The Role of Formal Institutions on

Development

Yardstick International College (YIC)

Motivation

Economic Development
• Development: Growth plus Change
• Growth: sustained improvement in the level of per capita
income
• Change: sustained improvement in institutions and
organizations that support growth
Growth
• Gross Domestic Product (GDP): Market value of all final goods
and services an economy produces in one year
• Real GDP: GDP in constant prices
• GDP Per Capita=(Real GDP/Population) or income per person
• Economic Growth=percentage change in Real GDP percapita
Motivation

• There are vast differences in per capita incomes between the

most developed countries and the least developed countries.
• In 1820, the average living standard between the West and all
other regions differed by about factor two,
• High income countries were on average 21 times wealthier
than their low income counterparts
• Average income levels in the world’s richest and poorest
nations differ by a factor of more than 100
• Sierra Leone, the poorest economy for which we have
national income statistics, has a per capita GDP of $490,
compared to Luxembourg’s $50,061
Sources of growth and development

Few questions have been at the forefront of empirical growth research

recently????
• What are the deep and robust determinants of economic growth?
• How can the differing convergence experiences of different countries
be explained?
• What accounts for these differences, and what (if anything) can we
do to reduce them?
• What are the fundamental causes of the large differences in income
per capita across countries?
• Similarly, the degree of income inequality varies sharply from the
developed world to the developing world, as well as among countries
and entire regions
Sources of growth and development

• There is still little consensus on the answer to this question

• There is general agreement that the factors determining
Economic Development are debatable
• One such area of recent interest and debatable factors are
institutions
• How formal institutions?
• What are the empirical evidences?
• Are institutions the cause of current economic performance?
Institutions and Economic
Development
(Q) How do institutions form?

Efficiency or Social Conflict view of Institutions:

(1) Institutions affect economic outcomes but society will
choose those institutions that maximise social surplus (North
and Thomas, Demsetz).
(2) Institutions are not always chosen by all of society but
instead by the few, hence not efficient. Coase Theorum does
not apply, i.e. the winners do not fully compensate the losers.
(3) North (1981) argues that institutions act to constrain the
individual in order to enhance the welfare of the ‘principals’.
Cont…

(Q) How do institutions form?

Institutions can and will likely result in an elite forming who

will attempt to retain their position of power. There may be
successful or may not be, but they can be replaced by an
alternative elite.
Institutions and Economic Development

Fundamental Causes of Growth

Economics Institutions: encouraging investment through

incentives, human capital, entrepreneurship, innovation,
occupational choice, land ownership.

Cultures: values, beliefs, religions

Geography: climate (affect productivity and worker effort),

agricultural (technological) productivity higher in temperate
zones than in tropics, burden of infectious diseases, natural
endowments, transport costs

Trade and Integration: affects productivity changes.

Sources of growth and development

Endowment View on Economic Growth

• First, there is a long and distinguished line of theorizing that
places geography at the center of the story
• It essentially argues that geographical factors directly shape the
output, income distribution or technology adoption in the
society
• Geography is a key determinant of climate, endowment of
natural resources, disease burden, transport costs, and
diffusion of knowledge and technology from more advanced
areas
• It exerts therefore a strong influence on agricultural
productivity and the quality of human resources
Sources of growth and development
• Direct Impact of Geography
• The endowment view claims that natural resources to
population determine the productivity and technology
in production
• Montesquieu: (Hypothesis)
• “The heat of the climate can be so excessive that the body
there will be absolutely without strength. So, prostration will
pass even to the spirit; no curiosity, no noble enterprise, no
generous sentiment; inclinations will all be passive there;
laziness there will be happiness.” “People are...more vigorous
in cold climates. The inhabitants of warm countries are, like old
men, timorous; the people in cold countries are, like young
men, brave.”
Sources of growth and development

• Direct Impact of Geography

• Moreover, Montesquieu argues that lazy people tend to be
governed by despots/dictator/, while vigorous people could be
governed by democratic regimes; thus hot climates are conducive
to authoritarianism and despotism.
Sources of growth and development
• Jared Diamond:
• Importance of geographic and ecological differences in determining
agricultural technology and availability of crops and animals.
• Jeff Sachs:
• “Economies in tropical ecozones are nearly everywhere poor, while
those in temperate ecozones are generally rich” because “Certain
parts of the world are geographically favored. Geographical
advantages might include access to key natural resources, access to
the coastline and sea...advantageous conditions for agriculture,
advantageous conditions for human health.”
• “Tropical agriculture faces several problems that lead to reduced
productivity of returning crops in general and of staple food crops in
particular.”
Montesquieu’s Story
Montesquieu’s Story

• Montesquieu’s story example of omitted variables bias and

identification problem.
• Exploit “natural experiments” of history, where some societies that
were otherwise similar were affected by historical processes leading to
institutional divergence.
• Examples of potential natural experiments of history:
• 1 South versus North Korea.
• 2 European colonization.

• Generally, the underlying narrative of the geography hypothesis is that

the natural endowments of the country determine the development path
of a country, and this becomes the destiny of the country
The Causal Effect of Institutions on Prosperity

• This hypothesis is contested by the institutional hypothesis, which

states that institutions are more important than geography in
explaining economic growth and development.
• While agreeing that absolute geography does have an impact on
growth and development, it is relegated to a secondary role, one in
which it influences the type of institutions that develop in these
countries.
• Evidence so far that institutions important for cross-country
differences in prosperity and long-run growth.
• But what is the magnitude of the effect?
• How much of differences in prosperity can be explained as a
result of institutions?
Back to the Colonial Experience
• Theory →
• Those with political power more likely to opt for good
institutions when they will benefit from property
rights and investment opportunities.
• Better institutions more likely when there are
constraints on elites.
• The colonial context:
• Europeans more likely to benefit from good institutions
when they are a significant fraction of the population, i.e.,
when they settle.
• Lower strata of Europeans place constraints on elites when
there are significant settlements.
• Thus: European settlements → better institutions
• Eg Canada, USA & Australia
Back to the Colonial Experience

• But European settlements are endogenous.:

• They may be more likely to settle if a society has greater resources
or more potential for growth.
• Or fewer settlements when greater resources;
• Eg East India Company and Spanish crown limited settlements.
• Look for exogenous variation in European settlements: the disease
environment
• In some colonies, Europeans faced very high death rates because of
diseases for which they had no immunity, in particular malaria and
yellow fever.
Back to the Colonial Experience

• potential mortality of European settlers → settlements

→institutions
• Moreover, for many reasons already presented, institutions
persist. So:
• potential mortality of European settlers → settlements → past
institutions → current institutions
Empirical evidence

• Acemoglu et al. (2001) exploit the differences

in the mortality rates faced by European
colonialists to estimate the effect of institutions
on economic performance.
 Institutions and Economic Development

Primacy of Institutions
Acemoglu et al control for settler mortality as an instrument to control for
endogeneity in their growth model. The variables in the model are
M = settler mortality
S = Colonial Settlements
R = Early Institutions and Modern Institutions
Y = Economic Performance

Settlements lead to the export of colonial institutions such as property rights.

Where settlements failed or were not attempted (due to high settler mortality) only
extractive institutions were exported.

Institutional Proxy is captured by either index of protection against expropriation or by

constraints on the executive.
Institutions and Economic Development

The Model – 2 SLS

LogYi =  +  Ri + X i + ui
Y = GDP per capita in1995in $ ( PPP a day).
64 countriesin the sample
R = Institutional Pr oxy
X = Other controls
Ri = a + b log M i + cX i + vi
M = Settlermortality17th − 19th ce
Institutions and Economic Development
Institutions and Economic Development

• The ‘b’ coefficient (mortality variable) in the first stage of the

regression is negative and significant – higher mortality rate the
worse institutions are.
• The beta coefficient is positive and significant implying
institutions have a positive impact on current GDP level.
• The introduction of latitude in line with Rodrik’s work does
not change the main result.
• If the US, Canada, Australia and New Zealand are omitted
then the results are still robust.
Main results and arguments
1. Europeans adopted different colonization
policies in different colonies, with different
associated institutions.
2. Choice of colonization strategy was in part
determined by whether the Europeans could
settle in the colony.
3. Where Europeans faced high mortality rates,
they could not settle and they were more
likely to set up worse (extractive) institutions.
4. If they could settle, superior growth
supporting institutions were established
Institutions and Economic
Development
5. The early institutions persisted to the present.

• Estimates imply that differences in institutions

explain approximately ¾ of the income per
capita differences across former colonies.
Institutions and Economic
Development
Glaeser et al estimate the following equation…

Results are as follows (2004, pp.35)…..

Institutions and Economic Development
Institutions and Economic Development
Interpretation

Coefficient on Initial level of schooling is always +ve and

significant.

So to the coefficients on Initial GDP per capita (-ve and

significant) and Share of Population living in Temperate Zone
(+ve and significant).

The beta coefficients are only significant when the institutional

proxies stand for outcomes (expropriation risk (82-90) or
government effectiveness (98-2000).
Other proxies for institutions such as judicial independence or
constitutional review are insignificant.
Institutions and Economic Development

What can we say about institutions and Development?

Measuring institutions is difficult. Popular measures are subject to criticism

since they are
Looking at country specific evidence though both the Institutional View
and the Developmental View have strengths but are not universal.

Development View - Some countries have very different initial institutions

and different histories, but have the same level of economic development
and have very similar current institutions, e.g. Tiger Economies - Taiwan
and South Korea with Japanese colonialisation then US occupation
compared to Hong-Kong and Singapore with British colonial past and less
intervention)
Institutions and Economic Development

Institutional Primacy View – Countries have similar

backgrounds and histories but start from different
institutions and hence diverge onto different growth
paths.

E.g. North and South Korea, East and West

Germany, Burma and Thailand.
The Korean Experiment
• Korea: economically, culturally and ethnically homogeneous at
the end of World War II.
• If anything, the North more industrialized.
• “Exogenous” separation of North and South, with radically
different political and economic institutions
• Exogenous in the sense that institutional outcomes not related
to the economic, cultural or geographic conditions in the North
and in the South.
• Approximating an experiment where similar subjects receive
different “treatment.”
• Big differences in economic and political institutions.
• Communism (planned economy) in the North.
The Korean Experiment

• Capitalism, albeit with heavy government intervention and initially

without democracy, in the South.
• Vast differences in economic performance.
The Korean Experiment
Collier (2007): The Four Traps

• 1. Conflict Trap
• Wars and coups or conflicts keep poor nations from
growing and therefore keep them dependent upon the
exports of primary products.
• In turn, because these nations stay poor, stagnant,
and dependent on primary products, they are
susceptible to wars and coups.
• Wars ‘and coups feed on themselves in...ways that
make history repeat itself’.
Collier (2007):
• 2. Natural Resources Trap
• A country with abundant natural resources will tend to
export these resources. These resource exports cause
the exporting country’s currency to appreciate against
other currencies.
• This appreciation makes the resource exporting
country’s other (non-resource) exports uncompetitive
(Dutch Disease).
• These now uncompetitive exports would have been
the best vehicles for technological progress in this
resource abundant country. This is the natural
resources trap.
Collier (2007):

• 3. Trap of Being Landlocked with Bad Neighbors

• Transport costs for a landlocked country depend greatly on how
much its coastal neighbor spends on transport infrastructure.
• Put differently, ‘‘landlocked countries are hostages to their neighbors”

• 4. Trap of Bad Governance in a Small Country

• In some small nations, bad governance persists for extended
periods of time as not everybody loses from bad governance.
• ‘Leaders of many of the poorest countries in the world are
themselves among the global superrich.
• They like things the way they are, and so it pays to keep their
citizens uneducated and ill-informed’.
Collier on Trade
• International trade has done great things
for Asia
• For Africa, international trade is more ‘likely
to lock yet more of the bottom-billion countries
into the natural resource trap than to save
them through export diversification’.
Institutional quality indicators
• Institutional quality is a broad concept that
captures law, individual rights and high quality
government regulation and services
• institutions should be viewed as a basic
requirement for economic success and long term
progress.
• Institutional quality and economic development
reinforce each other over the longer term,
• but we argue that institutional quality leads this
virtuous circle
•
indicators
I. World Governance indicators (WGI)
• Developed by WB and consist of six composite indicators of broad
dimensions of governance covering over 200 countries since 1996
• construct two measures of governance corresponding to each of
these three areas, resulting in a total of six dimensions of
governance:
• Voice and Accountability, Political Stability and Absence of
Violence/Terrorism, Government Effectiveness, Regulatory Quality, Rule of
Law, and Control of Corruption.
• These indicators are based on several hundred variables obtained from 31
different data sources, capturing governance perceptions as reported by
survey respondents, non-governmental organizations, commercial
business information providers, and public sector organizations worldwide
• reflect the perceptions of a very diverse group of respondent
I. The process by which governments are
selected, monitored, and replaced:
1. Voice and Accountability (VA) – capturing
perceptions of the extent to which a country's
citizens are able to participate in selecting their
government, as well as freedom of expression,
freedom of association, and a free media.
2. Political Stability and Absence of
Violence/Terrorism (PV) – capturing perceptions
of the likelihood that the government will be
destabilized or overthrown by unconstitutional or
violent means, including politically-motivated
violence and terrorism.
II. The capacity of the government to effectively formulate
and implement sound policies:

3. Government Effectiveness (GE) – capturing perceptions of

the quality of public services, the quality of the civil
service and the degree of its independence from political
pressures, the quality of policy formulation and
implementation, and the credibility of the government's
commitment to such policies.
4. Regulatory Quality (RQ) – capturing perceptions of the
ability of the government to formulate and implement
sound policies and regulations that permit and promote
private sector development.
III. The respect of citizens and the state for the institutions
that govern economic and social interactions among them:

5. Rule of Law (RL) – capturing perceptions of the extent to

which agents have confidence in and abide by the rules of
society, and in particular the quality of contract
enforcement, property rights, the police, and the courts,
as well as the likelihood of crime and violence.
6. Control of Corruption (CC) – capturing perceptions of the
extent to which public power is exercised for private gain,
including both petty and grand forms of corruption, as
well as "capture" of the state by elites and private
interests.

www.govindicators.org
II. Ease of Doing Business
• captures a multitude of aspects that determine the extent to which the
regulatory environment is conducive to business operation.

• The Ease of doing business index ranks countries against

each other based on how the regulatory environment is
conducive to business operation, stronger protections of
property rights.
•
• There are 10 parameters of Ease of Doing Business:
• Easy of Starting a Business,
• Dealing with Construction Permits,
• Getting Electricity,
• Registering Property,
• Getting Credit,
• Protecting, Minority Investors,
• Paying Taxes,
• Trading across Borders,
• Enforcing Contracts and
• Resolving Insolvency.
The World’s Best and Worst Places for Ease of Doing Business