What are institutions?

Institutions are basically the rules of the game, but the accurate description would be: institutions
are humanly devised constraints that structure human interaction (Douglas North). Some examples
of institutions would be form of government, labour institutions, tax systems, legal systems or
property rights.
The main objective of institutions is to put boundaries on human actions, and are imposed by human
societies, with this, we can say that institutions shape incentives of individuals and governments.
Individuals are incentivised to invest in physical and human capital thanks to those existing
institutions (for example, when the state grants propriety rights, entrepreneurs are way more willing
to invest). On the other hand, governments are incentivised to provide public goods (for example, in
order to be re-elected, the government must provide more and better public services)

Two problems with institutions:

1. Conceptual problem: the definition of institutions is very ambiguous, as we could also

include what we call "informal institutions" (sanctions, taboos, customs, traditions or
codes of conduct). Formal institutions would be the ones stated in the beginning.

2. Methodological problem: institutions are endogenous to economic growth, meaning that

we see that we see better and more developed institutions in richer countries. However,
we cannot assume that this correlation indicate causation. We cannot determine if a
country is democratic (for instance) because is rich, or if the country is rich because it has
a democratic system

How we solve this problem?

An study conducted in 2002 (Bocksette, Chanda and Putterman, 2002) tried to confirm that countries
which have had strong presence of state since the antiquity, have a more developed economy in the
present. This study used an index to check the state presence in the selected countries. Again, the
correlation between state presence and economic development turned out to be positive.

The presence of state, however, does not necessarily explains economic growth, as governments can
implement beneficial or negative policies for development. This leaves us the question of what are
good institutions. We can differentiate between two groups of institutions:

● institutions related to property rights: these refer to how easily property can be
expropriated
● contracting institutions: refers to which is the degree of protection both parts of a
contractual partnership have (laws and legal system, for instance)

The states that provide this two institutions tend to have a more developed economy. We can see,
for example, a positive relation between protection of property rights and economic development,
and the same happens with countries that have efficient legal systems. In conclusion, we can say that
when this two institutions exists on a high degree, people have more incentives to invest.

How institutions are created?

Four views on this topic:

1. Ideology view: This theory claims that institutions are determined by the ruling ideology
or culture of the country

2. The incidental institution view: This theory says that institutions are determined by
random historical events (for example, if two countries were colonised, but the level of
colonisation was different, the two countries will have different institutions)

3. Efficient institution view: This theory claims that countries chose the institutions which
turns out to be the more efficient for the economic development of the country.
However, there is a problem in this theory, called the commitment problem. According to
this problem, transitions form one system to another more efficient one are difficult, as
the balance of political power change with the new system, and the different parties
cannot agree on a solution.

4. The social conflict view--> institutions are not decided by the majority, but by different
groups that hold the political power--> this groups engage in a negotiation process to
decide the new ruling system (can be violent or pacific)--> the distribution of power-->
two type--> political power de jure, have the power to make laws--> political power de
facto, depends on the control of economic resources and influence over people-->
political institution determine who has de jure political power; who have the resources
have de facto political power--> de facto political power determines political institutions,
and de jure political power determines the economic institutions--> economic
institutions determine the economic performance and distribution of resources--> if the
same people who hold the majority of resources has also political de jure power-->
dictatorship

Can institutions explain the rise of Europe

North and Thomas 1973: "The rise of the western world": Western world rose due to efficient
economic system. Property rights were a determinant factor create incentives to innovate and invest
production.

In this book, it is stated that in the territories of Europe where the property rights were granted, the
economy began to develop earlier:

● England and Netherlands turned out to be very successful, due to protecting property
rights of merchants, as the states benefited from trade
 ● Spain was unsuccessful, as the king did not protect property rights, which meant that
king could expropriate any private property.

● France was unsuccessful, but not because property rights were not protected too
protected. In fact it was the other way. As property rights were too protected, the market
was inefficient due to creation of monopolies and barriers of entry.

We see than, that having property rights is not enough: too protection over property rights is not
good for economic growth

Political institutions and property rights

England was successful mainly thanks to the revolution that occurred in 1688, also called the
Glorious Revolution. A constitutional change was made after the Glorious Revolution, from absolute
monarchy to a more liberal system. In this new system property rights were secured in addition to
the protection of wealth.

Stuart's England:

● Limited credible commitments to property rights

● Stuart had problems rising revenue

● Crown solution: raised customs revenues, forced loans, monopoly grants, power
purveyance, selling hereditary titles. This were inefficient, and created no economic
development

● Stuart king had all the political power. The king was able to extract resources
from the territory

After revolution:

● Crown could not call and disband parliament

● Parliament gained direct role in financial matters, and acted as a counter-power to the
king

● England's credible commitments to secure propriety rights, as the king was forced by
parliament

The predictability of the government and taxation improved. Increase in government

expenditure. Rise of banks and securities. Falling private interest rates.

Can institutions explain underdevelopment?

Main historical moment when the institutions established turned out to be decisive for future
economic growth is colonialism.

There are two views to understand the differences between countries colonised: identity of
colonizers and conditions of colonies

Identity of colonizers

Legal systems

The areas colonized by France or Spain, civil law was implemented. On the other hand, the countries
that were colonized by the UK adopted the common law

When judges have more discretional power, loke in the case of common laws, the legal system tends
to be more flexibility, which means more efficiency. As investors had more legal coverture, the
incentives to invest were greater. By this, we can say that common laws turns out to be a better
institution for economic development.

Conditions of colonies

According to this view, it does not matter whether you were colonized by, the key factor to explain
economic growth are the conditions those colonies had.

Settler mortality

The level of mortality potential settlers would face when arriving the colony determined the size of
the new settlements. The size of those new towns and cities in the colonies determined, at the same
time, the institutions that would be established in the colony. The early institutions created in the
colonies, are related to the actual institutions we find in the territories that were colonised, and this
actual institutions explain the level of development.

We find out that, when the settler mortality was low, the institutions established in a colony were
better. The impact of this good institutions perdured over time, which end up meaning a high degree
of development. In colonies where only a small share of the population were settlers, the institutions
established only protected the rights of European colonizers, and enabled to use forced labour and
extraction of natural goods. The effects of this bad institutions also perdured over the centuries,
resulting in a low level of development.

Engerman and Sokoloff (1997, 2002) explain the variation in development between South and North
America. They stated that the importance of factors endowment and colonial rule.

South America was suitable to stablish large-scale plantations of globally traded crops and extraction
of minerals using forced or semi-forced labour. The evolution of these areas was characterized by
increasing economic and political inequality. This resulted in domestic institutions protecting the
privileges of the elites and restricting the participation of the population, with high costs in terms of
economic development.

Negative relationship between various measures of economic development and past slave use have
been found: U.S. states (Mitchener and McLean 2003) or counties (Lagerloff 2005) or across New
World countries (Nunn 2008). Nunn (2008) finds positive relationship between slavery and inequality
in the size of land holdings. However, he doesn't find relationship between initial economic
inequality and current income levels.

Type of economic activity

Bruhn and Gallego (2012) “Good, bad and ugly colonial activities: Do
they matter for economic development?"

In the colonies situated in South America, the effects of "bad" economic activities (those that relied
on using forced labour) left more negative effects than the positive effects that "good" activities left.

Bad: Activities such as mining and sugar production that involved economies of scale and
exploitation of labour.
Good: Activities such as subsistence crops, cattle raising, and manufacturing, with no exploitation of
labour
Ugly: “Bad" activities that relied on the native population as an exploitable resource.

Another example: Border effects

In Africa, during colonization, European countries created new borders, without taking into
consideration the relationships and interaction of the different ethnic, cultural or religious groups
that already existed. Partish ethnic groups, those groups that were spitted into two colonial
governments or states. Ethnic groups that were parted were weaker in front of the national
government because their political power was divided between two different states. This is why in
these countries it is much easier to enter into a civil war. These borders have persisted over time.
Stelios Michalopoulos and Elias Papaioannou (2016) “The Long-Run
Effects of the Scramble for Africa“, American Economic Review
African borders were arbitrarily drawn relative to pre-existing ethnic
groups.
Partitioned ethnic groups have suffered significantly more warfare
since independence.
Civil conflict spreads from the homeland of partitioned ethnicities to
nearby ethnic regions.