Neoclassical to Institutional Economics:
Two schools of heterodox economic traditions - Marxian Economics and Institutional Economics - emerged more or less independently. Both of these traditions had a character of a social movement. They were critical of classical and early neoclassical economics on the grounds of some of the assumptions on which these theories were based. Early institutional economists criticized the conventional neoclassical economics because of its irrational assumptions and neglect of institutional factors to explain economic behavior. They argued that the role of social, political, anthropological and organizational mechanisms is unaccounted for in the neoclassical theory.
Such an approach ignores the dynamics of real economic issues creating a gap between reality and theory. One of the other main arguments of Mam and his followers against classical economics was that they lacked a historical perspective. Marx considered production a social activity. On the other hand, institutionalisms' view of production goes beyond the traditional markets.
They focus on human-made and human-centric institutions like state, firm, individual, social norms, etc. and consider economic performance a result of the complex interaction of these institutions.
The development of institutional economics in its present form is a 20th century phenomenon. Some of the classical economists like Adam Smith, David Hume and J.S. Mill also highlighted the importance of various social, cultural, political and legal institutions in economic development. They, however, failed to analyze the economic behavior of human beings by taking the institutional factors into account. Similar shortcomings can be traced to Marxist economic theory. Against this background. institutional economics emerged as an alternative theory during the 'Great Depression' in the United States. The writings of the early institutional economists are also therefore referred to as 'American Institutionalism'. Thorstein Veblen is one of the prominent earlier institutionalisms who considered economics as an evolutionary science. He held that an evolutionary economics is a theory of 'a process of cultural growth as determined by the economic interest'. It is thus a theory of a cumulative sequence of economic institutions stated in terms of the processes. Veblen's analysis of institutional economics is influenced by Spencerian-Darwianian evolutionary principles. Stressing the importance of psychological and cultural institutions in determining the economic behavior of human beings, Veblen argues that there can be no 'normal equilibrium' but only a chain of evolutionary processes. His writings influenced others like J. M. Clark, J.R. Commons, etc.
Clark analyzed the concept of equilibrium raising the question 'why business adjustments (i.e. economic fluctuations) do not stop at a point (i.e. one of equilibrium) but continue to a point from which a more or less violent reaction inevitably take place'? Arguing that the concept of 'economic balance' (balance considered as synonym to equilibrium) is elusive and difficult to attain prevail in practice, Clark holds that the concept of equilibrium is nonetheless a necessary element and tool as conditions necessary for equilibrium furnish a starting-point in the analysis of why equilibrium is not reached. Commons also notes that it was the classical assumption of full employment which allowed the consideration of equilibrium of all the factors among themselves'. However, accommodating the views of the traditional school, Commons holds that institutional economics is not divorced from the classical and psychological schools of economics but is an extension from commodities and individuals to transactions and working rules of collective action'.
This also marked the transition from the classical school to the institutional school in economic analysis. Equilibrium signifies - what can take place if a system is left to operate on its own without a managed order by an effective interplay of institutions. Commons, thus, contrasts institutional economics with the ideas of classical-neoclassical school by observing that anything that focuses on: dynamic instead of static, a process instead 'of commodities, activity instead of feelings, mass action instead of individual action, heterogeneity instead of homogeneity, management instead of equilibrium, control instead of laissez faire, etc. is institutional economics. Further, maintaining that institutional economics deals with the rules of conduct enforced by the collective economic sanction, he identifies three types of sanctions relating to 'business ethics' viz. moral sanctions of collective opinion, economic sanctions of profit or loss, and organized sanctions of violence. Pointing out that institutional economics derives a large part of its base from the field of corporate finance, Commons says that institutional economics refers to the assets and liabilities of concerns in contrast to the Wealth of Nations theory put forward by Adam Smith.