Institutions

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Institutions

• UBC - Econ 334
• Mauricio Drelichman

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Last lecture recap

• In a society were factors of production are
  fixed, technical change is the only source of
  economic growth.
• Technical change, while slow, was present
  throughout the Malthusian period in Europe.
• The rate of technical change was between 0.02 and
  0.05 per year.
• Since income per capita remained constant,
  technical change resulted in population growth.
• Many of the technical innovations of the
  Malthusian period were to prove key in future
  advances.

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Technical change in a Malthusian economy

• The amount of land is fixed, and income per
  capita must be stable.
• Technical change results in population growth
  with no increase in income.

Output per person
y
(L/N)2
(L/N)1
Land per person
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Bibliography

• A Farewell to Alms, Chapter 8.
• North, Douglass C. Institutions. Journal of
  Economic Perspectives.

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Institutions

• Institutions are the humanly devised constraints
  that structure human interaction.
• Social
• Political
• Economic
• We can think of them as the rules of the game
  that we must follow to live in a society.
• Economic institutions provide the incentive
  structure of an economy.

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Why are institutions important?

• In an economy without transaction costs, there is
  no need for institutions. Once a transaction has
  been agreed upon, it would be immediately
  executed.
• But it is (sometimes very) costly to transact.
• Information costs.
• Negotiation costs.
• Enforcement costs.
• Economic institutions determine how large these
  costs are, and who pays them.
• Good institutions are those that reduce
  transaction costs, allowing for a greater scope
  of economic transactions.

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Incentives in the absence of institutions

• In any economic transaction, at least one of the
  parties has the potential to cheat.
• A restaurant patron may leave without paying.
• An online merchant may not deliver goods that
  have been paid for.
• A contractor may provide services of inferior
  quality than promised.
• If the two parties will not transact again, and
  if there is no punishment for cheating, the
  incentive is to always cheat.
• Knowing that the incentives encourage cheating,
  economic agents will not engage in transactions
  in the first place.

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What type of trade can take place?

• Personal trade.
• One may choose to trade with a particular
  merchant because he has a reputation for being
  honest.
• Repeated interactions.
• If the patron wants to go back to the restaurant
  tomorrow, he will pay today.
• Transactions within a family or tribal group.
• The loss of reputation from cheating might be
  greater than the economic gain.
• Transactions with members of the same religion.
• People fearing divine punishment will abstain
  from cheating.

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Institutions that enable impersonal trade

• Private institutions self-enforcing
  arrangements, where the threat of exclusion from
  a group is sufficient to ensure cooperation.
• Coalitions of merchants and traders.
• Guilds of artisans and craftsmen.
• Public institutions rules sanctioned by the
  state, backed by public enforcement.
• Property rights.
• Usually codified in a legal system.

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Institutions need not be efficient

• Institutions are chosen by holders of political
  power, who care about their own welfare.
• The welfare of political leaders usually does not
  coincide with the welfare of society at large.
• History is full of examples of inefficient
  institutions persisting for very long periods.
• Extractive governments.
• Markets with high information and negotiation
  costs.
• Insecure property rights.
• High level of violence.

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Institutions and economic outcomes
Source Acemoglu, Johnson and Robinson.
Institutions as the Fundamental Cause of Long Run
Growth.
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Why do economists put so muchweight on
institutions?

• Most economists believe that institutions are the
  fundamental case of long-run growth.
• Consider a country with a homogeneous population,
  geography, and natural resource endowments.
• Now split the country in two.
• Give one half secure property rights, a
  democratic government, and general economic
  freedom.
• Give the other half an authoritarian regime that
  claims all the economic surplus for itself. What
  will happen?
• We have one such natural experiment with the
  division of the Korean peninsula.
• South Korea is now the 40th wealthiest country in
  the world.
• North Korea is the 156th.

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Institutional innovations in Medieval Europe

• Institutions that increased the mobility of
  capital.
• By reducing the cost of moving capital from one
  place to another, it is possible to seek the
  highest rates of return. As a result, the number
  of productive ventures increases.
• Institutions that lowered information costs.
• Information costs are part of the total costs of
  a venture. If they fall, profitability increases.
• Institutions that spread risk.
• If a venture poses a high risk, an entrepreneur
  might not undertake it for fear of going broke.
  But if risk can be spread, then many risky but
  profitable activities become viable.

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Institutions that increased capital mobility

• Circumvention of usury laws.
• Mortgages and foreign exchange contracts.
• Trade and payment fairs.
• Provided a physical forum for the exchange of
  goods, the clearing of payments, and the flow of
  information.
• Bills of exchange.
• Allowed for large payments in a fast, cheap and
  secure way, without the need of transporting
  cash.
• Accounting procedures.
• Permitted monitoring the profitability of a
  venture and the behavior of agents.

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Institutions that reduced information costs

• Publication of catalogues reporting
• Prices of various commodities.
• Information on weights and measures in different
  countries.
• Information on the metallic content of coins and
  exchange rates.
• These developments resulted from the increased
  volume of trade, but also contributed to it.

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Institutions that spread risk

• Marine insurance.
• Allowed for the undertaking of ventures that
  required large amounts of capital.
• New contractual forms the commenda.
• A societal form in which a capitalist partner
  financed the venture, while a traveling partner
  conducted the actual trading operations.

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Institutional evolution according to North

• Institutions determine the incentives of agents
  in their effort to acquire wealth and political
  power.
• As agents acquire wealth and political power,
  they become empowered to alter the institutional
  framework itself.
• In Northern Europe, merchants acquired wealth
  through trade, and used it to change political
  institutions to their advantage.
• In particular, they limited the ability of
  governments to expropriate them or tax them at
  high rates.
• The new institutional framework favored
  mercantile and industrial activities, putting
  Northern European countries on a path towards the
  Industrial Revolution.

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Good institutions are not guaranteed

• Institutions are chosen by those who hold
  political power to serve their own interests.
• The interests of the political elite often do not
  include the welfare of the majority of the
  population.
• Many times, they do not even include secure
  property rights quite to the contrary, many
  elites will try to expropriate as much as
  possible.
• Institutions are path dependent. They cannot be
  changed overnight. They are the result of a
  historical process whose direction is determined
  by the initial conditions of a society (such as
  who happens to be in power at a specific time).

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Institutions in pre-industrial England

• Were institutions responsible for the slow growth
  in the Malthusian world?
• Clark contends they were not. Medieval England
  (and many other European countries) had very good
  political and economic institutions.
• In Clarks view, economic institutions respond
  to, rather than determine, economic performance.
• Rich societies need, and can afford, good
  institutions.
• Poor societies will not be able to take advantage
  of (expensive) institutions protecting property
  and constraining government.