The Role of Formal Institutions on

Development

Chapter THREE
Keywords
 Values Principles, standards, or qualities that a society or
groups within it considers worthwhile or desirable.

 Institutions Norms, rules of conduct, and generally accepted

ways of doing things.

 Economic institutions are humanly devised constraints

that shape human interactions including both informal and
formal “rules of the game” of economic life in the widely used
framework of Douglass North.
Keywords
 Gross national income (GNI) The total domestic and
foreign output claimed by residents of a country. It comprises
gross domestic product (GDP) plus factor incomes accruing
to residents from abroad, less the income earned in the
domestic economy accruing to persons abroad.

 Gross domestic product (GDP) The total final output of

goods and services produced by the country’s economy, within
the country’s territory, by residents and non-residents,
regardless of its allocation between domestic and foreign claims.
Keywords
 Income per capita Total gross national income of a
country divided by total population.

 Real per capita Total monetary growth of GNI per capita

minus the rate of inflation.

 Functionings What people do or can do with the

commodities of given characteristics that they come to
possess or control.

 Capabilities The freedoms that people have, given their

personal features and their command over commodities.
Introducing Economic Development:
A Global Perspective
How the Other Half Live?
When one is poor, she has no say in public, she feels inferior. She has
no food, so there is famine in her house; no clothing, and no progress
in her family.
—A poor woman from Uganda

For a poor person everything is terrible—illness, humiliation, shame.

We are cripples; we are afraid of everything; we depend on everyone.
No one needs us.We are like garbage that everyone wants to get rid
of.
—A blind woman from Tiraspol, Moldova

Life in the area is so precarious that the youth and every able person
have to migrate to the towns or join the army at the war front in order
to escape the hazards of hunger escalating over here.
—Participant in a discussion group in rural Ethiopia
How the Other Half Live?
 When food was in abundance, relatives used to share it.These days
of hunger, however not even relatives would help you by giving you
some food. —Young man in Zambia

 [Poverty is] . . . low salaries and lack of jobs. And it’s also not having
medicine, food, and clothes. --Discussion group, Brazil

 Don’t ask me what poverty is because you have met it outside my

house. Look at the house and count the number of holes. Look at the
utensils and the clothes I am wearing. Look at everything and write
what you see.What you see is poverty. —Poor man in Kenya
‘’A universal theme reflected in these quotes is that poverty is more
than lack of income – it is inherently multidimensional, as is economic
development’’.
Figure 3.1: World Income Distribution
Economies as Social Systems:The Need to Go Beyond
Simple Economics…

….The need for Social Systems: Interdependent

relationships between economic and non-economic factors

….Success or failure of development policy: Importance of

taking account of institutional and structural variables
along with more traditional economic variables.
What Do We Mean by Development?
 Because the term development may mean different things to
different people, it is important that we have some working
definition or core perspective on its meaning.

 Without such a perspective and some agreed measurement

criteria, we would be unable to determine which country was
actually developing and which was not.
What Do We Mean by Development?
Traditional Economic Measures….

 Development has traditionally meant achieving sustained

rates of growth of income per capita to enable a nation to
expand its output at a rate faster than the growth rate of its
population.

 Levels and rates of growth of “real” per capita GNI are then
used to measure the overall economic well-being of a
population—how much of real goods and services is available
to the average citizen for consumption and investment.
What Do We Mean by Development?
Traditional Economic Measures….

 Economic development in the past has also been typically

seen in terms of the planned alteration of the structure of
production and employment so that agriculture’s share
of both declines and that of the manufacturing and service
industries increases.

 Development strategies have therefore usually focused on rapid

industrialization, often at the expense of agriculture and rural
development.
What Do We Mean by Development?
Traditional Economic Measures….

 Until recently development was nearly always seen as an

economic phenomenon in which rapid gains in overall and per
capita GNI growth would either “trickle down” to the masses
in the form of jobs and other economic opportunities.

 Problems of poverty, discrimination, unemployment, and income

distribution were of secondary importance to “getting the
growth job done.”

 The emphasis is often on increased output, measured GDP.

What Do We Mean by Development?
The New Economic View of Development…

 The experience of the 1950s and 1960s, when many

developing nations did reach their economic growth targets
but the levels of living of the masses remained for the
most part unchanged, signalled that something was very
wrong with this narrow definition of development.

 Moreover, the degree of income inequality varies

sharply from the developed world to the developing world,
as well as among countries and entire regions.
What Do We Mean by Development?
The New Economic View of Development…

 Leads to improvement in wellbeing, more broadly understood.

 Amartya Sen’s “Capability” Approach

 Functioning’s as an achievement
 Capabilities as freedoms enjoyed in terms of functioning’s
 Development and happiness
 Well being in terms of being well and having freedoms of
choice
 “Beings and Doings”:
What Do We Mean by Development?
The New Economic View of Development…

 Some Important “Beings” and “Doings” in Capability to function:

 Being able to live long
 Being well-nourished
 Being healthy
 Being literate
 Being well-clothed
 Being mobile
 Being able to take part in the life of the community
 Being happy – as a state of being - may be valued as a
functioning
What Do We Mean by Development?
 Three Core Values of Development

 Sustenance: The Ability to Meet Basic Needs

 Self-Esteem: To Be a Person

 Freedom from Servitude: To Be Able to Choose

Figure 3.2: Income and Happiness: Comparing Countries
What Do We Mean by Development?

 The Central Role of Women

 To make the biggest impact on development, societies must

empower and invest in women

 The Three Objectives of Development

 Increase availability of life-sustaining goods

 Raise levels of living

 Expand range of economic and social choices

The Millennium Development Goals

 Millennium Development goals (MDGs): Eight goals adopted by

the United Nations in 2000
 Eradicate extreme poverty and hunger

 Achieve universal primary education

 Promote gender equality and empower women

 Reduce child mortality

 Improve maternal health

 Combat HIV/AIDS, malaria, and other diseases

 Ensure environmental sustainability

 Develop a global partnership for development

Table 3.3: Millennium Development Goals and Targets for 2015
MDGs and Targets for 2015 (cont’d…)
Sources of growth and development, and the
status
 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?
Sources of growth and development…
 The factors that determine economic development are
debatable ….

 And institutions are one of the recent interest and debatable

factors that determine current economic performance.

 Institutions could vary because underlying factors differ across

countries. Potential fundamental causes:
– Geography, ecology, climate
– Culture
– Perhaps other factors?
Sources of growth and development…
….Endowment View on Economic Growth

 Montesquieu’s story:
 Geography determines “human attitudes”

 Human attitudes determine both economic performance

and political system.

 Institutions potentially influenced by the determinants of

income.
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, while vigorous people could be governed by democratic
regimes; thus hot climates are conducive to authoritarianism and
despotism.

 Jeff Sachs argues “Economies in tropical ecozones are nearly

everywhere poor, while those in temperate ecozones are generally rich”
b/c certain parts of the world are geographically favoured. Geographical
advantages might include access to key natural resources and the
coastline and sea... advantageous conditions for agriculture and human
health.”
Sources of growth and development…

Montesquieu’s Story
Empirical pitfalls of correlations and OLS
estimates
 Montesquieu’s story example of omitted variables bias and
identification problem.

– Other omitted factors---human nature, culture, geography--- vary across

countries and affect economic performance.

– They also are correlated with or have a causal effect on institutions.

– Similar problem affects inferences about geography on income;

potentially correlated with omitted variables.

 Reverse causality: – Income affects institutions.

 Attenuation bias: – Measures of institutions poorly correspond

to conceptual measures, creating “errors in variables” problem.
Need for exogenous variation
 Exploit “natural experiments” of history, where some
societies that are otherwise similar were affected by historical
processes leading to institutional divergence.

…Building towards an “instrument” for institutions;

 a source of variation that affects institutions, but has no other effect,
independent or working through omitted variables, on income.

 Examples of potential natural experiments of history:

1. South versus North Korea
2. European colonization
3. Chinese experience….reading
The Korean experiment
 Korea: economically, culturally and ethnically homogeneous at
the end of WWII. 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 North

and South.

 Approximating an experiment where similar subjects are

“treated” differently.
The Korean experiment
 Big differences in economic and political institutions.
 Communism (planned economy) in the North.

 Capitalism, albeit with government intervention and early on without

democracy, in the South.

 Massive differences in economic performance.

The Korean experiment

GDP per capita

Culture?
 Culture is a relatively fixed characteristic of a group or nation,
affecting beliefs and preferences. Example: religion

 At some level, culture can be thought to influence equilibrium

outcomes for a given set of institutions.

 The most famous link between culture and economic

development is that proposed by Weber (1930) who argued
that the origin of industrialization in western Europe could be
traced to the set of beliefs about the world.

 See more evidence in this matter…

Do Institutions matter for prosperity?
 Evidence so far that institutions important for cross-country
differences in prosperity and long-run growth.

 Countries with “better” institutions prosper, while those with

“bad” institutions stagnate or decline.

 But what is the magnitude of the effect? How much of

differences in prosperity can be explained as a result of
institutions?

 We need an empirical framework to estimate causal effect of

institutions on economic outcomes.
Institutions matter for prosperity
 There is a widespread agreement among economists studying
economic growth that institutional quality holds the key to
prevailing patterns of prosperity around the world.

 Rich countries are those where investors feel secure about

their property rights, the rule of law prevails, private
incentives coupled with solid macroeconomic institutions.

 Poor countries are those where these arrangements are absent

or ill-formed.

 See IP-Article…
Institutions matter for prosperity

Figure 3.4: Institutions and economics performance (1)

Institutions matter for prosperity

Figure 3.4: Institutions and economics performance (2)

 Institutions matter for prosperity
 North’s theory of institutional change explains that formal
institutions are a crystallization of informal ones (North,1990), and
that both co-evolve through the operation of organizations
(informal and formal social groups, from households and villages to
networks, firms, parties, and governments).

 Institutions are designed by individuals who are acting rationally

and free of constraints: “institutions are a set of rules, compliance
procedures and moral and ethical behavioural norms designed to
constrain the behaviour of individuals in the interests of
maximising the wealth or utility of the principals.
Institutions, geography, or culture?
 Although there is correlation between institutions and
economic development, this does not establish that this is
a causal development. Why?

 See #Article_1
 Theory in Action: 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.

 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

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; East India

Company and Spanish crown limited settlements.

 Look for exogenous variation in European settlements: the

disease environment.
Back to the Colonial Experience….
 In some colonies, Europeans faced very high death rates
because of diseases for which they had no immunity, in
particular malaria and yellow fever.

 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 high
death rates because of diseases for which they had no
immunity, in particular malaria and yellow fever.