Economics of Development Chapter 8 Role of Institutions

Economics of Development Chapter 8. Role of Institutions in Development Process • • • Defining Institutions Role of institutions Measuring institutions Institutions versus geography Role of democracy 1

Economics of Development North Said (1990) in his book 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. North also said 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 and contractual rights discourages investment and specialization. Mancur Olson (1982) makes the same 2 point in his classic book, The Rise and Decline of Nations.

Economics of Development Definition: North (1990) describes institutions very broadly as the ‘formal and informal rules [or norms] governing human behaviour’. A similar broad definition is given by Lin and Nugent (1995): ‘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’. At a more formal, precise, level, institutions can be defined in terms of: • the extent of property rights’ protection • the degree to which laws and regulations are fairly enforced • the ability of government to protect the individual against economic shocks and provide social protection 3 • the extent of political corruption.

Economics of Development Why Institutions are required? • Rodrik (2008) says: ‘markets require institutions because they are not self-creating, self-regulating, self-stabilising, or self-legitimising’. Which institutions are important and which are not will differ across space and time according to the history of a country, its geography, stage of development and its political aspirations, that is, what sort of society its people want. In small rural communities where everyone knows each other, the scope for cheating, fraud and not honouring contracts is limited. Transaction costs associated with the costs of information, negotiation, monitoring, coordination and enforcement of contracts are low, and communities survive by adhering to norms of behaviour; but economic development is limited through a lack of 4 specialization.

Economics of Development In contrast, in large, modern, industrial societies, where transactions are impersonal, there is widespread scope for opportunistic behaviour (Bardhan and Udry, 1999). Transactions (and therefore production) costs may be very high without institutional structures that curtail such behaviour, such as the enforcement of property rights and the rule of law, the provision of limited liability, the guarantee of contracts, patent protection and so on. With low transaction costs, firms and markets can concentrate on the job of investment in the knowledge that property rights are secure. 5

Economics of Development Main Types of Institutions • • • Property rights and legally binding contracts Regulatory Institutions of Macroeconomic Stability Social Insurance Institutions of conflict management 6

Economics of Development Measuring Institutions Several indicators exist to guage strength and quality of institutions • Aggregate governance index (Kaufman et al. 1999) • Measures of property rights and expropriation risk (International Country Risk Guide) • Index of democracy, political rights and civil liberties (Gastil, 1983) • Political instability (Barro, 1991) • Index of corruption (Transparency International) • Economic freedom index (Heritage Foundation) • Index of social divisions 7

Economics of Development Institutions versus Geography • To estimate impact of institutions on development, an exogenous measure of institutions needed unrelated to development itself • Acemoglu et. al. argue early colonial institutions determined current institutions • In some countries only ‘extractive states’ created because of disease and high settler mortality. In others, European institutions were copied with property rights and rule of law. This is the influence of geography • Acemoglu et. al. test model that institutions matter by relating differences in income per capita today to early settler mortality rates • Many countries have experienced reversal of development fortunes which geography can’t explain because geography fixed e. g. Africa 8 once richer than Asia and now poorer

Economics of Development Role of Democracy • • Importance of democracy for development controversial • • Dictatorships bread corruption • Today’s developed countries did not develop on the basis of democracy Democracy can make strong leadership difficult because politicians succumb to vested interests But non-democratic regimes can still give freedom and economic rights e. g. China Research shows democracies: • Deliver more predictable long-run growth rates • Produce greater short term stability • Handle adverse shocks better • Promote fairer distribution of income 9

Economics of Development Summary • Development requires supportive institutional structures, particularly secure property rights and rule of law • Several measures of institutions used in empirical work: property rights and expropriation risk; index of democracy; index of corruption; etc. • Not easy to measure impact of institutions on economic development because institutional development itself a function of development • One measure of current institutions is mortality rates of early colonial settlers which determined nature of institutional development • Institutions more important than geography if fortunes of countries change, but geography partly determines institutions • Democratic countries perform better than autocracies • History teaches institutions should evolve naturally internally, not be imposed from outside 10

Economics of Development Websites • • • Transparency International www. transparency. org Heritage Foundation www. heritage. org Center for Global Development www. cgdev. org Food and Agricultural Policy Research Institute www. fapri. iastate. edu Freedom House https: //freedomhouse. org/ 11