Differences in Institutions is the Fundamental Cause of Long-Run Growth

We have often asked ourselves “Why are some countries so much poorer than others?”. Economics researcher AJR argued that accumulation of factors of production and endogenous growth are only proximate causes and that differences in institutions are the fundamental cause of differences in economic development. Endogenous growth theory imply that economic growth is primarily the result of internal forces, rather than external ones. It argues that improvements in productivity can be tied directly to faster innovation and more investments in human capital from governments and private sector institutions. Before highlighting why institutions are important, he defined institutions to be humanly devised constraints that shape human interaction. He then went on to argue that institutions matter because they determine how large transaction costs (information, negotiation and enforcement costs) are and who pays them. They, therefore, have an undeniable impact on the incentives of key players in societies and whether they choose to transact or not. With this impact in mind, we can state that good institutions are those that lower transaction costs and promote greater economic transactions. After highlighting the importance of institutions, AJR argued that economic institutions (such as property rights and legal systems) are endogenous ie. determined as collective choices of society, and because they determine the distribution of resources, there is bound to be conflict among groups over the choice of institution. Institutions arise out of this very conflict; whichever group has higher political power is likely to secure its preferred economic institution. Here, it is important to note that the distribution of political power is also endogenous and that it determines both economic and political institutions. While political institutions determine de jure political power, distribution of economic resources determines de facto political power. Given that political institutions are collective choices, AJR recognized 2 sources of persistence that prevent institutions from changing frequently and easily. Firstly, sufficiently large change in distribution of political power is needed to change the existing institutions. Secondly, holders of political power will bias the distribution of resources in their favor. Thus, the source of change that would allow institutions to transform lies in increases in the economic fortunes of outsider groups that will endow them with sufficient political power to challenge the established rulers and institutions. AJR further pointed that good economic institutions are likely to rise when there are checks on power holders, power is spread across groups and there is limited rent that power holders can extract.

Measuring institutions

While AJR provided us with why institutions are important and how and when they can and cannot be changed, it is also important to understand how to measure institutions. To measure institutions, researchers have created large databases where different aspects of institutions are scored with higher scores assigned to those with lower transaction costs. AJR provided us with some common measures of institutions such as protection against expropriation, rule of law, corruption etc. To further support his argument that institutions result in good economic performance, AJR demonstrated more than just a correlation between the common measures of institutions and country’s GDP per capita (eg: positive correlation between rule of law and GDP). Here, it is important to note that he showcased a correlation and not a causation. Causation explicitly implies that action A causes outcome B. On the other hand, correlation is simply a relationship between action A and B with no talk of causation.

Natural Experiments

To tackle issues of causality inherent in correlational studies, AJR found an exogenous source of variation in institutions. In an economic model, an exogenous variable is a variable that exists outside of the economic model. He looked at two natural experiments: the splitting of the two Koreas in 1945 and European colonization of the world. After the split, the two Koreas had radically different institutions while the geography and other potential determinants of economic development remained fixed. Owing to different institutions, South Korea experienced a rapid surge of economic prosperity while North Korea’s GDP stagnated. In the case of colonialism, Europeans encountered many different disease environments. In places where they could live, they established strong “home” institutions (eg: Canada) and where they were likely to die, they installed bad “extractive” institutions (eg: India). These institutional differences have persisted and continue to determine economic outcomes in once-colonized countries.

Source of inefficiency

This leads us to our final question: “If political and economic institutions are endogenous (determined by the society), why do inefficient institutions persist?” He argued that inefficient institutions continue due to commitment problems. Firstly, those in power cannot promise not to expropriate (taking property from its owner for public use or benefit) others in the future. Secondly, ascending power groups cannot promise to compensate incumbents for relinquishing power. Thirdly, those who would benefit from better institutions cannot promise to compensate those who would lose from them. All these factors prevent efficient institutions from taking shape in societies.

Thus, with the help of data and natural experiments, AJR showcased that given the distributional consequences of institutions, institutions are vital for economic growth and despite knowing that, commitment problems make it hard to replace inefficient institutions and establish efficient ones. In other words, differences in institutions result in differences in economic growth of countries.

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