Evolution and Design of Institutions

Christian Schubert, Georg Von Wangenheim

• Publisher: Taylor & Francis
• Year: 2006
• Print ISBN: 9780415375313
• eBook ISBN: 9781134187140
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

This book comprises nine papers approaching designed institutions and their interplay with spontaneous institutions from various angles.

While the evolution of spontaneous institutions is quite well understood in economic thinking, the development of consciously designed institutions has been examined much less. In new institutional economics, public choice, and law and economics the interaction between changing preferences and spontaneously evolving institutions on the one hand and the evolution of designed institutions (as, e.g., legal systems) on the other hand has largely been ignored.

A number of top class international contributors have been assembled to study this phenomenon including Viktor Vanberg, Bruno Frey, Elinor Ostrom and Francesco Parisi.

Part I
Designed institutions, preferences and behavior

2 Institutions shape preferences: The approach of “Psychology & Economics”

Bruno S. Frey

2.1 How to deal with preference changes

Why do so many people get used to, or even start to believe in, a dictator’s ideology though they previously thought it to be ridiculous? Why do others actively oppose it while still others withdraw themselves, resorting to purely private values? Or why do some people upon the introduction of a market economy adopt a promarket ideology while others become more adverse to commercialization? And why does the higher income produced by markets often not increase people’s happiness, in particular of those materialistically inclined?

These are some of the issues this chapter addresses. It is, of course, not claimed that these questions are answered here in a satisfactory way. But it is suggested that new developments in the newly emerging field of “Psychology & Economics” offer a fruitful avenue for approaching these issues.

Everyone knows: human preferences are variable. They develop and change over time. Part of what we liked when we were younger is no longer cherished when we grow older, and vice versa. What individuals may have rejected in the past (e.g., abstract painting) may be greatly valued by the same individuals today. Everybody is also aware that to some extent preferences differ between cultures.¹

Yet economics traditionally assumes that preferences are constant. This “unrealistic” assumption allowed economists to make great progress in explaining human behavior and in deducing relevant policy consequences. Taking preferences to be immutable focuses the analysis on the effect of (generalized) relative price changes (or changes in the opportunity set) on behavior. This approach has been most clearly visible in the work by Gary Becker (1962, 1976). To the surprise, and also the dismay, of many social scientists (including some economists), he demonstrated that the approach holding preferences constant provides valuable insights not only in the area of the economy, but far beyond. This success led to the claim of economics being the “Queen of the Social Sciences” (most prominently Stigler 1984, Lazear 2000).

At the same time, there were always economists who wanted to deal with changing preferences. There is a long intellectual history of attempts to explain changes in human preferences. But this approach has met with little success. Changing preferences play a minor role in economics. While quite a number of such efforts were undertaken in the 1970s and 1980s,² today there are but a few publications addressing this issue, at least in the leading journals. Economics, as revealed in advanced level textbooks, has essentially disregarded these attempts.

A different, and more successful, route explains changes in tastes by assuming the utility function to be time invariant and equal between individuals, but that individuals accumulate human capital based on their past experiences (Stigler and Becker 1977, Becker 1996). A particular consumption bundle leads to a different evaluation by individuals, depending on the amounts of such human capital accumulated. Most people would consider such a process to be a change in preference. This avenue produced noteworthy and empirically testable insights into human behavior (e.g., Becker and Murphy 1988 on addiction). It also yielded important policy results, for instance that drug addicts can only get rid of their dependence if they decide to abstain abruptly and completely (“cold turkey”). The approach, however, found relatively few followers, perhaps because such redefinition in terms of a change in human capital is considered to be somewhat artificial.

This chapter proposes that the situation has been changing quite considerably. “Psychology and Economics”³ has emerged as an academic discipline combining the traditional, but so far separated, fields of psychology and economics in order to develop a more satisfactory science of human behavior (see, more fully, Frey 2001). It has, in particular, been demonstrated that it is possible and useful to introduce aspects from psychology into economics. The elements imported range from motivational psychology to social neuroscience (e.g., Cacioppo 2002, Glimcher 2003). In particular, “Psychology & Economics” has resulted in two important developments:

1. The psychological theories allow economists to fill preference changes with content and life; they serve as a basis for formally modeling preference changes.
2. Research on the economics of happiness⁴ shows that reported subjective well-being or satisfaction are good approximations to individual utility. This allows economists to empirically address the phenomenon of preference change, a possibility so far lacking. Approximating utility by measurable data on reported subjective satisfaction makes it possible to directly test theories on preference changes. Empirical research has been greatly boosted by data on individual satisfaction being available in a panel form spanning many years.

This chapter pursues the avenue proposed by “Psychology & Economics”. The goal is to indicate in as concrete a way as possible, and in an empirically testable way, how institutions affect individual preferences. A change in institutions affects the constraints faced by the individuals or, in other words, produces changes in (generalized) relative prices. To analyze the effect of such changes on individual preferences, specific psychological theories are employed and integrated into institutional economics, thus performing a bridging function. In contrast, this chapter does not intend to provide an in-depth discussion of the concept of preference as used in the various disciplines. This has been done elsewhere (see, for instance, Niederle, in this volume). For the purpose here pursued it suffices to state that the term “preference change” refers to all changes in the behavior of individuals not accounted for by the changes in generalized relative prices (see Becker 1976).

The outline of the basic relationships linking institutions and preferences is given in Section 2.2. In order to be as concrete and empirically orientated as possible, the framework is applied to two specific cases: Section 2.3 discusses the effects on individual preferences when a dictator with a particular ideology comes to power; Section 2.4 traces the effects on individual preferences when a market economy is introduced. Section 2.5 offers concluding remarks.

2.2 Relating institutions and individual preferences

2.2.1 Two types of processes

In order to analyze the effects of institutions, it is useful to distinguish between two kinds of processes affecting individual preferences.

The first type of process is based on a conscious process. Individuals react in a cognitive and strategic way to the changes in constraints that they face. Their aim is to maintain their overall or (meta-) utility in the case of restraining changes in their opportunity set, and to raise their utility as much as possible in the case of enlarging changes in their opportunity set. It is thus assumed that individuals adjust their preferences in order to maximize their meta-utility. In contrast to standard economic theory, individuals not only adjust their behavior to a change in (generalized) relative prices, but also adjust their beliefs of what they like, and therefore their preferences.

A case in point is “cognitive dissonance theory” (see Festinger 1967, Aranson 1984: 113–79, or the survey in Reeve 2001: 291–8). Individuals can raise their utility if, after having made a choice, they adjust their preferences to the decision taken. They adopt a different self-image because they must explain to themselves why they have made that choice of their own free will. For example, after having bought a particular brand of car, they make an effort not to have their preferences influenced in an adverse way. They therefore seek advertisements validating their choice, and try to disregard advertisements praising other brands. This theory has been used in a path-breaking contribution to “Psychology and Economics” (Akerlof and Dickens 1982, see also Akerlof and Kranston 2003), which explains why workers who chose to work in a dangerous job fail to take all the precautionary measures deemed reasonable to outsiders. The reason is that doing so continually reminds them that they have chosen a dangerous job. This thought reduces their utility. Therefore they “rationally”⁵ decide to discount the danger to which they expose themselves.

As will be argued below, cognitive dissonance is only one particular case of the more general phenomenon of systematically adjusting one’s preferences to changes in constraints.⁶

The second type of process is unconscious. It happens more or less automatically. It is not willingly controlled, nor strategically used, by the individuals. Preferences are formed within the individuals by motivational and non-rational forces. These changes are thus psychological in a more narrowly defined sense.

An example is coping behavior in the face of an unfortunate event. Most persons show a considerable amount of resilience when, for instance, they lose their long-term partner. After suffering intense grief over some period of time, they recover and subsequently attain a similar level of well-being to before the event (see Stroebe and Stroebe 1987 for losing one’s partner, and Fredrickson et al. 2003 for the general processes). While this adjustment is unforeseen and unplanned, it is nevertheless real.

2.2.2 Consciously changing preferences

Individuals adjust their preferences in reaction to a change in relative prices in order to raise their meta-utility to a higher level than it would otherwise be. This can be done in two ways:

An active form is to strengthen those preferences in line with the changing constraints. Take, for example, the case of public transport being less expensive than private transport. One’s meta-utility is increased by raising one’s preference in favor of public transport. Similarly, when an individual is unable to attain a certain position (e.g., to become a full professor at a reputable university), he or she does well to emphasize the pleasures gained from engaging more fully in leisure-time activities. Such adjustments serve to increase the utility of the persons concerned. Indeed, people unable to adjust in this way lead miserable lives. It is difficult to imagine a world in which individuals would not cope in this way when they realize that they are unable to achieve a particular goal, even if it was initially very important. Many young people dream about becoming famous sportspeople or music superstars. But most of them find it quite easy to adjust their preferences when they see that they cannot reach their original goals.

A passive form of preference adaptation is to weaken those preferences incompatible with the change in relative prices. In the cases just given, an individual raises his or her utility by discounting a preference for private transport, e.g., by pointing out to him- or herself that private transport involves higher risk of accident. The person not attaining the desired professorial rank increases his or her utility, for instance, by persuading him- or herself that the “publish or perish” process involved is not worth the effort and does not really contribute to scientific advance. And those giving up their dreams of becoming a sports or music star can focus on the disadvantages of being famous.

These preference adaptations are familiar from everyday life and have also been discussed in the literature (for example Elster 1983). The “sour grapes” story describes how people adjust their preferences when they realize that they cannot attain a particular goal. In contrast, the “grass is always greener on the other side” story describes the utility decreasing inclination of focusing on unattainable goods and positions.

2.2.3 Unconciously changing preferences

There are two different processes guiding the adjustment of preferences to relative price changes which are unconscious.

The first process works through the perceptions persons have of the outside intervention experienced by the relative price change. If the intervention is taken to be supportive for the existing preferences, the individuals have a tendency to strengthen them further. A pertinent example is receiving a commendation for doing an activity for intrinsic reasons (for ex...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• List of Figures
• List of Tables
• List of Contributors
• Introduction
• Part I Designed Institutions, Preferences and Behavior
• Part II Emergence and Change of Designed Institutions
• Part III Normative Perspectives