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Title: Social

Chapter 7
Social Infrastructure and Long-Run Economic
Charles I. Jones
Importance of Economic Institutions
  • Both Solow and endogenous growth models have
    treated savings rates and the time individuals
    spend on education to be exogenously given.
  • What are the determinants of investment rates and
    of time spent accumulating new skills?
  • Geography natural resources abundance, milder
    climate, sunny weather
  • Cultural endowment Protestant ethics, Confucian
  • Counterexamples
  • South and North Korea
  • China versus Hong Kong, Taiwan
  • East versus West Germany

Olson (1996) Economic Institutions
Cost-Benefit Analysis
  • Cost-benefit analysis is a procedure that helps
    evaluate whether an investment is worth
    undertaking. It consists of the following steps
  • Evaluate the costs associated with the
    investment, C
  • Evaluate the benefits associated with the
    investment, B
  • If BgtC, go ahead with the project if BltC,
    abandon the project

Cost-Benefit Analysis an Example
  • A manager considers launching a business
    subsidiary, e.g. opening an office in a foreign
  • Costs
  • A one-time setup cost F
  • Domestic and foreign business licenses
  • Establishing business contacts with suppliers and
  • Construction costs (of a new office building)
  • Benefits
  • The present discounted value of the future
  • Suppose your subsidiary will be functioning for
    20 years. In the end of each year your overseas
    project will pay you .
  • (r is the bank interest rate)

Managers Decision
The manager decides on the investment project
according to the following rule If
, open the subsidiary If , do not
open the subsidiary Note the greater than or
equal sign can be replaced with strictly
greater without loss of generality. For example,
in case one can toss a coin.
Technology Diffusion and Skill Acquisition
A lot of technology transfer occurs exactly by
means of a manager deciding on opening a foreign
subsidiary. Cost-benefit analysis is also
applicable to the area of skills
acquisition One additional year of schooling
will cost you F (the sum of direct costs and
opportunity costs), and the benefit will be
the present discounted value of your future wages
(e.g. 40 years x 12 months x monthly wage).
Variation in Benefits and Costs of Investments
Main hypothesis there is a great deal of
variation in F and around the world that
explains differences in investment rates and the
time individuals spend on education. This
variation is mainly due to the differences in
government policies and institutions, otherwise
known as social infrastructure.
What is a good government policy? A good
government policy is the one that minimizes F and
maximizes since it is encouraging
investment. Alternatively, we can talk about the
maximization of
The Bribe Curse
  • Suppose you want to set up a hot-dog stand in the
    middle of a street.
  • You will likely have to go through the following
  • Purchase property (a plot of land, or a small
    shop building)
  • Have your stand inspected by the officials for
  • Obtain business permit from the district council
  • Get connected to the electricity grid
  • At each step, the government bureaucrats enter
    the process, which gives them an opportunity to
    extort bribes.
  • The last bureaucrat in the chain will want a
    bribe whose amount is almost equal to . Given
    all the previous bribes, the ex ante decision
    (i.e. the one before the first bribe is paid) is
    not to invest!

Bribes and the Role of Institutions
In a healthy market economy, the healthy economic
institutions, or social infrastructure, minimize
concerns related to bribes, which results in a
dynamic and thriving business environment. Howeve
r, in many countries these institutions are
almost absent Shleifer and Vishny (1993) To
invest in a Russian company, a foreigner must
bribe every agency involved in foreign
investment, including the foreign investment
office, the relevant industrial ministry, the
finance ministry, the executive branch of the
local government, the legislative branch, the
central bank, the state property bureau, and so
on. The obvious result is that foreigners do not
invest in Russia. Such competing bureaucracies,
each of which can stop a project from proceeding,
hamper investment and growth around the world,
but especially in countries with weak governments.
De Sotos Story
  • In the summer of 1983, de Soto and a team of
    researchers started a small garment factory
    outside of Lima, Peru, to assess the extent of
    bureaucratic intervention (red tape).
  • This is what they had to go through
  • Obtain documents
  • Zoning certificate
  • Registration certificate with the tax authorities
  • Municipal license
  • 289 person-days spent on meeting these
  • Ten bribes requested, only two of them paid
  • The cost of starting a small business is 32 times
    the monthly minimum living wage

Starting a New Business International Outlook
The World Bank compiles Doing Business report for
a range of countries. This is what the report
found for 2012 US 6 days to register a new
company, the cost is 1.4 of income per
capita India twice as many procedures compared
to the US, registration takes 29 days, costs are
close to 50 of income per capita Nigeria 34
days to register, costs around 70 of income per
capita Honduras 14 days to register, costs are
63 of income Korea 3 days to register, 14
income per capita
Investment Profitability
  • The determinants of profitability fall into three
    broad categories
  • Market size
  • Extent to which production is favored over
  • Stability of economic environment

Market Size
Windows 8 took hundreds of millions of U.S.
dollars to develop. Selling it to a small market
does not make economic sense. However, the
market for Windows 8 is the whole world, so
development costs F are justified. We have
already discussed this scale effect in a
different context. The extent of openness of an
economy to the international trade thus plays a
very important role.
Production versus Diversion
  • To favor production, an economy needs social
    infrastructure encouraging individuals to do
  • Diversion happens when resources are expropriated
    from production units or individuals.
  • Theft
  • Corruption
  • Racketeering (protection money)
  • Taxation by the government
  • Frivolous litigation
  • Lobbying with the government

The economic effects of diversion are those of a
tax you either pay the bandits or the
government, or you invest in order to avoid
diversion e.g. security guards, bribing
government officials
Diversion and the Government
The economic institutions maintained by the
government play the key role in reducing the
extent of possible diversion in the economy. In
an economy that favors diversion, the government
itself is often the key benefactor of
diversion. In general, taxation laws can be used
by the government in order to turn tax proceeds
into their private rents. Such rents divert
productive resources away from their productive
uses, decrease investment rates, provide
disincentives to learn new skills, and ultimately
thwart economic growth and development.
Stability of Environment
Returns to investment are positively influenced
by the stability of the market environment. An
economy where rules and institutions change
frequently is a risky place to invest. Wars and
revolutions are extreme forms of instability.
What is a Business-Friendly Country?
  • A business-friendly country is the one that
    attracts investments in the form of capital for
    businesses, technology transfer from abroad, and
    skills from individuals. This country will be
    characterized by
  • Institutions and laws that favor production over
  • Openness to international trade
  • Stable economic institutions

Empirical Indicators
  • World Bank Governance Indicators Project collects
    data on
  • Accountability of politicians
  • Political stability
  • Government effectiveness
  • Regulatory quality
  • Rule of law
  • Control of corruption

The World Bank provides ranking of each country
in these six areas. We can take an average of
these rankings and normalize it to the value of 1
for the country with the highest average.
Causality, or Chicken and Egg Problem
  • Causality problems occur when one can argue that
  • A causes B
  • B causes A

Let A be good social infrastructure and B the
high TFP and investment. We argued that A
causes B. However, we can also argue that B
causes A, that is, it is because an economy is
productive and invests a lot, it is easy to
afford a luxury of having good social
infrastructure. The solution is to look at cases
when infrastructure changes exogenously without
accompanying changes in TFP or investment rates.
Exogenous Changes in Infrastructure
Acemoglu, Johnson, and Robinson (2001)
colonization of coutnries by Europeans placed
better infrastructure in colonies, which
increased incomes per capita that persisted even
after independence. Dell (2010) the mita system
based on forced labor enforced by the Spanish
from 1573 to 1812 in Bolivia and Peru. The mita
areas were found to be those with much worse
infrastructure compared to the neighboring areas
that share same cultural and geographic
background. The overall conclusion is, the
causality runs from infrastructure to investments
and TFP, not the other way round.
Investments and Social Infrastructure
Countries with good social infrastructure have
higher investment rates in physical
capital Returns on investment are higher in
countries with good social infrastructure
Education and Social Infrastructure
Countries with good social infrastructure invest
more in human capital Better education increases
return on investments as well.
Migration of Skilled Workers Revisited
One of the stylized facts in Chapter 1 said that
both skilled and unskilled workers migrate from
poor to rich countries. The question was, why is
it that skilled workers do not migrate to the
poor countries where they are scarce, and hence
will receive a higher return? Returns to skill
are not fully realized in poor countries because
these countries have a lot of problems with
Social Infrastructure and TFP
Higher TFP means you produce more with the same
inputs Better infrastructure is associated with
higher TFP In a country with poor social
infrastructure, returns on diversion are higher
than returns on production
Differences in the level of social infrastructure
I drive differences in output
Choice of Social Infrastructure
  • Why is it that social infrastructure is so
    different across countries?
  • Max Weber (1920) The Protestant Ethic and the
    Spirit of Capitalism belief systems are
  • Culture
  • Climate and geography the distance from equator
  • Douglass North (1981) how easy is it to replace
    the governor?
  • Ownership structures maximize rents to the ruler
  • Efficient systems reduce transaction costs and
    encourage economic growth

Commitment Problem
  • Acemoglu and Robinson (2012)
  • Ruling elite have incentives to maximize their
    rents, which results in diversion rather than
    production, so they cannot commit to favoring
  • The governees cannot commit to remunerate the
    rulers after they have stepped down
  • The resulting economic system favors diversion
    rather than production for lack of commitment on
    both sides

The Chinese Mystery
  • China was unable to maintain technological lead
    after the 14th century
  • Paper, horse harness, printing type, compass,
    clock, gunpowder, spinning wheel, iron casting
  • Industrial revolution happened in the West, not
    in China why?
  • Lack of institutions seems to be the reason
  • The Ming dynasty replaced the Mongol dynasty in
  • Stable and controlled environment strongly
  • Innovators and purveyors of foreign ideas
    considered troublemakers
  • As a result, lots of inventions were forgotten,
    some inventions simply never improved

Persistence of Social Infrastructure
  • Acemoglu, Johnson, Robinson (2002)
  • Reversal of fortune in former colonies
  • Europeans colonized both Africa and North
    America, but the wealth outcomes are vastly
  • In Africa, Europeans instituted a diversionary
    infrastructure that favored extraction of rents
  • In North America, Europeans instituted an
    infrastructure that favored production
  • Sokoloff and Engerman (2000)
  • North America versus Brazil both colonized by
  • Economic outcomes differ a lot between the two
  • Sugar production favored large plantations?small
    ruling elites?diversion economy
  • Family farming favored in the North, more
    population involved in politics?production-oriente
    d economy

Growth Miracles and Disasters
  • Korea
  • One of the poorest countries in 1945
  • An industrialized economy now, a technological
  • Income per capita 62 of the US level in 2012
  • Japan
  • 1870-1945 Japans income 25 of the US level
  • Income per capita 69 of the US level in 2012
  • Argentina
  • End of nineteenth century as rich as most
    Western European countries
  • By 2008 income per worker is only 30 of the US
  • Policy reforms changed infrastructure in
    disastrous way

Long-Run Income Distribution
  • Some convergence to the US level at the top of
  • In the last 40 years more growth miracles than
  • The world is gradually discovering the social
    infrastructure conducive to long-run growth
  • World income distribution still evolving
  • Years to shuffle say how many years will have
    to pass before the initial conditions cease to