individualism, rejecting functional-holist views of economic organization. It is
granted that the ontological individualism of Austrian economics differs from the
reductionism of neoclassical economics. As alluded to earlier, however, the difference is
related to the neoclassical conception of the agent as mechanical in the optimization
operation. This allows for covering-law models of explanation. In contrast, the Austrian
conception of the agent as purposeful allows for historical models of explanation. Thus, it is
appropriate to set the Austrian tradition apart from the Marxian/Veblenian approach with
regard to the theory of organization. In this manner, the Austrian tradition is reductionist with
regard to the theory of organization, but it is essentialist with regard to the theory of
institution.9
So, it is with regard to the theory of institution which affords the Austrian, Marxian,
and Veblenian perspectives to stand on a common ground. As Figure 1 shows, they uphold
an essentialist view of the institutional scheme. And, in fact, they treat all institutions as
paradigms--generally failing to allow for certain institutions to arise for efficiency purposes,
i.e., as convenient conventions. Following a tradition which could be traced to Menger,
Hayek views institutions as being determined through trial and error as the person's capacity
becomes more concretized through the learning process. For Hayek [1948, 1988], institutions
are not optimized according to an omniscient designer because no one could comprehend the
complexity of the fragmented and diffused knowledge in the economy. However, as Armen
Alchian's [1950] and Milton Friedman's [1953] applications of the Darwinian natural
selection idea show, it is possible to postulate rational maximization behavior without

9
Consistently, Young Back Choi [1993] advocates an essentialist position with regard to
the modeling of decision making, viz., as underpinned by deep paradigms, while he also
promotes an ontological individualist position with respect to the theory of organization.
 12

appealing to the notion that agents consciously design institutions according to maximization
principles. This is the case because firms that follow suboptimal rules would be eliminated
by market competition. But the Darwinian selection theory does not guarantee optimum
outcomes, but rather the survival of players with the relatively most efficient rules [see
Vromen, 1994, ch. 2]. Hayek confusingly also flirts with the Darwinian selection idea, which
entails maximization rationality and an anti-essentialist view of institutions. But Hayek's
stress on the learning process implies that institutions for him are deep schemes which define
the cognitive ability of the agent [see Hayek, 1963; see Herrmann-Pillath, 1992].
With respect to the theory of price, Menger views prices as the expression of some
deep need. As argued by Barry Smith [1990; see also Mäki, 1990], Menger's theory was
influenced by Aristotle's essentialism: The prices of commodities are not simply the outcome
of the intersection of supply and demand but rather the outcome of inmost psychological
needs. While such a view shares certain essentialist elements with the Marxian theory of
value, it rejects the attribution of the essence of value to some labor-time embodied in the
production process.
With respect to Marx's theory of value, new research has uncovered an essentialist
perspective behind Marx's dichotomy between value categories and price categories [Zeleny,
1980; Meikle, 1985]. Marx argues that prices are surface phenomena regulated by a deep
essence, which is for him abstract, socially necessary labor time.10 Such a proposal completes
the notion of "natural" price in the classical tradition, where market prices are proposed to be
the manifestation of an inner essence. But for Marx, as recognized by Paul Sweezy and
Anwar Shaikh [in Steedman et al., 1981], the deep essence expresses the contradictions of
capitalist production. Sweezy and Shaikh fault Steedman and other Sraffian economists who
dismiss the necessity of the labor theory of value. Sweezy and Shaikh stress the qualitative
aspect of value relations, which is as important as the quantitative aspect attempted by Sraffa.
With regard to institutions, Marx's theory of classes could be best understood as an
essentialist concept. For Marx, the members of the capitalist or the proletariat class, even
when they are not organized consciously "for themselves," share common traits not because
of some contingent sociological circumstances. Rather, for Marx, a class "in itself" is a deep
character defined by position in production. Therefore, a class acts behind the conscious will
of agents as a hidden essence which formulates the cultural-political attitude of its members.
Veblen's concept of institution is essentialist in the same sense as Marx's concept of
class. All habits or institutions for Veblen [1934, pp. 190-191] are not the product of
optimization rationality, but rather are necessary paradigms which assist the person in

10
The reason why, for Marx, the cost of production plays such a role in capitalist relations
is because human rationality of collective planning is subverted by the anarchy of the
capitalist market [Khalil, 1990b]. In this sense, the over-powering role of labor value
categories is not a "reductionist" conception of organization as claimed by David Levine
[1977; 1978, ch. 1] and Marco Lippi [1979]. Rather, it is an essentialist position which views
values of commodities as stemming from essences beneath surface phenomena, which
explains Marx's concept of commodity fetishism. In fact, Jindrich Zeleny [1980, chs. 1-3]
differentiates Marx's essentialist view of value from Ricardo's on the basis that Marx's
value/price dichotomy is only specific to one historical stage of production, viz., capitalist
relations.
 13

conceiving the world of experience.11 That is, institutions as paradigms as well as

conventions are not insubstantial. One faces the same difficulty in changing an inefficient
convention as changing a paradigm which defines the identity. Conventions are seen as deep
as paradigms and, hence, exhibit the same inflexibility in the face of the variation of external
variables like income and relative prices.12 Such a view, put simply, conceives agents as fully
a part of an existentialist process, rather than even partially standing as maximizing outsiders
[see Day, 1975]. The existentialist perspective counters the idea that at least some rules and
norms are contingent constraints ultimately stipulated, in light of circumstances, by optimality
rationality.
The different positions reviewed above with regard to the theory of institution have
been broadly confused as positions about the theory of organization. For instance, many
researchers working in the Veblenian tradition have misconstrued the meaning of the term
"institution" with the term "organization." As Walter Neale [1987, p. 1181] records, the word
"institution" has been used to denote organizational entities like the U.S. Federal Reserve
Bank as well as to denote the laws and norms which regulate the activity of the Bank. As
William Waller [1982, p. 759] chronicles, Veblen was aware of the difference. Veblen
restricted the term "institution" to behavioral patterns as opposed to the organizational
context. Likewise, C.E. Ayres, a student of Veblen, clearly stated that the term "institution"
does not refer to organizational aspects like "the division of the total substance of society into
its constituent parts" [quoted in Waller, 1982, p. 762]. The validity of the
organization/institution distinction should be valid irrespective of whether one subscribes to
old or new institutionalist economics.

6. Grand-Scale Organization and the Reification of Institutions

Some contemporary economists--like James Buchanan, Mancur Olson, and Douglass North--

11
The idea that some institutions are deep, non-optimizing paradigms may entail that
humans share a common paradigm and, hence, it is possible to compare their tastes. The
insinuation of inter-personal utility comparison is flatly rejected by the Paretian criterion of
welfare on the basis that humans do not share a common nature, but rather share stochastic
traits which happen to be similar for accidental circumstances.
12
Veblen also gives a totally different meaning to institutions when he defines them as
artifacts created by the powerful in order to maintain the symbols of conspicuous
consumption and status. According to such a view, institutions are seen as negative since the
concern with status hinder workmanship (i.e., entrepreneurship) and industrial progress. In
this regard, Warren Samuels finds the double view of institutions as deep necessary essences,
on one hand, and as artifacts and negative, on the other, to be paradoxical:

It is a curious paradox that the founder of institutionalism

[Veblen] had in his analysis rather negative role for institutions
[Samuels, 1992, p. xi].

To clarify, however, the idea of institutions as deep defining the nature of the agent should
not insinuate that they are natural and, hence, must be accepted. There is no inconsistency in
the matter. The opposite of "essence" is "insubstance," while the opposite of "natural" is
"artificial."
 14

have noted the organization/institution distinction. But they have generally failed to carry out
the implication of the distinction. They have tended to overstress the role of institutions in
their evaluation of the performance of organization at the grand scale.13
For example, Buchanan [1991] advocates strict constitutional rules against deficit
spending. This assumes that the passage of such rules ensures that rent-seeking behavior
would be greatly eliminated in the post-constitutional game--as if politicians cannot find other
means to spend more than they collect in taxes. Buchanan's analysis, stated broadly,
emphasizes the constitution at the expense of the state of affairs of the organization at a
certain historical juncture. Agents always react differently to the same set of institutions.
That is, the action of agents is not fully determined by the scheme of institutions. We might
have the perfect set of laws and instruments of implementation, but actors fail to behave as
desired. To use an analogy, a patient may follow the strict instructions of the doctor in term
of diet, exercise, style of life, and medical treatment without being able to recover from
cancer.
Similarly, Olson [1993] poses the question: which is better for economic
development--democracy or dictatorship? To note, this is not a clear-cut question because, as
Olson records, a secure autocrat has an incentive to provide a peaceful order, property rights,
and other public goods because he usually bequeaths it to his lineage. This is not the place to
investigate Olson's answer. The point is rather to show the implicit assumption which
undergirds Olson's question. Namely, he assumes that if we have the "correct" institution, we
would have ceteris paribus lasting economic growth. The assumption ignores the issue that
historically specific organizations interpret the same set of institutions differently. That is,
democratic rules of government could direct the organization on a path of economic growth
or a path of economic decline depending on the historical juncture of the organization itself.
Likewise, dictatorship could engender diverse outcomes. There is simply no one-to-one
correspondence between the institutional scheme and the behavior of organization.
Likewise, as mentioned at the outset, North [1990, ch. 11] thinks that the instituting in
the Seventeenth Century of a secure institutions of property rights in Britain, as opposed to
insecure rights in Spain, is mostly responsible for the divergence of the British-North
American and the Spanish-Latin American developments. This neglects that the scheme of
institutions in Spain was very successful in driving out the Moors in the Fifteenth Century,
economic expansion in the Sixteenth Century, and the continuation of the empire in Latin
America in the following two centuries. Also, the "correct" British-North American regime
of property rights has not secured a lasting superiority for the British or, as we witness in the
last quarter of the Twentieth Century, the U.S. economy.
North's stress on institutions (which he defines as formal and informal constraints)
leads him to neglect how organizations behave in light of such institutions--as if the set of
institutions is the only relevant substance. To wit, as if the path of growth determined by the
institutional scheme is the exclusive determinant, he asks in his Noble Lecture: "Why do
economies once on a path of growth or stagnation tend to persist?" [North, 1993, p. 19]. Of

13
In fact, e.g., Vanberg [1992] explicitly conceives the organization as an individual by
virtue of its underpinning scheme of institutions which he calls "constitution." Vanberg
proposes the nexus of underpinning implicit and explicit contracts as the reason why firms are
organizational actors. This amounts to the conception of the actor as nothing other than the
underpinning scheme of institutions.
 15

course, he does not mean to say that they tend to persist forever. So, it might be interesting to
ask: "Why do fruitful institutional paths, after a long period of time, cease to persist?"
Needless to state, the appeal to exogenous events, like invasions and natural disasters,
is the easy explanation of the eventual decline of once successful paths. But if one searches
for endogenous reasons for the eventual decline of once successful paths, one should bring in
the role of organization and, hence, underemphasize the role of institution--i.e., discount the
thesis that economic success is mostly a function of efficient institutions. If one tries to
provide an endogenous theory of decline, the institutional scheme obviously would be an
insufficient explanatory variable. I would argue that one should instead examine the tastes or
goals of organizations/agents. If organizations are not motivated enough--i.e., agents heavily
discount future (including intergenerational) consumption--or prefer leisure and poetry over
other kinds of goods, we would not have economic growth even if we had efficient
institutions. For a play to be successful, it is insufficient to have a play like Hamlet; there is a
need for motivated actors and an appreciative audience.
If this is the case, the Anglo-American "correct" matrix of institutions does not
guarantee persistent economic growth. To wit, the fact that most successful civilizations have
had divergent (and certainly different from the Anglo-American) institutions should highlight
that economic development might be a function of tastes of organizations as much as a
function of institutions. As admitted by Thrainn Eggertsson [1990], actual or operational
behavior is not necessarily guaranteed to be desirable once we have erected the "correct"
regime of constraints. Evidence shows that "similar rules can create different behavior and
outcomes" [Eggertsson, 1990, p. 310]. Thus, what matters, besides the erection of the
"correct" institutions, is an analysis of the behavior of the organization, which varies during
the historical process. Buchanan's and North's negligence of the role of organization amounts
to the reification of institutions, making institutions more important than they really are.
An example of the reification of institutions is the explanation offered by some
economists of the recent success of the Japanese and other East Asian economies. For
example, Harvey Leibenstein [1987, chs. 13-14] attributes the organizational efficiency of
Japanese firms to the supposedly unique Japanese personality, principle of distribution of
wealth, and cultural attitudes. Others [e.g., MacFarquhar, 1980; Morishima, 1982] argue that
the cultural character of Japanese Confucianism which emphasizes loyalty is behind the
economic miracle. Following Max Weber's thesis, Peter Berger [1986, ch. 7] contends that
Japanese Confucianism emphasizes frugality--similar to the role which the Protestant ethic
played in the rise of capitalism in Western Europe.14
However, it has been only five decades since the literature attributed the relative
backwardness of East Asia to its Confucian heritage. While culture matters, it cannot be
treated abstractly from the goals and preferences of the organizational actor. Stated broadly,
the same cultural values could enhance or inhibit economic growth, depending on the tastes
of the actor. It is illusive to think that success or failure of organizations is the result of the
"correct" mix of laws and regulations. For instance, the abuse of power on the part of

14
In addition, Alan Blinder [1991] attributes the success of the Japanese firm to Keiretsu,
the `buddy' system which links companies together in industrial groups. While companies
have the security of vertical linkage, which encourage them to invest in fixed costs, they do
not have the full security which might let them grow fat and lazy--their products are still
subjected to some market competition.
 16

members of the U.S. Congress is currently blamed by some commentators on the inertia of
incumbency, i.e., a few members are voted out of office by their constituency. But even if
term limits are instituted, what would prevent members of Congress from using their limited
tenure in office to amass friends and contacts who would be helpful in personal pursuits later?
This should not suggest that institutional reform is futile in correcting the behavior of
agents. In many cases, institutional reform is effective. But the success should not be
attributed to institutions, because the same institutions could generate suboptimal outcomes.
The success is more likely to be the result of the change of preferences of organizational
agents which accompanied the change of institutions. As stated earlier, a country could
protect property rights, promote income distribution based on productivity, and avoid
predatory public finance. But that may not produce economic growth if the tastes of
households remain strongly in favor of leisure time over income.
It is outside the scope of the paper to suggest how to rectify the reification of
institutions in economics. The organization/institution distinction would hopefully remind
theorists of the importance of organizations and their objective preference functions.
Organizations are the ones which, in the final analysis, embody and interpret the scheme of
norms and rules according to their preferences.

7. Conclusion
The main thesis of the paper is that the theory of organization should be distinguished from
the theory of institution. In many expositions, the concept "institution" is employed without
reference to "organization," or the organization is made as one type of institutions. This
engenders two problems. First, it presents the ends of organization as dictated by institutions.
Second, it neglects the issue of division of labor and how intra-organizational relations
cannot be fully answered by only examining the underpinning institutions.
It is recognized that separating the theory of organization from the theory of
institution is problematic. Both are needed in order to identify the individual agent. The
theory of organization investigates the status of organizational goals: Is the organization an
artificial vehicle manufactured for the convenience of its constitutive members, or is it a
natural, self-constitutive entity which cannot be divided? In contrast, the theory of institution
examines the substantiality of the scheme which constrains the agent's actions: Is the scheme
a conventional constraint persisting because (after allowing for transaction cost) of optimality
considerations, or is it a substantial enframing of one's resources and, hence, cannot be
changed according to optimization?
It is important to differentiate the two questions. The distinction sheds light on the
difference between the "context-sensitivity" thesis of Leibenstein's [1987] theory of the firm,
on one hand, and "deeply-embedded-institutions" or rules-of-thumb thesis of Simon's [1976,
1978] theory of the firm, on the other. The context-sensitivity thesis entails that the action of
a member is somewhat dependent on the choices which other members of the organization
make, and, hence, it is about the theory of organization. In contrast, the deeply-embedded-
institutions thesis means that even when circumstances change, the organization finds it
difficult to shed away certain constraints even when transaction costs are zero, and, hence, it
is about the theory of institution. Besides the theory of the firm, the proposed
organization/institution distinction should prove useful in understanding the metatheoretical
differences and similarities of different schools which have emerged in the history of
economic thought.
17
 18

References

Curtis, Gerald L. The Logic of Japanese Politics: Leaders, Institutions, and the Limits of
Change. New York: Columbia University Press, 1999.