Chapter Two

Heterodox Economic Thought

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 Outlines
 Early Critics of Neoclassical Economics
 The Old Institutional School
 The development of Modern Heterodox school
 The New Institutionalist School
 Quasi- Institutionalists: Joseph Schumpeter,
Gunnar Myrdal, John Kenneth Galbraith
 Post-Keynesians

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 Early Critics of Neoclassical Economics
Introduction to the Old Institutional School (OIS)
 The Old Institutional School (OIS) emerged in the late 19th
and early 20th centuries as a response to the limitations of
neoclassical economics.
 Unlike neoclassical economics, which centers on
mathematical models and rational agents, OIS emphasizes
the role of social institutions, historical context, and the
impact of human psychology on economic behavior.
 Thorstein Veblen, John R. Commons, and Wesley Mitchell
are considered the primary thinkers of the OIS.
Criticisms of Neoclassical Economics
 The Old Institutional School provided a variety of critiques
against the assumptions and methodology of neoclassical
economics. Here are some key points of contention:

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 Cont’d…
1. Individualism and Rationality Assumptions
o Neoclassical Assumes that individuals are rational, utility-
maximizing agents who make decisions based on perfect
information. While, OIS argued that individuals are often
influenced by habits, customs, and social norms rather than
purely rational considerations. Decisions are often guided
by "institutionalized" behaviors, not always aimed at utility
maximization.
2. Static Nature of Neoclassical Economics
o Neoclassical Tends to focus on equilibrium states and
assumes that economic systems tend toward a stable
equilibrium. Whereas, OIS theorists argued that economies
are dynamic and constantly evolving. Institutions,
technologies, and social norms change over time, so a static
analysis of equilibrium is insufficient for understanding 4
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 Cont’d…
3. Neglect of Institutions
o Neoclassical often abstracts away from the influence of institutions
(such as governments, corporations, laws) and focuses on individual
market exchanges. For OIS, institutions are crucial to understanding
economic outcomes. They shape and constrain individual choices
and are integral to the functioning of the economy.
4. Historical and Social Context
o Neoclassical Relies on universal principles, often ignoring historical
or cultural contexts. OIS argued that economic behavior is shaped by
history and culture. Economic phenomena cannot be fully
understood without considering their historical development and
social context.
5. Methodology – Focus on Empiricism
o Neoclassical Heavily relies on deductive reasoning, mathematical
models, and hypothetical scenarios. The OIS advocated for an
empirical, inductive approach, arguing that economic theories should
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 Cont’d…
Key Thinkers and Their Contributions
Thorstein Veblen (1857–1929):
 Known for his work The Theory of the Leisure Class
(1899), Veblen introduced the concept of
"conspicuous consumption," showing how
consumption could be driven by social status rather
than utility maximization.
 He criticized the "ceremonial" aspects of economic
behavior, where people are guided by social norms
and values rather than rational choice.
 Veblen coined the term "institutional economics" and
argued that economic behavior is largely shaped by
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habits and social structures, which change over time. 6
 Cont’d…
John R. Commons (1862–1945)
 Commons emphasized the importance of collective
action and social institutions in shaping economic
behavior.
 He focused on the role of laws, trade unions, and
corporate governance in the economy, which he
explored in his book Legal Foundations of
Capitalism (1924).
 He introduced the concept of "transaction" as the
basic unit of economic analysis, suggesting that
economic activity is more about transactions within
institutions than isolated acts of choice by
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 Cont’d…
Wesley C. Mitchell (1874–1948)
 Known for his work on business cycles, Mitchell
was instrumental in developing empirical methods
to study economic trends over time.
 He founded the National Bureau of Economic
Research (NBER) to promote data-driven
research on the economy.
 Mitchell focused on economic fluctuations and
argued that institutions and social factors play a
significant role in creating and sustaining business
cycles.

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 Cont’d…
Impact and Legacy of the Old Institutional School
 Development of Institutional Economics: The OIS paved
the way for New Institutional Economics (NIE), which
reintroduced the study of institutions into mainstream
economics but with more formal models and theoretical
rigor.
 Behavioral Economics: Concepts from OIS, particularly
Veblen’s emphasis on irrational behavior, foreshadowed the
development of behavioral economics, which explores
deviations from rationality.
 Influence on Economic Policy: The OIS has influenced
economic policy, particularly in areas like labor rights,
antitrust regulation, and social welfare. The school's
emphasis on social institutions informed policies aimed at
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 Cont’d…
 The Old Institutional School was a pioneering force in
broadening the scope of economic analysis beyond the
mathematical and individualistic focus of neoclassical
economics.
 By emphasizing institutions, history, and social factors, the
OIS highlighted aspects of economic behavior that
neoclassical theory overlooked.
 Though the OIS lost some influence with the rise of
mathematical economics, its ideas continue to inform
interdisciplinary approaches and inspire critiques of
mainstream economic thought.

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 The Development of Modern Heterodox Economics
The New Institutionalist School
 The New Institutional Economics (NIE) emerged in the
late 20th century as a revival and extension of the ideas
from the Old Institutional School, integrating
institutions into the analysis of economic systems
within a more formal, theoretical framework.
 Unlike neoclassical economics, which assumes perfect
information and frictionless markets, NIE investigates
the "real-world" complexities that institutions,
transaction costs, and bounded rationality introduce
into economic processes.
 Key figures in the development of NIE include Ronald
Coase, Douglass North, and Oliver Williamson.
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 Cont’d…
Principles and Concepts of New Institutional Economics
The NIE attempts to explain why institutions arise, how they
evolve, and how they impact economic behavior and outcomes.
Here are some of its central concepts:
1. Institutions as Rules and Constraints
o Institutions are defined as the "rules of the game"
in economic transactions. They include formal
rules (laws, regulations) and informal constraints
(norms, traditions).
o Institutions reduce uncertainty in human
interactions by providing a framework that shapes
individual behavior, thereby allowing for more
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 Cont’d…
2. Transaction Costs
 Unlike traditional economics, which often overlooks the cost of
transactions, NIE considers transaction costs as central to
understanding economic behavior.
 Transaction costs include search and information costs, bargaining
and decision-making costs, and policing and enforcement costs.
These costs influence decisions on how transactions are conducted
and whether they are internalized within firms or managed in
markets.
3. Bounded Rationality
 Unlike the perfect rationality assumed in neoclassical models,
bounded rationality suggests that individuals have limited
information, time, and cognitive resources, which constrains their
ability to make fully rational decisions.
 Bounded rationality implies that decision-makers rely on rules of
thumb, heuristics, and institutional structures to navigate complex
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 Cont’d…
4. Property Rights
 NIE emphasizes the importance of property rights as
fundamental to economic development and efficient resource
allocation.
 Clearly defined and enforced property rights give individuals an
incentive to invest, innovate, and maintain resources. Weak or
poorly enforced property rights, on the other hand, can lead to
underinvestment, resource depletion, and economic stagnation.
5. Path Dependence
 Path dependence means that economic decisions and outcomes
are shaped by historical choices and events, often making it
difficult for economies to shift from established (and sometimes
inefficient) institutions.
 Historical patterns can create "lock-in" effects, where certain
institutional structures persist even when they are inefficient or
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 Cont’d…
Key Thinkers and Their Contributions
Ronald Coase (1910–2013)
 Coase’s work, particularly "The Nature of the Firm" (1937) and
"The Problem of Social Cost" (1960), laid the groundwork for
NIE by introducing the concepts of transaction costs and property
rights.
 Coase Theorem: Coase suggested that, in the absence of
transaction costs, resources would be allocated efficiently
regardless of initial property rights allocations. However, in the real
world, transaction costs exist, and their presence influences
institutional arrangements. His ideas prompted economists to study
how firms and markets minimize transaction costs.
Douglass North (1920–2015)
North focused on the historical evolution of institutions and their role
in economic development. His seminal works include Institutions,
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 Cont’d…
 Path Dependence: North introduced the concept of path dependence to
explain why certain institutions persist over time and why some societies
develop more robust economic structures than others.
 He argued that institutional frameworks (property rights, political
systems) are key to understanding economic growth, showing how stable
institutions promote development.
Oliver Williamson (1932–2020):
 Williamson advanced the study of transaction cost economics, examining
why certain economic activities are organized within firms rather than
through markets.
 Market vs. Hierarchy: In Markets and Hierarchies (1975) and The
Economic Institutions of Capitalism (1985), he argued that hierarchical
organization (e.g., firms) is often used to reduce transaction costs when
markets are inefficient.
 Williamson’s work focused on the structures within firms and markets
that help minimize transaction costs, helping to explain the boundaries of
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 Cont’d…
Impact and Applications of New Institutional Economics
 Understanding Economic Development: NIE has been
influential in understanding why some nations experience
economic growth while others remain stagnant. It has led to
policy recommendations focusing on strengthening
institutions, particularly property rights, rule of law, and
anti-corruption measures.
 Public Policy and Governance: NIE’s emphasis on
transaction costs, institutional quality, and enforcement of
property rights has shaped policies that encourage
transparency, improve governance, and reduce regulatory
burdens.

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 Cont’d…
 Corporate Governance: NIE has informed corporate
governance structures by highlighting the need to align
incentives and minimize transaction costs within firms
through appropriate ownership structures, contracts, and
organizational designs.
 Law and Economics: By focusing on property rights and
the cost of legal enforcement, NIE has influenced the field of
law and economics, showing how legal frameworks affect
economic transactions and the efficiency of markets.

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 Cont’d…
Comparison with Neoclassical and Old Institutional Economics
 Formal Modeling: Unlike the Old Institutional School, which
was less formal in its approach, NIE incorporates rigorous
modeling and empirical analysis, bringing institutional analysis
closer to mainstream economics.
 Integration with Neoclassical Theory: While critical of
neoclassical assumptions (e.g., perfect rationality, absence of
transaction costs), NIE does not completely reject these
principles but instead modifies and extends them. NIE can be
seen as a “bridge” between neoclassical and heterodox
economics.
 Continuity and Differences with OIS: NIE retains the OIS’s
focus on the importance of institutions but emphasizes formal
theory, transaction costs, and property rights rather than the
historical and cultural aspects central to the OIS. 1
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 Cont’d…
Quasi-Institutionalists – Joseph Schumpeter, Gunnar Myrdal,
and John Kenneth Galbraith
 Quasi-Institutionalists were economists who shared some of the
concerns of Institutional Economics but developed distinct
frameworks and theories. Their work bridged the gap between
mainstream economic theory and the more holistic, historically
oriented perspectives of institutionalism.
 These economists – Joseph Schumpeter, Gunnar Myrdal, and
John Kenneth Galbraith – emphasized the importance of social,
political, and cultural factors in economic systems, criticizing the
narrow focus on equilibrium and rationality in traditional
economic theory.
 By emphasizing innovation, power structures, and social values,
they expanded economic thought beyond traditional frameworks
and influenced both institutional economics and broader
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 Cont’d…
1. Joseph Schumpeter (1883–1950)
Schumpeter is best known for his theory of economic
development, entrepreneurship, and innovation.
Creative Destruction
 In Capitalism, Socialism, and Democracy (1942),
Schumpeter introduced the concept of "creative
destruction" to describe how capitalism perpetually
disrupts existing economic structures through innovation.
 This cycle of innovation involves the continuous creation of
new industries, products, and technologies that render old
ones obsolete, driving economic growth and
transformation.

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 Cont’d…
Entrepreneurship and Economic Development
 Role of the Entrepreneur: Schumpeter argued
that entrepreneurs are the central figures in
economic development, as they introduce
innovations that disrupt markets and create new
growth opportunities.
 Institutional Dynamics: For Schumpeter,
economic development cannot be fully
understood through neoclassical equilibrium
models. Instead, dynamic factors like
entrepreneurship and innovation must be studied
alongside institutional structures that enable or
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 Cont’d…
2. Gunnar Myrdal (1898–1987)
 Myrdal’s work integrated economic analysis with social,
political, and cultural factors. He was particularly known for
his studies on inequality, development, and the interplay
between economics and values.
Circular Causation:
 Myrdal introduced the idea of "circular causation" to
describe complex social and economic processes in which
various factors reinforce each other. For example, poverty
can lead to poor education, which in turn reinforces
poverty.

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 Cont’d…
Value-Based Economics:
 Myrdal argued in The Political Element in the
Development of Economic Theory (1930) and
other works that economic research is inherently
value-laden. He criticized the view that economic
science could be purely objective and free from
ideological influences.
 Institutional Influence on Economic Outcomes:
Myrdal believed that social norms, politics, and
culture must be acknowledged as fundamental
influences on economic outcomes, especially in
areas like poverty and inequality.
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 Cont’d…
Development Economics and Welfare:
Asian Drama: An Inquiry into the Poverty of
Nations (1968): Myrdal’s influential study on
South Asia examined the root causes of poverty
and economic underdevelopment. He argued that
economic underdevelopment could not be solved
without addressing the social and institutional
issues underlying poverty.
Role of the State and Policy: Myrdal advocated
for active state intervention to address inequality
and poverty, emphasizing that institutions, culture,
and social policies play critical roles in fostering or
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 Cont’d…
John Kenneth Galbraith (1908–2006)
 Galbraith was known for his critiques of corporate power,
consumer culture, and the failures of traditional economic
theory to address real-world economic issues.
 The Affluent Society:
 Concept of "Dependence Effect": In The Affluent
Society (1958), Galbraith argued that consumer demand
in advanced economies is increasingly shaped by
corporate advertising and societal expectations rather
than by natural or rational needs.
 Institutional Power: He highlighted the role of
institutions, especially large corporations, in shaping
consumer preferences, leading to overconsumption and
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 Cont’d…
Countervailing Power:
 Market Power of Corporations: Galbraith argued in
American Capitalism: The Concept of Countervailing
Power (1952) that large corporations hold substantial
power in modern economies, often distorting free-market
principles.
 Countervailing Institutions: To balance corporate
power, Galbraith proposed that countervailing forces
(like labor unions, government regulations, and
consumer organizations) are necessary to create a fairer
and more balanced economic system.

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 Cont’d…
Critique of Neoclassical Economics:
 Galbraith criticized neoclassical economics for its
abstraction and failure to address the actual
dynamics of power and decision-making in modern
economies. He argued that economics should focus
on real-world issues, including inequality, power
structures, and institutional dynamics.
Impact and Legacy of the Quasi-Institutionalists
 Influence on Institutional and Heterodox Economics: The
work of Schumpeter, Myrdal, and Galbraith contributed
significantly to the development of institutional economics,
emphasizing the role of innovation, cultural factors, and
power structures in economic systems.
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 Cont’d…
Policy Implications
State Intervention: Each thinker highlighted
limitations in laissez-faire economics and the
need for strategic state intervention to address
economic imbalances, social inequality, and
power concentration.
 Interdisciplinary Approach: These economists
encouraged an interdisciplinary approach,
combining insights from sociology, politics, and
history to offer a more holistic view of economic
issues.

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 Cont’d…
Comparison with Neoclassical Economics and Institutional Economics
 Divergence from Neoclassical Assumptions: Unlike
neoclassical economics, which is rooted in assumptions of
equilibrium, rationality, and utility maximization, these quasi-
institutionalists focused on the dynamic and often irrational
aspects of human behavior, power, and institutions.
 Overlap with Institutional Economics: Schumpeter, Myrdal,
and Galbraith shared the Institutionalists’ concerns about the
importance of social structures, historical context, and non-
market forces in economics. Distinct Focus: Each thinker
brought a unique perspective:
o Schumpeter focused on innovation and entrepreneurship.
o Myrdal explored social values and development economics.
o Galbraith emphasized corporate power and consumer
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 Cont’d…
Post-Keynesian Economics
 Post-Keynesian economics is a school of thought that
emerged in the 1950s as a reaction to mainstream
interpretations of Keynes’ ideas. It seeks to continue and
expand upon the economic theories of John Maynard
Keynes, especially those in The General Theory of
Employment, Interest, and Money (1936).
 Unlike neoclassical economics, which emphasizes
equilibrium and rationality, Post-Keynesian economics
focuses on uncertainty, real-world dynamics, and the roles of
institutions and social factors in shaping economic behavior.
 Post-Keynesians emphasize the importance of effective
demand, the role of uncertainty, the significance of historical
time, and the structural issues within capitalist economies.
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 Cont’d…
Principles and Concepts of Post-Keynesian Economics
 Post-Keynesian economics diverges from neoclassical economics
and Keynesian synthesis (or "mainstream Keynesianism") in key
areas:
Principle of Effective Demand
 According to Keynes, economic output is primarily
determined by aggregate demand (total spending in the
economy). Post-Keynesians expand on this idea, arguing
that supply does not automatically create its own demand,
as neoclassical economics suggests.
 In this framework, underemployment and unused capacity
can persist because there’s no automatic adjustment to full
employment. Aggregate demand, particularly consumption
and investment, drives economic activity.
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 Cont’d…
Role of Uncertainty and Expectations
 Radical Uncertainty: Post-Keynesians emphasize
fundamental uncertainty, where future outcomes
cannot be known or probabilistically forecasted. This
uncertainty affects decision-making and investment
behavior, as individuals and firms make choices
based on expectations that may not materialize.
 Impact on Investment: Investment decisions, which
are crucial to economic growth, are influenced by
uncertain expectations about the future. As a result,
investor confidence and "animal spirits" (a term
coined by Keynes) play a significant role.

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 Cont’d…
Historical Time
 Irreversibility: Post-Keynesians reject the neoclassical
assumption of "logical time" (reversible, where past
decisions have no bearing on future outcomes). Instead,
they emphasize "historical time," where decisions and
events are irreversible and affect future possibilities.
 Path Dependence: Economic processes are path-
dependent, meaning that past events and choices shape
present and future economic conditions.
Income Distribution
 Importance of Class and Power: Post-Keynesians
highlight that income distribution between wages and
profits is essential for understanding demand and
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 Cont’d…
 Wage-led vs. Profit-led Growth: Some Post-Keynesians
propose that economies can be either "wage-led" (where
increases in wages lead to higher demand and growth) or
"profit-led" (where profit increases lead to growth). This
depends on the relative importance of consumption and
investment in driving growth.
Endogenous Money:
 Money Supply as Demand-Driven: Post-
Keynesians argue that the money supply is
endogenous, meaning it is determined by the
demand for loans rather than central bank actions
alone. Banks create money when they issue loans,
responding to the demand from borrowers.
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 Cont’d…
The Role of Institutions and Power
Institutions Matter: Like institutional economists,
Post-Keynesians argue that the economy is shaped
by institutions (such as banks, governments, and
labor unions) and power structures that influence
economic outcomes.
Market Power and Inequality: They also focus
on issues of monopoly power, bargaining power
between labor and capital, and the role of
government in regulating economic activity.

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 Cont’d…
Key Thinkers and Their Contributions
Joan Robinson (1903–1983):
 Robinson criticized the marginal productivity theory
of distribution, arguing that it failed to explain how
income is actually distributed between wages and
profits.
 She expanded on Keynes’ ideas by focusing on
imperfect competition and the role of firms’ pricing
strategies in determining market outcomes.
 In her work on capital theory, she explored how
growth and distribution interact, arguing that
capitalist economies do not naturally tend toward
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 Cont’d…
Nicholas Kaldor (1908–1986):
 Growth and Distribution: Kaldor developed models
that linked economic growth to income distribution,
showing how income shares affect savings,
investment, and growth rates.
 Kaldor’s Laws: He identified empirical "laws" of
economic growth, including the idea that higher output
growth is associated with higher productivity growth,
and that the manufacturing sector drives long-term
growth.
 Endogenous Money and Demand-Led Growth:
Kaldor argued for a demand-led view of growth,
where aggregate demand drives the economy and
Saturday investment decisions are influenced by uncertainty. 3
 Cont’d…
Paul Davidson (1930–2023):
 Uncertainty and Financial Markets: Davidson
emphasized the importance of uncertainty in
financial markets and developed theories to
explain why instability is a common feature of
capitalism.
 Supporter of Keynes’s Original Theories:
Davidson was a key proponent of Keynesian
fundamentalism, working to preserve and promote
Keynes’ original ideas on uncertainty and
aggregate demand, which he believed were
misunderstood by neoclassical synthesis
Saturday economists. 3
 Cont’d…
Hyman Minsky (1919–1996):
 Financial Instability Hypothesis: Minsky’s theory
explained how financial markets are inherently unstable
due to the build-up of speculative borrowing and risk-
taking during economic booms, which eventually leads to
financial crises.
 Stages of Financial Fragility: Minsky argued that
economies move through phases of financial stability and
instability, from "hedge finance" (conservative borrowing)
to "speculative finance" and finally "Ponzi finance"
(unsustainable debt levels), resulting in financial crises.
 Minsky Moment: His work gained renewed interest
during the 2008 financial crisis, which validated his
insights into the cyclical nature of financial instability. 4
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 Cont’d…
Policy Implications of Post-Keynesian Economics
Active Fiscal Policy
 Post-Keynesians advocate for active government
intervention to manage aggregate demand and
reduce unemployment. They argue that fiscal
policy is more effective than monetary policy in
stimulating economic growth and addressing
structural unemployment.
 Public Investment: Emphasis is placed on public
investment in infrastructure, education, and
healthcare to support long-term growth and
stability.
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 Cont’d…
Monetary Policy and Financial Regulation:
 Given their view of endogenous money and financial
instability, Post-Keynesians believe that monetary policy
should focus on financial stability rather than strict inflation
control.
 Regulation of Financial Markets: They argue for stronger
regulation of financial markets to prevent speculative bubbles
and reduce the likelihood of financial crises.
Income Redistribution and Wage Policy:
 Fair Wages: Post-Keynesians advocate for policies that
ensure fair wages and a more equitable distribution of income
to support demand-led growth.
 Role of Labor Unions: They support the role of labor unions
in ensuring that wage growth keeps pace with productivity,
Saturday which helps maintain aggregate demand. 4
 Cont’d…
Job Guarantee Programs:
 Post-Keynesians often propose a job guarantee
program as a means of achieving full employment.
By providing a job to anyone willing and able to
work, the government can stabilize demand and
reduce unemployment, effectively becoming the
"employer of last resort."
Focus on Environmental Sustainability:
 Some Post-Keynesians argue for policies that
address environmental concerns and encourage
sustainable growth. They emphasize that long-term
economic growth must consider environmental
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 Cont’d…
Critiques of Neoclassical Economics by Post-Keynesians
Equilibrium and Rationality:
 Post-Keynesians reject the neoclassical emphasis on equilibrium
and rationality, arguing that real-world markets are often unstable
and influenced by irrational behavior due to uncertainty and
speculation.
Atomistic Individualism:
 Post-Keynesians criticize the neoclassical focus on individuals
acting independently of one another, instead emphasizing that
collective behaviors, social norms, and institutions play a central
role in economic outcomes.
Monetary Neutrality:
 Neoclassical economics often assumes that money is neutral in
the long run, but Post-Keynesians argue that money and finance
are integral to the economy and have lasting effects on growth,
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 Cont’d…
Legacy and Influence of Post-Keynesian Economics
 Economic Policy and Welfare: Post-Keynesian insights have
influenced progressive economic policies, such as social safety
nets, public spending on welfare, and income redistribution to
address inequality and promote stable growth.
 Macroeconomic Stability and Financial Crises: The 2008
financial crisis renewed interest in Post-Keynesian economics, as
mainstream models failed to predict or address the causes of the
crisis. Minsky’s financial instability hypothesis, in particular,
gained attention as a framework for understanding financial cycles
and crises.
 Institutional and Heterodox Economics: Post-Keynesianism has
contributed to heterodox economics more broadly, with its focus
on real-world economic conditions, historical processes, and the
roles of institutions in shaping the economy
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