Institution and Development Economics rx

Institution and development

1. Institutions & Development Data choice and measurement

2. Extractive vs Inclusive Institutions I nstitutional structures created by European powers during the colonial period - classified into two categories Extractive institutions -a small ruling elite that used its power to extract resources from the rest of the population . (Property rights were not well-defined, the rule of law was weak, and economic activity was subject to random government intervention. These types of institutions were often established in colonies that were seen as having abundant natural resources that could be exploited by the colonizing power). Inclusive institutions- more equitable distribution of power and resources. ( Property rights were better defined , the rule of law was stronger, and there was more economic freedom. These types of institutions were often established in colonies that were seen as having a more diverse economic base and a larger population).

3. Economic Institutions Approach For economic institutions, one of the main theories is the transaction cost theory, and the principal-agent theory. Transaction cost theory: argues that the design of economic institutions, such as property rights and contracts, can affect the costs of economic transactions. The principal-agent theory: explains how economic institutions can be designed to align the incentives of principals (such as business owners or shareholders) with those of agents (such as managers or employees).

4. Contd … Difference in economic institutions is the main cause of different patterns of growth. Its based on idea that : The way humans decide to organize their societies Some encourage people to innovate Some take risk Some save for future “Prosperity of society depends on economic institutions” Supported by Adam Smith (Mercantilism, role of markets) John Sturart Mill (societies are successful when they have good economic institutions)

5. Contd … Within this system there must be enforcement of property rights, individuals should have incentive to invest, innovate and take part in economic activity Some scholars examined stable property laws . Skaperdas (1992), Grossman & Kim (1995,1996), Hirshleifer (2001) & Dixit (2004) Some examined how rent seeking & redistributional conflict has implications for growth . Tornell & velasco (1992), Murphy, Shleifer & vishny (1991), Acemoglu (1995), Alesina & perotti (1996) Literature on perfectionism & spread of markets is a key of economic institutions. Adam Smith, Hicks work Capital markets – played a key role

6. Contd … Banarjee & Newman (1993) and Galar & Zeira (1993) propose models of how imperfect financial markets can impede growth and development Models of poverty traps by Rosenstein- Roden (1943), Murphy, vishny $ shleifer (1989a,1989b) & Acemoglu (1995,1997) are based on the idea that market imperfections can lead to the existence of multiple pareto ranked equibrium So a country can get stuck with pareto inferior equilibrium associated with poverty Getting out of this mechanism is difficult

7. Possibilities of getting out of trap Getting out of trap is possible: Increasing returns to scale – Durlauf (1993), Krugman & V enables (1995) Addressing labor market imperfections- Aghion & Howitt (1994) , Pissarides (2000) Addressing industrial organization, market structure and nature of competition All this discussion shows that idea of market imperfections & economic institutions play a central role since beginning

8. Institutions discussed in political economy models Institutions have been discussed in political economy models: Some Influential models were developed by Perotti (1993), Saint-Paul&vedier (1993), Alesina & Rodrik (1994) & Persson & Tabellini (1994) They developed dynamic models to examine the effect of redistributive taxation and growth Currently there are many models where political mechanisms & outcomes can have important influences on the growth rate . Ades & Verdier (1996) Krusell and Rios- Rull (1999), Bourguignon & Verdier (2000) Then there were ideas - where institutions were connected (economic and political)- for growth and development

9. Problem and Motivation

10. Approaches Empirical side: Establishing causal role of institutions in development Theoretical side : Why institutions differ across countries? Assessing the causal role of institutions on empirical side: a complex task, but there are some general approaches that can be used to accomplish this goal. One common approach : natural experiments or quasi-experimental designs to study the impact of institutional changes or variations in institutional quality on relevant outcomes . I f a country introduces a new policy or institutional reform that affects any particular sector, researchers can compare the outcomes of that sector before and after the reform to assess its causal impact. I f two regions or countries have different institutional arrangements but are otherwise similar, researchers can compare outcomes in those regions or countries to assess the causal role of institutions.

11. Contd … Another approach : econometric techniques to control for potential confounding variables that might affect the relationship between institutions and outcomes. Example, researchers can use regression analysis to estimate the impact of institutional variables on outcomes while controlling for other factors that might affect those outcomes, such as demographics, economic variables, or historical events.

12. Assessing causal role Assessing the causal role of institutions in empirical work requires careful consideration of research design, data quality, and appropriate statistical methods. It is important to be aware of the limitations and assumptions of different approaches and to use multiple methods to confirm the robustness of findings.

13. Problem??? Literature lack comparative statics There is absence of truly comparative focus Eg In model by Grossman &Kim (1995) stable property rights may emerge as an equilibrium but whether it is done in reality or not-it depends on parameters of technology- and it is hard to interpret Most models of imperfect markets & multiple equilibria Fail to provide explanation : Why markets are incomplete or imperfect? How some societies manage to get into good equilibrium while others are not.

14. How and Why things vary across countries? Markets are imperfect? Imperfection in information? Possibilities for opportunism? Ans : We believe that structure of markets is endogenous and partly determined by property rights. Once individuals have secure property rights there is equality of opportunity then Incentives are there to create and improve markets (achieving perfect markets is typically impossible So we can say “Differences in markets is an outcome of differing systems of property rights and political institutions”

15. Motivation “enforcement of the property rights of a broad cross-section of society” Some comparative studies in literature Baner jee and Newman (1993) Alesina & Rodrik (1994) Persson and Tabellini (1994) La Parta et al. ( 1998)

16. Second Approach 2- Geography institutions For geography institutions, the main theory is the geography hypothesis. The Geography hypothesis: suggests that geography plays a significant role in shaping economic institutions and development. Impact of physical characteristics such as: natural resources, climate, ecology and landscape on the development of economic institutions These characteristics determine both the preferences and opportunity set of individual economic agents in different societies

17. Geography Hypothesis Geography hypothesis - has a significant role in shaping economic institutions and development. Idea- the characteristics of a region ,( such as natural resources, climate , ecology, landscape) have a direct impact on the development of economic institutions and the way in which they function. R egions with abundant natural resources and favorable climate conditions are more likely to develop strong and effective economic institutions. R egions that are geographically isolated, have poor soil quality, or are subject to natural disasters are more likely to have weaker and less efficient economic institutions. Economic institutions are not solely the result of human choice or historical issues, but are also influenced by the physical environment in which they operate.

18. Three versions of geography hypothesis (each emphasizes a different mechanism Climate is an important determinant of work effort, incentives or even productivity. Montesquie (1748) talked about climate in his book “The Spirit of Laws”. Marshall (1890) came up with related views Geography may determine technology available to the society. Eg in Agriculture. Myrdal (1968) wrote on it and he was a nobel prize winner Poverty is linked to “disease burden”. Sachs (2000), Bloom & Sachs (1998) claim that prevalence of Malaria, a disease which kills million of children every year in Sub Saharan Africa, reduces the annual growth rate of Sub Saharan African economies by more than 1.3 percent a year.

19. Third Approach - Social Institutions For social institutions, one of the main theories is the cultural hypothesis. The culture hypothesis argues that cultural factors such as shared beliefs, values, and norms can have a significant impact on economic institutions and development. Another theory is the social capital theory, which suggests that social networks and relationships can be an important source of economic resources, such as information, trust, and cooperation.

20. Culture Hypothesis I dea- cultural norms and values influence the behavior of individuals and organizations in economic activities. In cultures that place a high value on trust and social capital, individuals and organizations may be more likely to engage in cooperative behavior and to establish long-term relationships. (This lead to the development of economic institutions that are more effective and efficient in managing risk and promoting economic growth). In contrast, in cultures that place a lower value on trust and cooperation, economic institutions may be more fragmented and less effective in managing risk and promoting economic growth. Economic institutions are not solely the result of economic factors, but are also influenced by cultural factors.

21. Contd … Culture can influence institutions. Greif (1994), Weber (1930) (1958) worked on culture Lan des (1998) highlighted religious differences Barro & McCleary (2003) also worked on related issues These differences play a role in “shaping economic performance”

22. Institutions Matter This section argues that there is convincing empirical support for the hypothesis that “ differences in economic institutions cause differences in income”. See the graph 403 Countries with secure property rights have higher average incomes.

23. Figure 1- page 403 shows the cross-country bivariate relationship between the log of GDP percapita in 1995 and a broad measure of property rights, "protection against expropriation risk , averaged over the period 1985 to 1995. The data on economic institutions – taken from Political Risk Services (a private company Assesses the risk that investments will be expropriated in different countries. These data, first used by Knack and Keefer ( 1995) and subsequently by Hall and Jones (1999) and Acemoglu , Johnson and Robinson (2001,2002) are imperfect as a measure of economic institutions, but the findings are robust to using other available measures of economic institutions. Findings -The scatter plot shows that countries with more secure property rights, i.e., better economic institutions, have higher average incomes

24. Contd …. The figure depicting a causal relationship (i.e., as establishing that secure property rights cause prosperity ). BUT there may be some problems with making such an inference. Reverse causation - perhaps only countries that are sufficiently wealthy can afford to enforce property rights . ( the causality might actually flow in the opposite direction. Wealthy countries may have the resources to enforce property rights effectively, rather than secure property rights directly causing prosperity) Omitted variable bias. It could be something else, e.g., geography, that explains both why countries are poor and why they have insecure property rights. I f omitted factors determine institutions and incomes- possibility of spurious inferernce in the existence of a causal relationship between economic institutions and incomes when in fact no such relationship exists. Knack and Keefer (1995) and Barro (1997 ) - tried to estimate the relationship between institutions and prosperity using Ordinary Least Squares. Resulted in biased regression coefficients

25. Contd …. S uppose that climate, or geography more generally, matters for economic performance. A simple scatterplot shows a positive association between latitude (the absolute value of distance from the equator) and income per capita. Montesquieu, not only claimed that warm climate makes people lazy and unproductive, but also unfit to be governed by democracy . He argued that despotism would be the political system in warm climates. Therefore, a potential explanation for the patterns we see in Figure 1 is that there is an omitted factor, geography, which explains both economic institutions and economic performance . Ignoring this potential third factor would lead to mistaken conclusions.

26. Contd … Even if Montesquieu's story appears unrealistic , still the general point should be taken seriously: T he relationship shown in Figure 1, and for that matter that shown in Figure 2, is not causal. T he effect of religion on economic performance, these types of scatterplots, correlations, or their multidimensional version in OLS regressions, cannot establish causality.

27. The Natural Experiments

28. Korean History Until the end of World War II, Korea was under Japanese rule. Korean independence in 1945- after the Japanese Emperor Hirohito announced the Japanese surrender on August 15, 1945. After this, Soviet forces entered Manchuria and North Korea and took over the control of these provinces from the Japanese . The major fear of the United States during this time period was the takeover of the entire Korean peninsular either by the Soviet Union or by communist forces under the control of the former guerrilla fighter , Kim Il Sung. U.S. authorities therefore supported the influential nationalist leader Syngman Rhee, who was in favor of separation rather than a united communist Korea .

29. Korean Story- A Natural Experiment In 1945, the two occupying powers agreed to divide Korea with the Soviet Union administering the north and the United States administering the south. The division was intended to be temporary, with the goal of eventually reunifying the country under a single government. T ensions between the two powers escalated. In 1948, separate governments were established in North and South Korea. Both adopted different type of institutions. The North established a communist government- where economic decisions were made by state not by market. The South established a democratic government

30. Contd …. In 1950, North Korea invaded South Korea, sparking the Korean War. The war ended in a stalemate in 1953, with the signing of an armistice agreement that established a demilitarized zone along the 38th parallel. Since then, North and South Korea have remained divided, with occasional tensions and military incidents . Efforts to reunify the country have been made over the years, but progress has been slow and difficult due to political, economic, and ideological differences between the two Koreas . North Korea – endowed with better natural resources. Industries by Japan

31. Figure 3 and further explaination Consistent with the hypothesis that it is institutional differences that drive comparative development, since separation, the two Koreas have experienced dramatically diverging paths of economic development (Figure 3 ) . L ate 1960's South Korea was transformed into one of the Asian "miracle " economies, experiencing one of the most rapid surges of economic prosperity in history while North Korea stagnated. By 2000 the level of income in South Korea was $16,100 while in North Korea it was only $1,000. By 2000 the South had become a member of the Organization of Economic Cooperation and Development (OECD), the rich nations club, while the North had a level of per-capita income about the same as a typical sub-Saharan African country. Different economic experiences on the two Koreas after 1950: their very different institutions led to divergent economic outcomes . Important point: the two Koreas not only shared the same geography, but also the same culture

32. The colonial experiment The colonization of much of the world - by Europeans - provides such a large scale natural experiment . Beginning in the early fifteenth century and massively intensifying after 1492 , Europeans conquered many other nations. The colonization experience transformed the institutions in many diverse lands conquered or controlled by Europeans. Europeans imposed very different sets of institutions in different parts of their global empire eg t he economic institutions in the northeast of America Plantation societies of the Caribbean As a result, while geography was held constant, Europeans initiated large changes in economic institutions, in the social organization of different societies. We will now show that this experience provides evidence which conclusively establishes the central role of economic institutions in development.

33. Plantation societies of the Caribbean R efer to the social, economic, and political systems that emerged in the Caribbean during the colonial period. These were based on large-scale plantations that produced cash crops such as sugar, coffee, tobacco, and cotton for export to Europe and North America. The plantation societies of the Caribbean were characterized by a hierarchical class structure- wealthy plantation owners at the top enslaved African people at the bottom. (slaves- who were forcibly brought from Africa to work on the plantations. Slaves had no rights or freedoms). The plantation economy was labor-intensive and required a large workforce. (Plantation owners relied on the slave trade - bring enslaved people to the Caribbean to work on their estates. Brutal conditions for slaves- physical and psychological abuse - harsh living conditions). The plantation societies of the Caribbean had a profound impact on the social and cultural development of the region. They shaped the cultural traditions, languages, and religions of the Caribbean, and contributed to the development of a distinct Caribbean identity. Still the region continues to struggle with issues of inequality, poverty, and social injustice.

34. The Reversal fortune The "reversal of fortune" is a phrase - refers to a sudden and unexpected change in someone's circumstances, especially when they experience a decline in their financial or social status. A dramatic shift in the fortunes of a nation. The reversal of fortune can occur due to a variety of factors : financial crisis, a major legal or political scandal, a health issue, or a sudden change in market conditions .

35. Contd … See figure 4,5,6,7,8,9 See the reversal among former colonies