eco paper 12pages

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Chapter 8

Why Isn’t the Whole World Developed?

8 Why Isn’t the Whole World Developed?

Chapter Outline

8.1 Proximate Versus Fundamental Causes of Prosperity

8.2 Institutions and Economic Development

EBE Are Tropical and Semitropical Areas Condemned to Poverty by Their Geographies?

8.3 Is Foreign Aid the Solution to World Poverty?

8 Why Isn’t the Whole World Developed?

Key Ideas

Proximate causes of prosperity link prosperity and poverty of nations to the levels of inputs, while fundamental causes look for reasons why there are such differences in the levels of inputs.

The geography, culture, and institutions hypotheses advance different fundamental causes of prosperity.

8 Why Isn’t the Whole World Developed?

Key Ideas

Inclusive and extractive economic institutions affect economic development.

Creative destruction is integral to economic growth through technological change.

Reversal of fortune evidence provides support for the institutions hypothesis.

8.1 Proximate Versus Fundamental Causes of Prosperity

Proximate causes of prosperity

High levels of factors of production such as physical capital, human capital, and technology that result in a high level of GDP per capita.

The factors of production are proximate causes because they link high levels of prosperity to high levels of the factors, but without providing an explanation for why these factors are high.

Fundamental causes of prosperity

The root reasons for the differences in the proximate causes.

The fundamental causes are ultimately the deep determinants of economic development.

8.1 Proximate Versus Fundamental Causes of Prosperity

Exhibit 8.1 Fundamental and Proximate Causes of Prosperity

8.1 Proximate Versus Fundamental Causes of Prosperity

Fundamental causes can be classified into three categories or theories:

Geography hypothesis

Culture hypothesis

Institutions hypothesis

8.1 Proximate Versus Fundamental Causes of Prosperity

The geography hypothesis claims that differences in geography, climate, and ecology are ultimately responsible for the large differences in prosperity observed around the globe.

The following map of the world reveals that economies with low levels of GDP per capita are located in tropical areas, while those with high levels are in temperate areas (outside the tropics).

8.1 Proximate Versus Fundamental Causes of Prosperity

Tropic of Capricorn

Tropic of Cancer

8.1 Proximate Versus Fundamental Causes of Prosperity

Source: http://www.geocurrents.info/economic-geography/a-global-northsouth-division-in-the-demic-framework

In the past, the French philosopher Montesquieu and the British economist Alfred Marshall argued that tropical climates decreased work effort.

8.1 Proximate Versus Fundamental Causes of Prosperity

Economist Jeffrey

Sachs and geographer

Jared Diamond argue

that tropical climates are

more prone to infectious

diseases such as malaria

and dengue fever, which

result in poverty.

The following graph tests the geography hypothesis using cross-country data.

8.1 Proximate Versus Fundamental Causes of Prosperity

Instructor: The graph examines the relationship between malaria exposure in 1966 (horizontal line) and real GDP per capita (vertical line) in 2010. Each dot represents a different country, with the red dots labeled. The blue line is the exponential fitted line.

If the geography hypothesis is correct, there should be a negative relationship between the two variables. The data seem to support the hypothesis, although the numerous countries with 0% and 100% make it difficult to interpret.

Sources: Malaria data is from Gallup, John, and Jeffrey Sachs (1998); “Geography and Economic Development”; Brookings Papers on Economic Activity and GDP data is from Penn World Table Version 7.1

Test of Geography Hypothesis

0.356700003147125 0.0 0.0 0.0 0.0 0.0 0.046000000089407 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.813560009002686 0.276659995317459 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.622160017490387 0.000130000000353903 0.0 0.0 0.000880000006873161 0.245639994740486 0.0 0.938000023365021 0.0 1.0 0.759999990463257 0.0 0.266559988260269 0.0 0.095040000975132 0.0 0.0 0.400499999523163 0.578760027885437 0.0 0.26418000459671 0.0 0.00255000009201467 0.0 0.0478399991989136 0.0 0.0 0.0900000035762787 0.213499993085861 0.00193999998737127 0.0 0.0204000007361174 0.0 0.0 1.0 0.0 0.0280000008642673 0.889999985694885 0.0130000002682209 0.0 0.034000001847744 0.0379999987781048 0.4167799949646 0.0644000023603439 0.0108899995684624 0.0 0.00323999999091029 0.0 0.131860002875328 0.48743000626564 0.740000009536743 0.949999988079071 0.0 0.0 0.862999975681305 0.720480024814606 0.428970009088516 0.00528000015765429 0.889999985694885 1.0 1.0 0.0 0.0 0.896000027656555 0.0 1.0 1.0 1.0 1.0 1.0 0.0 0.632000029087067 1.0 1.0 0.980000019073486 0.980000019073486 1.0 0.046169999986887 0.860000014305115 0.0024600001052022 1.0 0.800000011920929 1.0 1.0 1.0 1.0 1.0 1.0 1.0 0.850000023841858 0.519999980926514 1.0 0.759999990463257 1.0 1.0 1.0 1.0 1.0 0.0 0.0 0.0 0.720480024814606 0.720480024814606 0.0 0.0 136248.1365 75588.11588 60175.41205 55862.41792 54790.36195 50487.52367 45866.49122 44555.22975999999 41364.99676 41239.92412 41113.58523 39978.02568 38684.72037 38585.51335 38190.63356 37103.55928 36132.38489 35612.06548999999 35556.61991 34876.73916 34268.00841 34089.0961 33705.00435 32988.84535 32241.09426 32104.92001000001 31447.22902 31299.27919 30749.3483 30111.01875 28377.45915 28088.5447 27789.63139999999 27331.49875 26609.14522999999 26034.56006 25216.3956 24902.86703 23395.99736 23101.09418 22818.46595000001 22389.89684 21850.39245 20189.30062 19782.44545 19491.10357999995 19284.29056 18755.66964 17012.13304 16705.1708 16556.75738 15635.39997 15398.29573 15067.59911 14674.82839 14656.76147 14485.51961 14136.10182 13958.25367 13503.14015 12699.95681 12524.77748 12418.93489 12351.08593 12340.33033 12303.18827 11956.05057 11939.39769 11717.66303 11510.84651 11500.08711 10857.0944 10648.53813 10589.64708 10502.94265 10437.96451 10164.05376 9895.85837799999 9675.35136599999 9638.060660999989 9474.258567 9432.057232999989 9377.618319 9070.606092 9064.885783999987 8594.189588 8538.638843 8324.386558999997 8064.722442 7628.467095999998 7538.743390999994 7536.351193 7513.191606 7414.966991 7350.149490000001 7312.67849 7129.564044 7044.365476 6966.305199 6896.368090000001 6697.727646 6617.127792 6439.16715 6263.340651 6226.772647000001 6168.61922 6105.322079 6091.21587 5944.932957 5411.157654 5107.542184 5100.637732 4853.826756 4810.407014999999 4536.523606 4477.551533 4462.946339 4151.743 822 4069.84135 4063.350521 4003.527241 3966.039158 3946.397675 3916.614015 3792.662419 3743.844217 3692.334198 3664.667568 3622.421889 3591.838616 3579.585202 3522.954407 3477.308781 3193.901161 2780.049264 2774.470665 2680.012576 2643.482226 2623.715095 2410.547437 2392.894517 2297.054831 2289.817151 2288.22226 2253.75032 2094.278303 2081.528655 1973.86698 1938.575462 1892.050829 1764.447524 1748.110073 1695.4525 1615.71421 1517.238716 1469.307153 1410.011917 1394.738264 1371.013355 1330.639095 1283.670551 1271.46968 1246.761329 1178.486386 1176.867108 1145.23877 1119.446102 1101.747559 1048.599213 1025.218612 997.9699260999988 933.5405185999994 929.9250863999994 856.2210252999994 798.4121349999994 787.7003452 781.2569103 732.8525575999988 702.5809121999994 680.4287547 655.6087685 588.7788164 587.9976075999994 521.9902509999994 461.7454491 458.7361567999993 396.169121 319.0431206 240.5498984

Percentage of the population exposed to malaria in 1966

Real GDP per capita in 2010 (proportional scale)

The culture hypothesis claims that different values and cultural beliefs are ultimately responsible for the large differences in prosperity observed around the globe.

8.1 Proximate Versus Fundamental Causes of Prosperity

In 1905, the German socialist Max Weber argued that Protestant beliefs lead to a greater work effort, higher savings, and increased income.

The following graph tests the Protestant work ethic hypothesis using cross-country data.

8.1 Proximate Versus Fundamental Causes of Prosperity

Instructor: The graph examines the relationship between the percentage of the population that is Protestant in 1900 (horizontal line) and real GDP per capita (vertical line) in 2010. Each dot represents a different country with, the red dots labeled. The brown line is the exponential fitted line.

If Weber’s Protestant Work Ethic hypothesis is correct, there should a positive relationship between the two variables. There is little evidence in support of this hypothesis given the many rich countries with 0 Protestants.

Sources: Religion data is from the World Religion Database and GDP data is from Penn World Table Version 7.1

Test of Weber's Protestant Work Ethic Hypothesis

0.001 0.014 0.0 0.014 0.0 0.99 0.752 0.002 0.482 0.0 0.63 0.562 0.01 0.027 0.601 0.509 0.988 0.995 0.004 0.103 0.884 0.611 0.992 0.97 0.078 0.001 0.002 0.017 0.367 0.84 0.001 0.833 0.771 0.0 0.001 0.002 0.001 0.001 0.056 0.004 0.0 0.052 0.0 0.0 0.0 0.074 0.002 0.541 0.029 0.27 0.0 0.008 0.001 0.415 0.85 0.005 0.004 0.001 0.012 0.009 0.45 0.155 0.005 0.009 0.006 0.003 0.016 0.003 0.005 0.12 0.198 0.001 0.003 0.004 0.022 0.011 0.108 0.875 0.0 0.0 0.013 0.001 0.405 0.738 0.009 0.001 0.001 0.154 0.252 0.001 0.05 0.001 0.017 0.856 0.538 0.195 0.0 0.877 0.003 0.0 0.0 0.0 0.001 0.0 0.001 0.0 0.002 0.005 0.056 0.0 0.43 0.003 0.724 0.0 0.023 0.0 0.012 0.0 0.0 0.001 0.001 0.007 0.546 0.0 0.503 0.001 0.0 0.005 0.0 0.0 0.009 0.0 0.011 0.0 0.0 0.002 0.003 0.006 0.0 0.0 0.033 0.002 0.16 0.0 0.0 0.0 0.002 0.005 0.0 0.001 0.0 0.024 0.074 0.001 0.0 0.0 0.021 0.001 0.004 0.002 0.0 0.023 0.0 0.0 0.0 0.039 0.0 0.0 0.0 0.0 0.0 0.003 0.187 0.0 0.013 0.0 0.0 0.0 0.0 0.055 0.0 0.022 0.006 0.0 0.001 0.852 0.512 0.019 0.036 0.016 0.003 0.0 0.045 136248.1365 75588.11588 60175.41205 55862.41792 54790.36195 50487.52367 45866.49122 44555.22975999999 41364.99676 41239.92412 41113.58523 39978.02568 38684.72037 38585.51335 38190.63356 37103.55928 36132.38489 35612.06548999999 35556.61991 34876.73916 34268.00841 34089.0961 337 05.00435 32988.84535 32241.09426 32104.92001000001 31447.22902 31299.27919 30749.3483 30111.01875 28377.45915 28088.5447 27789.63139999999 27331.49875 26609.14522999999 26034.56006 25216.3956 24902.86703 23395.99736 23101.09418 22818.46595000001 22389.89684 21850.39245 20189.30062 19782.44545 19491.10357999995 19284.29056 18755.66964 17012.13304 16705.1708 16556.75738 15635.39997 15398.29573 15067.59911 14674.82839 14656.76147 14485.51961 14136.10182 13958.25367 13503.14015 12699.95681 12524.77748 12418.93489 12351.08593 12340.33033 12303.18827 11956.05057 11939.39769 11717.66303 11510.84651 11500.08711 10857.0944 10648.53813 10589.64708 10502.94265 10437.96451 10164.05376 9895.85837799999 9675.35136599999 9638.060660999989 9474.258567 9432.057232999989 9377.618319 9070.606092 9064.885783999987 8594.189588 8538.638843 8324.386558999997 8064.722442 7628.467095999998 7538.743390999994 7536.351193 7513.191606 7414.966991 7350.149490000001 7312.67849 7129.564044 7044.365476 6966.305199 6896.368090000001 6697.727646 6617.127792 6439.16715 6263.340651 6226.772647000001 6168.61922 6105.322079 6091.21587 5944.932957 5411.157654 5107.542184 5100.637732 4853.826756 4810.407014999999 4536.523606 4477.551533 4462.946339 4151.743822 4069.84135 4063.350521 4003.527241 3966.039158 3946.397675 3916.614015 3792.662419 3743.844217 3692.334198 3664.667568 3622.421889 3591.838616 3579.585202 3522.954407 3477.308781 3193.901161 2780.049264 2774.470665 2680.012576 2643.482226 2623.715095 2410.547437 2392.894517 2297.054831 2289.817151 2288.22226 2253.75032 2094.278303 2081.528655 1973.86698 1938.575462 1892.050829 1764.447524 1748.110073 1695.4525 1615.71421 1517.238716 1469.307153 1410.011917 1394.738264 1371.013355 1330.639095 1283.670551 1271.46968 1246.761329 1178.486386 1176.867108 1145.23877 1119.446102 1101.747559 1048.599213 1025.218612 997.9699260999988 933.5405185999994 929.9250863999994 856.2210252999994 798.4121349999994 787.7003452 781.2569103 732.8525575999988 702.5809121999994 680.4287547 655.6087685 588.7788164 587.9976075999994 521.9902509999994 461.7454491 458.7361567999993 396.169121 319.0431206 240.5498984

Percentage of the population that is Protestant in 1900

Real GDP per capita in 2010 (proportional scale)

Almost 20 years ago, the Harvard political scientist Samuel Huntington talked of a “clash of civilization” between the West and Islam.

The following graph tests the Clash of Civilization hypothesis using cross-country data

8.1 Proximate Versus Fundamental Causes of Prosperity

Instructor: The graph examines the relationship between the percentage of the population that is Muslim in 1900 (horizontal line) and real GDP per capita (vertical line) in 2010. Each dot represents a different country with the red dots labeled and blue line is the exponential fitted line.

If Huntington’s clash of civilization hypothesis is correct, there should be a negative relationship between the two variables. There is no evidence in support of this hypothesis, given that the fitted brown line has a zero slope.

Sources: Religion data is from the World Religion Database and GDP data is from Penn World Table Version 7.1

Test of Clash of Civilizations

0.996 0.0 0.999 0.22 0.0 0.0 0.0 0.61 0.0 0.997 0.003 0.0 0.003 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.003 0.002 0.0 0.001 0.038 0.0 0.0 0.0 0.0 0.0 0.0 0.833 0.128 0.0 0.0 0.997 1.0 0.0 1.0 0.0 0.938 0.0 0.216 0.001 0.0 0.0 0.984 0.089 0.0 0.001 0.0 0.0 0.0 0.001 0.206 0.0 0.0 0.003 0.001 0.939 0.488 0.0 0.0 0.0 0.0 0.005 0.1 0.172 0.0 0.773 0.109 0.0 0.0 0.0 0.893 0.981 0.008 0.0 0.0 0.003 0.001 0.015 0.084 0.0 0.006 0.0 0.0 0.051 0.002 0.0 0.0 0.0 0.685 0.0 0.866 0.0 0.0 0.875 0.0 0.395 0.102 0.0 0.068 0.811 0.0 0.895 0.063 0.942 0.022 0.0 0.069 1.0 0.4 0.01 0.0 0.831 0.0 0.0 0.0 0.964 0.0 0.0 0.01 0.137 0.035 0.007 0.0 0.984 0.001 0.002 0.995 0.985 0.821 0.0 0.62 0.0 0.05 0.963 0.0 0.977 0.02 0.983 0.05 0.259 0.0 0.0 0.7 0.0 0.0 0.656 0.36 0.05 0.81 0.034 0.07 0.07 0.01 0.02 0.99 5 0.002 0.3 0.1 0.1 0.999 0.15 0.58 0.03 0.04 0.005 0.246 0.03 0.004 0.5 0.451 0.999 0.02 0.002 0.002 0.006 0.0 0.0 0.0 0.0 0.0 0.0 0.032 0.0 0.0 0.097 136248.1365 75588.11588 60175.41205 55862.41792 54790.36195 50487.52367 45866.49122 44555.22975999999 41364.99676 41239.92412 41113.58523 39978.02568 38684.72037 38585.51335 38190.63356 37103.55928 36132.38489 35612.06548999999 35556.61991 34876.73916 34268.00841 34089.0961 33705.00435 32988.84535 32241.09426 32104.92001000001 31447.22902 31299.27919 30749.3483 30111.01875 28377.45915 28088.5447 27789.63139999999 27331.49875 26609.14522999999 26034.56006 25216.3956 24902.86703 23395.99736 23101.09418 22818.46595000001 22389.89684 21850.39245 20189.30062 19782.44545 19491.10357999995 19284.29056 18755.66964 17012.13304 16705.1708 16556.75738 15635.39997 15398.29573 15067.59911 14674.82839 14656.76147 14485.51961 14136.10182 13958.25367 13503.14015 12699.95681 12524.77748 12418.93489 12351.08593 12340.33033 12303.18827 11956.05057 11939.39769 11717.66303 11510.84651 11500.08711 10857.0944 10648.53813 10589.64708 10502.94265 10437.96451 10164.05376 9895.85837799999 9675.35136599999 9638.060660999989 9474.258567 9432.057232999989 9377.618319 9070.606092 9064.885783999987 8594.189588 8538.638843 8324.386558999997 8064.722442 7628.467095999998 7538.743390999994 7536.351193 7513.191606 7414.966991 7350.149490000001 7312.67849 7129.564044 7044.365476 6966.305199 6896.368090000001 6697.727646 6617.127792 6439.16715 6263.340651 6226.772647000001 6168.61922 6105.322079 6091.21587 5944.932957 5411.157654 5107.542184 5100.637732 4853.826756 4810.407014999999 4536.523606 4477.551533 4462.946339 4151.743822 4069.84135 4063.350521 4003.527241 3966.039158 3946.397675 3916.614015 3792.662419 3743.844217 3692.334198 3664.667568 3622.421889 3591.838616 3579.585202 3522.954407 3477.308781 3193.901161 2780.049264 2774.470665 2680.012576 2643.482226 2623.715095 2410.547437 2392.894517 2297.054831 2289.817151 2288.22226 2253.75032 2094.278303 2081.528655 1973.86698 1938.575462 1892.050829 1764.447524 1748.110073 1695.4525 1615.71421 1517.238716 1469.307153 1410.011917 1394.738264 1371.013355 1330.639095 1283.670551 1271.46968 1246.761329 1178.486386 1176.867108 1145.23877 1119.446102 1101.747559 1048.599213 1025.218612 997.9699260999988 933.5405185999994 929.9250863999994 856.2210252999994 798.4121349999994 787.7003452 781.2569103 732.8525575999988 702.5809121999994 680.4287547 655.6087685 588.7788164 587.9976075999994 521.9902509999994 461.7454491 458.7361567999993 396.169121 319.0431206 240.5498984

Percentage of the population that is Muslim in 1900

Real GDP per capita in 2010 (proportional scale)

The institutions hypothesis claims that differences in the way societies organize themselves and shape the incentives of individuals and businesses (so-called economic rules of the game) are ultimately responsible for the large differences in prosperity observed around the globe.

8.1 Proximate Versus Fundamental Causes of Prosperity

Instructor: The graph examines the relationship between the rule of law in 1995 (horizontal line) and real GDP per capita (vertical line) in 2010. Each dot represents a different country, with the red dots labeled. The blue line is the exponential fitted line.

If the institutions hypothesis is correct, there should a positive relationship between the two variables. There is strong evidence in support of this hypothesis, given that the fitted blue line is positively sloped, with the observations clustered close to it.

Sources: Rule of law data are from Daniel Kaufmann, Aart Kraay, and Pablo Zoido-Lobatón (1999), "Aggregating Governance Indicators," World Bank Policy Research Working Paper No. 2195, and GDP data are from Penn World Tables 7.1

Test of Institutions Hypothesis

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27331.49875 26609.14522999999 26034.56006 25216.3956 24902.86703 23395.99736 23101.09418 22818.46595000001 22389.89684 21850.39245 20189.30062 19782.44545 19491.10357999995 19284.29056 18755.66964 17012.13304 16705.1708 16556.75738 15635.39997 15398.29573 15067.59911 14674.82839 14656.76147 14485.51961 14136.10182 139 58.25367 13503.14015 12699.95681 12524.77748 12418.93489 12351.08593 12340.33033 12303.18827 11956.05057 11939.39769 11717.66303 11510.84651 11500.08711 10857.0944 10648.53813 10589.64708 10502.94265 10437.96451 10164.05376 9895.85837799999 9675.35136599999 9638.060660999989 9474.258567 9432.057232999989 9377.618319 9070.606092 9064.885783999987 8594.189588 8538.638843 8324.386558999997 8064.722442 7628.467095999998 7538.743390999994 7536.351193 7513.191606 7414.966991 7350.149490000001 7312.67849 7129.564044 7044.365476 6966.305199 6896.368090000001 6697.727646 6617.127792 6439.16715 6263.340651 6226.772647000001 6168.61922 6105.322079 6091.21587 5944.932957 5411.157654 5107.542184 5100.637732 4853.826756 4810.407014999999 4536.523606 4477.551533 4462.946339 4151.743822 4069.84135 4063.350521 4003.527241 3966.039158 3946.397675 3916.614015 3792.662419 3743.844217 3692.334198 3664.667568 3622.421889 3591.838616 3579.585202 3522.954407 3477.308781 3193.901161 2780.049264 2774.470665 2680.012576 2643.482226 2623.715095 2410.547437 2392.894517 2297.054831 2289.817151 2288.22226 2253.75032 2094.278303 2081.528655 1973.86698 1938.575462 1892.050829 1764.447524 1748.110073 1695.4525 1615.71421 1517.238716 1469.307153 1410.011917 1394.738264 1371.013355 1330.639095 1283.670551 1271.46968 1246.761329 1178.486386 1176.867108 1145.23877 1119.446102 1101.747559 1048.599213 1025.218612 997.9699260999988 933.5405185999994 929.9250863999994 856.2210252999994 798.4121349999994 787.7003452 781.2569103 732.8525575999988 702.5809121999994 680.4287547 655.6087685 588.7788164 587.9976075999994 521.9902509999994 461.7454491 458.7361567999993 396.169121 319.0431206 240.5498984

Rule of law (-2 is lowest; +2 is highest)

Real GDP per capita in 2010 (proportional scale)

Institutions have three important features:

They are determined by individuals.

They place constraints on behavior.

They shape human behavior by determining incentives.

8.1 Proximate Versus Fundamental Causes of Prosperity

The “natural experiment” of the two Koreas provides a test of the institutions hypothesis.

In the 1940s, North and South Korea were a single country, with a unified language, culture, and geography.

In 1947, the country was split into two countries along the 38th parallel by an agreement between the United States and the Soviet Union.

8.1 Proximate Versus Fundamental Causes of Prosperity

Exhibit 8.2 GDP per Capita in North and South Korea (in PPP-adjusted 2005 constant dollars)

By 2010, North Korea was an economic “disaster,” with a GDP per capita of $1,500, while South Korea was an economic “miracle,” with a GDP per capita of close to $30,000.

What happened?

Was it geography? Was it culture? Was it institutions?

8.1 Proximate Versus Fundamental Causes of Prosperity

The South Korean autocratic government of Syngman Rhee and Park Chung-hee adopted a market-based economy, providing incentives for investment in physical and human capital.

The North Korean dictatorship of Kim Il-Sung and his son Kim Jong-Il adopted a strict communist system (called Juche) that outlawed private property and banned markets.

8.1 Proximate Versus Fundamental Causes of Prosperity

8.2 Institutions and Economic Development

Economic institutions

Aspects of society’s rules that concern economic transactions.

Economic institutions include:

Protection of property rights and ownership

Impartiality of the justice system

Financial arrangements between savers and borrowers

Regulations concerning new businesses or occupations

8.2 Institutions and Economic Development

Inclusive economic institutions

Institutions that support and encourage economic transactions and, as such:

Protect private property

Uphold law and order

Allow and enforce private contracts

Allow free entry into new lines of business and occupations

8.2 Institutions and Economic Development

Extractive economic institutions

Institutions that remove resources from the economy and, as such:

Do not protect private property

Do not enforce private contracts

Interfere with the workings of markets

Restrict entry into new lines of business and occupations

8.2 Institutions and Economic Development

Political institutions

The aspects of society’s rules that determine who holds political power and what types of constraints are placed on them.

In North Korea, political power in the past lay completely with Kim Il-Sung and then Kim Jong-Il, and it now lies with Kim Jong-Un.

In South Korea, political power is spread between an elected president and Parliament.

The experience in Eastern Europe provides another example of the institutions hypothesis.

In 1948, Czechoslovakia (forcibly) became communist, with extractive institutions, while Austria followed a market system with inclusive institutions.

8.2 Institutions and Economic Development

Exhibit 8.3 GDP per Capita in Austria and the Neighboring Czechoslovakia Since 1948 (in PPP-adjusted 2005 constant dollars)

By 1989, Czechoslovakia had a GDP per capita of $12,066, while Austria had a GDP per capita of $22,514—almost twice as high!

What happened?

Was it geography? Was it culture? Was it institutions?

8.2 Institutions and Economic Development

Instructor: The real GDP per capita data are from Penn World Tables 7.1

After the fall of Communism, the Czech Republic and Slovakia with their inclusive institutions are starting to close the GDP per capita gap with their neighbor Austria.

8.2 Institutions and Economic Development

Extractive economic institutions tend to support inefficient firms and prevent entrepreneurs with new ideas from entering the market.

8.2 Institutions and Economic Development

We rank potential entrepreneurs in descending order, according to the return they could earn by starting a business.

The return-to-entrepreneurship curve is the downward-sloping blue line on the next slide, which shows the number of entrepreneurs (horizontal axis) against their return (vertical axis).

8.2 Institutions and Economic Development

Exhibit 8.4, Panel (a) How Extractive Economic Institutions Reduce the Number of Entrepreneurs

Instructor: The downward-sloping blue line is the return-to-entrepreneurship curve, which shows the number of entrepreneurs against their return.

We then add the opportunity cost of the entrepreneurship, which is assumed to be the same for all entrepreneurs.

The opportunity cost line is the red horizontal line drawn at a constant opportunity cost.

8.2 Institutions and Economic Development

Exhibit 8.4, Panel (a) How Extractive Economic Institutions Reduce the Number of Entrepreneurs

Instructor: The horizontal red curve is the opportunity cost schedule, which indicates the value to the entrepreneur of her best alternative.

The intersection of the two lines gives us the equilibrium return and the equilibrium number of entrepreneurs.

8.2 Institutions and Economic Development

Exhibit 8.4, Panel (a) How Extractive Economic Institutions Reduce the Number of Entrepreneurs

Instructor: The intersection of the two curves at point E1 gives the equilibrium where 700 entrepreneurs choose projects with a return of $50,000 or greater.

Extractive institutions have two main impacts:

Weak property rights and legal enforcement prevent the entrepreneur from capturing the full returns they create.

This shifts the return-to-entrepreneurship line to the left.

8.2 Institutions and Economic Development

Exhibit 8.4, Panel (b) How Extractive Economic Institutions Reduce the Number of Entrepreneurs

Instructor: Extractive economic institutions shift the return-to-entrepreneurship curve to the left due to (a) weak property rights and (b) lack of contract enforcement. As a result, the new equilibrium is E2, where only 300 entrepreneurs undertake projects.

Barriers to entry in the marketplace increase the cost of entering the market.

This shifts the opportunity cost line upward.

8.2 Institutions and Economic Development

Exhibit 8.4, Panel (c) How Extractive Economic Institutions Reduce the Number of Entrepreneurs

Instructor: Extractive economic institutions also shift the opportunity cost curve upward because they erect barriers to entry for entrepreneurs. As a result, the new equilibrium is E3, where only 100 entrepreneurs undertake projects.

Why would a country adopt extractive economic institutions if they retard economic growth?

The notion of political creative destruction predicts that economic growth destabilizes existing regimes and reduces political power.

Therefore, rulers such as Kim Jong-Un of North Korea use extractive economic institutions to maintain political power.

8.2 Institutions and Economic Development

Inclusive economic institutions allowed the Industrial Revolution, with all of its complex social and economic processes, to occur in England in the late 18th century and in the United States in the 19th century.

8.2 Institutions and Economic Development

Evidence-Based Economics Example

Question: Are tropical

and semitropical areas

condemned to poverty by

their geographies?

Data: Urbanization and population density rates in 1500 and urbanization rates and GDP per capita in 2010.

8 Why Isn’t the Whole World Developed?

In late 15th century, the European powers “colonized” Africa, Asia, Australasia, Latin America, and North America.

Although there is no GDP per capita data for that time, we can measure the living standards of these former colonies by using urbanization and population density rates in 1500.

8 Why Isn’t the Whole World Developed?

Countries that generate sufficient agricultural surplus and a transportation and trading network can support a larger population per square mile in general and a larger urban population in particular.

What, then, is the relationship between prosperity in 1500 and prosperity today, measured as GDP per capita?

8 Why Isn’t the Whole World Developed?

Exhibit 8.6 The Reversal of Fortune Using Urbanization

Instructor: The data for urbanization rates in 1500 do not contain the former colonies in sub-Saharan Africa.

8 Why Isn’t the Whole World Developed?

Exhibit 8.7 The Reversal of Fortune Using Population Density

Instructor: The data for population density rates in 1500 do contain the former colonies in sub-Saharan Africa.

The two graphs show what we call “reversal of fortune”: Former colonies that were poor in 1500 are rich today, while former colonies that were rich in 1500 are relatively poor today.

What happened?

8 Why Isn’t the Whole World Developed?

The settlers in the poor, temperate areas of North America, Australasia, and Argentina developed inclusive economic institutions due to low settler mortality rates.

The settlers in the rich tropical areas of Mexico, Peru, India, and Morocco adopted extractive institutions due to high settler mortality rates.

8 Why Isn’t the Whole World Developed?

Evidence-Based Economics Example

Question: Are tropical and semitropical areas condemned to poverty by their geographies?

Answer: No. Although tropical areas tend to have lower GDP per capita levels today, the reason is not the geography of the tropics but rather the fact that extractive institutions were adopted in these areas.

8 Why Isn’t the Whole World Developed?

Many people, like the singer

Bono, actress Angelina

Jolie, and economist Jeffrey

Sachs, argue that increased

spending on foreign and

development aid by the

West is needed to alleviate

poverty around the world.

In the book The End of Poverty, Sachs argues that extreme poverty can be eliminated by the year 2025 through carefully planned and targeted development aid.

8.3 Is Foreign Aid the Solution to World Poverty?

Surprisingly, most economists contend that foreign aid has been ineffective, on the whole, in alleviating poverty.

Dambisa Moyo states in her book Dead Aid that more than $1 trillion of aid has gone to Africa, and yet most of the recipients of this aid are not better off, and some are even worse off.

Why?

1. The amount of foreign aid provided is not large enough to lead to sizable increases in physical capital and educational attainment and, more importantly, does not impact technology or the efficiency of production.

8.3 Is Foreign Aid the Solution to World Poverty?

2. In practice, much foreign aid does not get invested in education or new technologies but is captured by corrupt government officials.

Many studies indicate that only about 10% to 15% of foreign aid actually reaches its intended destination.

8.3 Is Foreign Aid the Solution to World Poverty?

3. If the root of poverty is extractive economic institutions, then foreign aid given within these institutions will not fix the fundamental causes of poverty.

Think about why most people insist on donating money through charitable organizations rather than giving directly to the needy individuals.

Instructor: The answer to why most people insist on donating money through charitable organizations is that the donors want a mechanism to ensure that the money is spent on “correct” things, such as food, shelter, and schooling, rather than “incorrect” things, such as alcohol, drugs, and maybe video games.