How political and social institutions interact with economic decisions

Question 1

1.1 Why are some countries rich and others poor? - spectacular gap between world’s rich and poor countries (6)

Answer 1

• Average income in richest countries > 10x world’s poorest countries
• income/capita in Sierra Leone = 1/100 of Luxembourg
• Nearly 2/3 of the world’s population lives in countries where average income is 10% of US income
• Disparities in income lower during the Industrial Revolution
• Estimates of GNP per capita for selected countries from 1830-1970 show that the world was divided into one front-runner (the USA) and a diverse array of partners
• Income/capita in rich industrialised nations vs poor non-industrialised, say Switzerland and Mozambique, is today about 400:1.
  o Growth models explain this by using differences in capital per person and TFP (as per Solow) but theory isn’t always a great guideline to reality

Question 2

1.1 Why are some countries rich and others poor? - speed of convergence (5)

Answer 2

• It took the quickest of the European ‘follower’ countries more than a century to catch up
• Among the followers, variety of growth rates e.g. Soviet Union vs UK.
• Appreciable economic growth in modern times only occurred after the Industrial Revolution, with many developed nations being transformed within a century
• For many less developed countries, growth began only after WW2 after the decline of colonialism
• LDC’s need to grow faster than historical experience, so the ‘natural progress of opulence’ (Smith) will be different for LDC’s today

Question 3

1.1 Economic growth & development definitions

Answer 3

Economic growth is an increase in GNP per capita, development is growth coupled with a decrease in poverty and inequality. We are interested in the DISTRIBUTION of resources, incentives and institutions as a result.

Question 4

1.2 What is development? (3)

Answer 4

• Baseline definition of achievement of a minimum physical quality of life
• Difference between economic development and development (Nigel Knight)
  o Todaro defines economic development by three factors:
   The increased availability and widened distribution of life-sustaining goods
   Higher real incomes
   Expansion of range of economic choices
  o Development includes expansion of social choices too e.g. freedom of speech
• There are many different measures for economic development, and these are all valid:
  o Indicators of 4Ps
   Physical well-being – GNP
   Productive well-being – literacy, infant mortality (deaths before age 1), life expectancy
   Psychological well-being – attitudes and values, happiness (can correlate with physical indicators like blood pressure)
   Political well-being – political rights and civil liberties

Question 5

1.2 What is development? - Dasgupta & Weale (1992) (4)

Answer 5

• Dasgupta and Weale (1992) create Borda rank correlation matrix of constituent rankings of well-being, and find that per capita income, life expectancy at birth, infant mortality rates, adult literacy rates, the index of political rights, and the index of civil rights all have statistically significant correlations with each other at a 5% level
  o Finds that life expectancy at birth has 0.9133 correlation with Borda rank, single best indicator of development
  o GNP per capita has 0.8407 correlation, still very good
• But no measure is perfect e.g. Kerala has low GNP per head but has long life expectancies and high education levels

Question 6

1.3 Endowments and institutions in poor countries - relationship between endowments, institutions and outcomes (5)

Answer 6

• Countries begin with economic endowments
• These endowments favour the emergence of particular institutions
• Institutions and endowments produce outcomes together
• Outcomes determine the endowments for the future
  o Consequently, poor countries which have poor endowments are likely to have poor institutions, causing poor outcomes, and thereby the persistence of poor outcomes
  Overall - endowments –> institutions. institutions + endowments –> outcomes. outcomes –> endowments.

Question 7

1.3 Endowments and institutions in poor countries - How do outcomes vary with human capital, fertility rates, etc? Barro (1991) (7)

Answer 7

• For 98 countries in the period 1960-1985, the growth rate of real per capita GDP is positively related to initial human capital (proxied by 1960 school enrolment rates) and negatively related to the initial (1960) level of real per capita GDP, but only once the initial level of human capital is held constant.
• The hypothesis that poor countries tend to grow faster than rich countries seems to be inconsistent with the cross-country evidence, which indicates that per capita growth rates have little correlation with the starting level of per capita product. The average growth rate of per capita real GDP from 1960-1985 is not significantly related to the 1960 value of real per capita GDP: the correlation is 0.09.
• A poor country tends to grow faster than a rich country, but only for a given quantity of human capital; that is, only if the poor country’s human capital exceeds the amount that typically accompanies the low level of per capita income.
• The two main proxies for human capital are the 1960 values of school enrolment rates at the secondary and primary levels. With these school enrolment rates held constant, the estimated coefficient on starting GDP per capita is negative and highly significant (-0.0075) i.e. an increase in per capita real GDP by $1000 lowers the real per capita growth rate by 0.75%. Thus, the results indicate that holding constant a set of variables that includes proxies for starting human capital, higher initial per capita per GDP is substantially negatively related to subsequent per capita growth.
• Regressions also show that per capita growth is positively related to the proxies for initial human capital.
• Problems with the data: results may be subject to measurement error in GDP but defended by Barro as these would have to persist for periods over 10 years to result in estimation problems.
• Main conclusion: poor countries tend to catch up with rich ones if they have high human capital per person in relation to their level of GDP per capita, but not otherwise.

Question 8

1.3 Endowments and institutions in poor countries - endowments of poor countries (8)

Answer 8

• Geography
• Low physical capital – Harrod-Domar model stipulates doubling savings rate doubles growth rate, govts followed H-D in 1950s
• Low human capital
• Poor infrastructure
• Poor information flows – imperfect information (especially in labour and financial/credit markets) is a big factor e.g. returns and importance of education not understood despite govt investment so underutilised
• Undiversified assets (e.g. land and labour)
• High inequality
• Ethnolinguistic fractionalisation

Question 9

1.3 Endowments and institutions in poor countries - institutions that characterise poor countries (6)

Answer 9

• Household production (e.g. use of family labour) – 2/3 of child labour in developing countries not accounted for by GDP
• Exchange with kin – social networks important as social security
• Informal and segmented markets (e.g. labour and credit)
• Interlinkages between factor markets (e.g. sharecropping [tenant leases land and gives proportion of output to landlord] and informal rural lending)
• Dualism (e.g. urban-rural sectors, formal-informal sectors) – key interactions between sectors e.g. migration
• Weak governance and civil society (e.g. poor political or legal institutions)

Question 10

1.3 Endowments and institutions in poor countries - outcomes observed in poor countries (8)

Answer 10

• Low savings (exceptions – India and China with household savings rates of over 40%)
• Low investment in physical capital
• High fertility – due to high infant mortality and poor institutions (lack of social security and pension plans)
• Low human capital investment
• Poor information flows (e.g. small networks)
• Rent seeking and corruption – lobbying for import licences
• High inequality
• Persistence of poor outcomes – poverty trap

Question 11

1.4 Model of Dialectic Development with institutions - the model (3)

Answer 11

Culture (Value System), Institutions (Rules), Resources (Production factors), Technology (Production function) ALL INTERACT
* An economy with a Cobb-Douglas production function can see economic growth through increases in per capita endowments of resources and/or progress in technology
o Endowments = natural resources, labour and capital
* The Economic Sector consists of interactions between technology and resources
* These interact with each other as well as Culture and Institutions, which also interact with one another
o Culture = the value systems of people in society
o Institutions = rules sanctioned by members of the society including both formally stipulated laws and informal conventions; “the formal and informal rules that organize social, political and economic relations” (North, 1991)

Question 12

1.4 Model of dialectic development with institutions - How do institutions fit into this economic model? (5)

Answer 12

• The productivity of an economic subsystem is conditioned by culture, political, legal and social institutions in society
• Culture and institutions are inseparably related - e.g. the savings ratio as a determinant of the rate of investment- central to models like the Harrod-Domar growth model and the Solow model
• This parameter is determined largely by people’s future preferences over present consumption, which is part of their value system
• Culture determines how a given policy is received, manipulated, obstructed or supported by various different groups, and thus limits the set of feasible policies
• Markets and entrepreneurship appear to function better in some environments than others regardless of whether or not governments encourage them, as evidenced by Schultz (1964) and Myrdal (1968) who argue that the impact of government planning on agriculture can be good or bad according to culture

Question 13

1.4 Model of dialectic development with institutions - How does culture affect growth? (2)

Answer 13

• Lewis (1954) finds that culture is essential in determining savings rates. He runs a regression on countries’ growth rates and savings rates, and finds a statistically significant correlation – but this result is not robust and is reliant on strong positive correlation between savings rates and growth for industrial countries and upper-middle income countries, whereas relationship is negative for other countries.
• Schultz (1964) and Myrdal (1968) argue that the impact of government planning on agriculture can be good or bad according to culture

Question 14

1.4 Model of dialectic development with institutions - How do economic factors in turn affect culture and institution? (5)

Answer 14

• Neoclassical economics assumes fixed preferences which implies that the upper subsystem in the diagram is relatively constant
• This approach would not be complete for dealing with economic development as culture and institutions affect both preferences and the constraint structure
• But while culture and institutions may condition resources and technology, the latter may profoundly change the former (e.g. Weber’s 1902 thesis about the Protestant ethic and modern capitalist development, echoed by Landes 1998)
  o Encouraged reading the Bible, lead to reading other books including science, which led to growth and development
• Economic and social development through the interactions between economic forces and institutional elements are repeated in history

Question 15

Conclusion - how do political and social institutions influence development? (6)

Answer 15

• A range of forces can explain global wealth disparities between nations
• Factors like income distribution, government policy, institutions, culture, history all affect the level of progress a country is achieving
• Economic endowments are important
• Institutions may explain underdevelopment
• Dialectic model shows how economic theory interacts with institutions
• So, a useful way of analysing development is to combine economic theory with an informed understanding of political, legal, social institutions and policy.