ISSUES IN DEVELOPMENT

POLICY: IDEC 8003

LECTURE 3
The role of institutions in economic
development
 Key Issues
• The importance of institutions
• Measuring institutions
• The role of democracy
• The roles of both political and economic
institutions
• Conditions for economic growth
 A summary
• Institutions have been argued to be one of
the fundamental determinants of long-run
economic performance
• Institutions are humanly devised rules that
constrain behaviour
• Institutions facilitate social cooperation by
making interactions more predictable
• Good economic institutions are those which
incentivise productive economic activity
 Key factors in determining growth
• Demography (factor endowment)
– both quantity (including structure) and quality
of population (efficient unit of labour)
• The stock of knowledge
– cumulative process
• Institutions (political and economic)
– both formal and informal constraints and
enforcement

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 The role of institutions
• I wish to assert a fundamental role for
institutions in societies: they are the
underlying determinants of the long-run
performance of economies – Third World
countries are poor because the institutional
constraints define a set of pay-offs to
political/economic activity that do not
encourage productive activity.
Douglass North (1990)
 Low-cost of enforcement of
contracts
• North also said that ‘the inability of
societies to develop effective low-cost
enforcement of contracts is the most
important source of both historical
stagnation and contemporary
underdevelopment in the Third World’,
because the absence of secure property
rights discourage investment and
specialisation.
 Why institutions matter?
• All human interaction requires a degree of
predictability. Individual actions become more
predictable when people are bound by rules.
• Institutions are the rules of the game in a
society or, more formally, are the humanly
devised constraints that shape human
interaction.
• In consequence they structure incentives in
human exchange, whether political, social, or
economic.
• Institutional change shapes the way societies
evolve through time and hence is the key to
understanding historical change.
 The role of institutions and
uncertainty
• The major role of institutions in a
society is to reduce uncertainty by
establishing a stable (but not
necessarily efficient) structure to
human interaction.
• From conventions, codes of conduct,
and norms of behaviour to statute laws,
and common law, and contracts
between individuals, institutions are
evolving and, therefore, are continually
altering the choices available to us.
 Predictability
• All human interaction requires a degree of
predictability. Individual actions become
more predictable when people are bound by
rules.
 The rule of law
A Theory of Justice, 1971, John Rawls
• ‘A legal system is a coercive order of public
rules addressed to rational persons for the
purpose of regulating their conduct and
providing the framework for social
cooperation. When these rules are just they
establish a basis for legitimate expectations.
They constitute grounds upon which
persons can rely on one another and rightly
object when their expectations are not
fulfilled (p. 235)
 Definition of institutions
• North describes institutions as the ‘formal and
informal rules [or norms] governing human
behaviour’.
• Lin and Nugent (1995) define institutions as ‘a set
of humanly devised behavioural rules that govern
and shape the interaction of human beings, in part
by helping them to form expectations of what
other people do’.
• Institutions can be defined in terms of the extent
of property rights’ protections; the degree to which
laws and regulations are fairly enforced; the
ability of the government to protect the individual
against economic shocks and to provide social
protection, and the extent of political corruption.
 Institutions: A necessary
condition for market activities
• The reason why institutional structures and
rules of behaviour are a necessary condition
for economic activity to flourish is that
incentives and price signals, so vital to a
market economy, cannot function properly
without them.
• Rodrik (2008) says: ‘markets require
institutions because they are not self-
creating, self-regulating, self-stabilising, or
self-legitimising’.
 Five main types of market supporting
institutions for rapid economic progress
• Property rights and legally binding contracts:
market-creating institutions
• Regulatory institutions: market-regulating
institutions
• Institutions for macroeconomic stability: market-
stabilizing institutions
• Social insurance institutions: market-legitimizing
institutions
• Institutions of conflict management: market-
legitimizing institutions
 Five propositions about
institutional change (1)
1. The continuous interaction between institutions
and organizations in the economic setting of
scarcity and hence competition is the key to
institutional change.
2. Competition forces organizations to
continually invest in skills and knowledge to
survive. The kinds of skills and knowledge
individuals and their organizations acquire will
shape evolving perceptions about opportunities
and hence choices that will incrementally alter
institutions.

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 Five propositions about
institutional change (2)
3. The institutional framework provides the
incentives that dictate the kinds of skills and
knowledge perceived to have the maximum
pay-off.
4. Perceptions are derived from the mental
constructs of the players (the role of learning)
5. The economies of scope, complementarities,
and network externalities of an institutional
matrix make institutional change
overwhelmingly incremental and path
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dependent.
Which institutions are important?
• Which institutions are important will differ
across space and time according to the
history of a country, its geography, stage of
development and its political aspirations.
• In small rural communities, the scope for
cheating, fraud and not honouring contracts
is limited.
• In contrast, in large, modern societies,
where transactions are impersonal, there is
widespread scope for opportunistic
behaviour.
 Institutional arrangements in poor
countries that are absent (Rodrik
2000)
• A clearly defined system of property rights
• A regulatory apparatus curbing the worst
forms of fraud, anti-competitive behaviour
and moral hazard
• A moderately cohesive society exhibiting
trust and social cooperation
• Social and political institutions that mitigate
risk and manage social conflict
• The rule of law and clean government
 Measuring institutions
• An aggregate governance index
– Voice and accountability
– Political stability and absence of violence
– Government effectiveness
– Regulatory burden
– Rule of law
– Freedom from graft
• A measure of property rights and risk of
appropriation
• An index of corruption
 Three characteristics of good
institutions (Acemoglu 2008)
• The enforcement of property rights and the
rule of law, so that individuals have the
incentive to save, invest and take risks
• Constraints on those in positions of power
so that they cannot expropriate the
resources of a country for their own benefit
• Equal opportunities for all, so that everyone
has the incentive to better themselves and to
participate productively in society
 Institutions and geography
• ‘Quality of institutions is the only positive and
significant determinant of income levels. Once
institutions are controlled for, integration has
no direct effect on income, while geography
has but weak direct effects. These results are
very robust’ Rodrik and Subramanian (2008)
• ‘Geography has a strong indirect effect through
institutions by influencing their quality’ Rodrik
et al (2004)
 Institution and human capital
• The policy that allows greater scope for individual
choices (a key in building a harmonious society)
• The policy that produces freer entry and exit of
producers
• The policy that minimizes the distortions induced
from mobilising public sector revenue
• ‘If new institutions change incentives, the fraction of
the available human capital that is devoted to
producing and sharing ideas could continue to rise’
(Jones and Romer, 2010, p. 235)
• ‘An effective development strategy will seek the
mechanisms that increase a society’s capacity to
process information and ideas’ (Hausmann, 2009, p.
 The role of democracy
• The challenge for any government is to
provide leadership in resolving collective
action problems.
• Democracy can make this more difficult
because politicians can succumb to vested
interest groups and take short term decisions.
• On the other hand, dictatorships may have no
interest in maximising total output, and may
allocate resources very inefficiently.
• Democracy makes life difficult for corrupt
elites.
Rodrik (2000): several important
conclusions
• Democracies deliver more predictable long-run
growth rates
• Democracies produce greater short-term stability
• Democracies handle adverse shocks much better
• Democracies promote a fairer distribution of
income
• Democracies produce superior institutions better
suited to local conditions
• However, there is little evidence that the average
growth rate is higher in democracies than in more
autocratic regimes, but the variance around the
average is significantly lower in democracies.
Democracies and institution building
• Democracies deliver better institutional
outcomes because they tend to create more
equal opportunities for people.
• Democracy helps to build better institutions
based on local knowledge: ‘participatory
and decentralised political systems are the
most effective ones we have for processing
and aggregating local knowledge. We can
think of democracy as a meta-institution for
building other good institutions’ (Rodrik
2000).
 Democracy and development
• Most agree that democracy tends to follow
economic development, rather than precede it;
what is debated is the role of democracy in
sustaining development once it has started.
• Barro (2008) argues that democracy can
hamper growth in the early stages of
development by the tendency of majority
voting to support programmes that redistribute
income from rich to poor, involving tax
increases and other distortions that reduce
incentives.
Democracy and economic growth
• Democracies may give in to pressure groups
that redistribute resources to themselves.
• On the other hand, democracy is a check on
corrupt autocracies.
• Barro finds the relationship between
democracy and growth across countries is
weakly negative, but not statistically
significant.
• There is evidence of non-linearity: more
democracy increases growth when political
freedoms are weak but depresses growth when
a moderate degree of freedom has been
 What matters more?
• Barro concludes that ‘democracy is not the key
to economic growth;…advanced Western
countries would contribute more to the welfare
of poor nations by exporting their economic
systems, notably property rights and free
markets, rather than their political systems,
which typically developed after reasonable
standards of living had been attained’.
• Alesina and Perotti (1994) suggest that growth
is influenced not so much by the nature, but by
the stability, of the political regime.
 Lessons from history
• Chang (2003) documents that the now-
developed countries did not develop on the
basis of democracy.
• The lessons of history are that many
institutions deemed to be important for
developing countries today emerged after, not
before, economic development was taking
place.
• Institutional reforms in developing countries
should not be imposed from outside, but
should be allowed to evolve naturally,
internally.
Why Nations Fail (Daron Acemoglu and
James A. Robinson, 2012)
• How prosperity and poverty are determined
by the incentives created by institutions,
and how politics determines what
institutions a nation has,
• How institutions that encourage prosperity
create positive feedback loops that prevent
the efforts by elites to undermine them,
• How institutions that create poverty
generate negative feedback loops and
endure.
 The roles of both political and
economic institutions
• Countries rise when they put in place the right
pro-growth political institutions and they fail—
often spectacularly—when those institutions fail
to adapt. Powerful people always and everywhere
seek to grab complete control over government,
undermining broader social progress for their own
greed. Keep those people in check with effective
democracy or watch your nation fail.
• Inclusive political institutions in support of
inclusive economic institutions is key to sustained
prosperity.
 Human freedom and good
institutions
• ‘These freedoms strengthen men’s
sense of their own worth, enlarge their
intellectual and moral sensibilities, and
lay the basis for a sense of duty and
obligation upon which the stability of
just institutions depends’.
– A Theory of Justice, 1971, John
Rawls, p. 234
Conditions for economic growth
• Macroeconomic observations (K, L, TEC,
NR, etc)
• Microeconomics of change (structural
change)
• Micro foundations (entrepreneurs,
preferences)
• Institutional economics (norms and values)
 The central tenet of the
institutional economics
• A modern economy is a complex, evolving
system whose effectiveness in meeting diverse
and changing human purposes depends on
rules which constraint possibly opportunistic
behaviour.
• These rules are institutions: The rules that
govern human interaction are so decisive for
economic growth that the very survival and
prosperity of humankind depend on the right
institutions and the fundamental human values
that underpin them.
 Tutorial questions
1. Why are institutional structures and rules
of behaviour a necessary condition for
economic activity to flourish?
2. What institutions do you think are the most
important for encouraging investment in
developing countries?
3. In what ways can democracy help and
hinder economic development?
 Readings
• Chapter 4 in Economics of
Development (Thirlwall 2011).
• Many others