A Model of Institutional Hysteresis

In recent years, renewed interest has been shown in both the importance of institutions for the functioning of capitalism and the impact of capitalism's dynamics on the nature of institutions.1 However, the common interests of this literature conceal profound methodological differences, which in turn give rise to substantially different conclusions with regard to the origins, nature, and role of institutions in a capitalist economy. The purpose of this paper is to show how a critique of the methodologies underlying the two most popular approaches to institutional analysis gives rise to a new, more satisfactory methodology based on hysteresis. A model of institutional hysteresis is developed, which resembles the work of Cornwall [1990] and Cornwall and Cornwall [1987]. The insights of these earlier analyses are extended by focusing on the effects of hysteresis on the nature of institutions (in particular, their eff'iciency properties), rather than on economic outcomes. The conclusion reached is that institutions are best treated as evolving, non-optimal, path-dependent phenomena, rather than in terms of either simple historicism or the standard equilibrium metaphor of mainstream economic theory.