Why All Policy Analysis Needs Institutional Economics, and Why This Economics Needs to Admit Unequally Rational Individuals and Comprehend Economic Change

Abstract

Today’s economists increasingly agree that an economy’s performance importantly depends on its institutions (though in not always well-defined meaning). If this is the case, the knowledge of this dependence is doubly important for the policy analysis that seeks a remedy for an underperforming economy: the institutions may contain the causes of the underperformance, which the analysis needs to identify; and institutional change may be a necessary ingredient of the remedy, the effects of which the analysis needs to assess. This paper has two main objectives, indicated by its title: (1) to show that this is indeed the case, and that policy analysis therefore needs help from certain parts of Institutional Economics (IE); (2) that IE, to effectively help and not mislead policy analysis, needs to be extended by certain parts of certain “heterodox” fields, divided into Behavioral-Informational economics, and Evolutionary-Developmental economics. The paper interconnects all the needed parts into a consistent conceptual model, able to help policy analysis deal more reliably with a broader range of important policy issue, and avoid proving optimal in theory policies that grossly fail in practice. Its usefulness is illustrated by new contributions to four old policy issues: the economic sustainability of socialism; the social efficiency of selective industrial policies; the social efficiency of large, transaction-costs saving firms; and the regulations of the financial sector, including the financial transaction tax.