Summary – Acemoglu, Johnson and Robinson (2005), Institutions as a

fundamental cause of long-run growth

Introduction
Basic case: differences in economic institutions = fundamental cause of differences in econ growth.
They are so by determining incentives and constraints. De facto vs de jure power makes the
necessary framework dynamic – political institutions and distribution of resources are state variables
(because they change slowly and determine econ performance & econ inst.). If political institutions
can:

 allocate power to groups who encourage PR-enforcement

 create constraints on power-holders
 and few rents can be captured by power holders

econ growth is stimulated.

The article illustrates this through historical examples. The basis for the argument that institutions
are the fundamental explanation of economic growth is that other (in neoclassical theory) suggested
explanatory factors (innovation, econ of scale, education, capital accumulation) not only cause
growth but in fact ARE growth. (North and Thomas).

Basic argument:

Economic institutions:

1. are endogenous (determined as collective choices, through political power)

2. shape incentives (influence investments, organization of production) and determine distribution
of resources in the future.
3. allocate resources (should facilitate and encourage factor accumulation, innovation)

Political institutions are also endogenous (and determined by collective choices).

De facto political power shaped by:

1. ability to solve collective action problem

2. economic resources, i.e. distribution of resources de facto political power.
Thus, two sources of persistence in the system:

1. Pol. Inst are durable

2. If one group in society rich relative to others – increase its de facto pol power – shape
institutions according to interest.

Potential for change:

Shocks (tech change, international environment). E.g. the glorious revolution (more de facto power
of merchants (land market, cross-atlantic trade) – change in distribution of pol power – changes in
econ institutions (strengthened PR) – econ growth (industrial rev) – different distribution of econ
resources compared to before. )

The issue of COMMITMENT central for the framework. (e.g. credible secure PR demand a reduction
in the political power of a dictator) and not enough to only change policies, need to change the
institutions themselves, in order to secure future and not only present benefits. E.g. if de facto power
– change political (de jure) and not only economic institutions, since this power is likely to reverse in
the future. Makes the changes durable.

GOOD INSTITUTIONS (in this article)= THOSE THAT PROVIDE SECURE PR AND RELATIVELY EQUAL
ACCESS TO ECONOMIC RESOURCES TO A BROAD CROSS-SECTION OF SOCIETY.

The definition leads to comparative statics:

1. Checks on political power?

2. Broad group (with significant investment opportunities) holding power?
3. Limited rents that power holders could extract from the rest of the society?

Aim of chapter:

1. review evidence of basic case presented above

2. outline framework for analyzing why economic institutions vary across countries
3. further areas for research

The three causes of income differences

1. Economic institutions
The way humans organize their societies determines whether they prosper or not. (innovate, take
risks, save, improve, educate, solve problems of collective action, provide public goods etc). The
authors regard market structure as endogenous, and thus market imperfections are a result of
institutions.
2. Geography
Including climate and ecology. Determining preferences and opportunity set of economic actors.
1. Climate determining work effort, incentives and productivity
2. Geography determining availability of technology.
3. Geography and climate determining “disease burden”.
3. Culture
Differs due to differences in shared experiences and religion – determining values, preferences &
beliefs – shaping economic performance. This will affect the possible equilibria of societies (given a
specific set of institutions). Example: webers argument about the role of the protestant reformation
(especially Calvinism) in the industrial revolution. Also, some argue that other particular cultural
endowments play a role.

The role of institutions, they matter

Rather than geography or culture, they cause differences in income. to show causality , need IV:s or
natural experiments:

1. Korea
Stemming from the course of events in this case, differences in economic performance can plausibly
be attributed to differences in institutions. In 2000: level of income in south korea: $16100, north
korea: $1000. North korea an example of when bad institutions are kept in place for the benefit of
the ruling elite and at the expense of the society as a whole. A common pattern in cases of
institutional failure. Problems with establishing the link only through this case:
a. Only one case
b. Extreme case
This is why the second “experiment” is helpful:

2. Colonialism
Basically- geography was held constant while Europeans initiated large changes in economic
institutions (social organization) in different societies. We have had a

- REVERSAL OF FORTUNE in the colonies: previously rich civilizations are now poor and vice versa
(mughals in india, Aztecs, incas vs, north America, new Zealand, Australia). Proxies for
income/capita in pre-industrialized countries: urbanization rate and population density. Negative
correlation found btw econ prosperity in 1500 and today, extraordinary result considering
persistence in prosperity of regions btw 1000 and 1500, and also in non-colonies btw 1500 and
1995 suggesting that reversal wasn’t a general pattern during this later period.
- What actually happened in the European colonies? Previously poor colonies surpassed former
highly-urbanized ones around 1850-1900. Suggested reason: institutions (the reversal is in fact
what the institutions hypothesis predicts), also because:
a. Geography hypothesis inconsistent with historical evidence presented here
b. Culture is argued to have changed in the colonial experiment, but the hypothesis doesn’t
provide a natural explanation for the existence of the reversal nor its timing. Also no
econometric proof that there is an effect of religion or culture on prosperity. (Acemoglu et al
2001)+ historical examples supporting these econometric results (both dutch and british
colonization).
Basically: colonialism led to institutional reversal, since densely settled and highly urbanized
colonies ended up with worse, more extractive, institutions (or inherited the ones already in
place in these societies), while sparsely-settled and non-urbanized had an influx of European
migrants developing institutions protecting PR for broad cross-section of society. This happened
because of incentives (for the Europeans) i.e. few Europeans controlling the area+resources to
extract+difficulty to settle (high mortality) “bad” institutions, no econ or civil rights for
majority of population. Europeans themselves forming the majority of the population + little to
extract+easy to settle econ inst protecting their own PR. Thus geography would affect GDP
today only through its effect on mortality of the settlers and through that on the formation of
institutions.
 To conclude: all this would prove that econ institutions are the fundamental cause of differences
in income/capita across countries.

Reasons to why institutions differ

A theory of econ institutions in order to explain Why countries have different institutions and the
evidence above, i.e. explain the equilibrium set of inst in a country and the comparative statics will
explain the differences btw countries.

1. Efficient institutions view – political Coase theorem

Societies will choose the inst that are socially efficient. Distribution of surplus btw agents doesn’t
affect this choice. Coasian logic= when different economic parties can negotiate costlessly, they will
be able to bargain to internalize potential externalities. Political coase theorem= this notion applies
to political life. Limitations:
a. Commitment problem in politics
b. Doesn’t explain the effect of inst on econ outcome – if chosen efficiently they are always
optimal and thus cannot be fundamental cause of income differences.
BUT, we need to understand WHY societies end up with institutions that are not in their best interest
from a societal point of view. (e.g. Korean case where inst were imposed and not based on the needs
of the societies).

1. Ideology view
Inst differ bcs of ideological differences. (Modified political coase theorem). Basically different inst
are chosen bcs people/leaders disagree on what would be good for the society. i.e. well-meaning
actors but uncertainty about solutions (also btw societies).

BUT the scope of the theory (based on ideology) is highly limited. E.g. in the 80’s it was clear that the
econ inst in north korea weren’t working, the fact that the leaders have been clinging to them has to
be explained by them looking after their own interests at the expense of the population. + british
colonists established very different econ inst in different parts of the world. SO, ideology plays
important role, but a satisfactory theory can in this case not be founded on it. Key agents rather take
actions based on rationality and consequences.

2. Incidental Institutions view

Institutions are the by-product or unintended consequence of other social interactions or historical
accidents. For example nature of relationships or legal origins. (civil law, common law).
BUT even though historical accidents and persistence are important, the aspect of choice of inst
seems too important to be neglected. Persistence is also a choice, at some point people will start to
ask why the society has the inst it has, and consider alternatives. Choice.

3. Social conflict view, advocated in the article.

The distribution of political power in society determines which econ inst that emerge/are chosen.
Those with power will choose in order to maximize their own rents. Those with pol power benefit
from bad institutions, because institutions influence distribution of resources as well as efficiency.
 Equilibrium of econ inst will maximize the rent for the powerful groups and not total
surplus/wealth/income. (e.g. a dictator not enforcing PR). Transaction costs (especially commitment
problems) root of the divergence.

Implications:
a. Includes situations where inst start of as efficient but environment changes and they become
inefficient, changing them may not be privately rational
b. Political institutions important role, contrast to efficient inst view.
c. Main distinction from ideological view: social conflict can lead to choices of econ inst that
cause underdevelopment with all agents knowing that this is the case.
d. Distinction from incidental view: these are conscious choices.
e. Distinction from efficient inst view: doesn’t assume that inst are efficient (its only one
outcome, not the only one or the most likely, why is discussed below)

Sources of inefficiencies
Commitment problems are intrinsic, inability to commit to how pol power will be used in the future,
because there is no third party that can be trusted to enforce contracts when it comes to institutional
choices =the commitment problem in politics. Therefore the Political version of coase theorem
doesn’t hold, i.e. the impact of econ inst on efficiency cannot be separated from their effects on
distribution. The commitment problems will lead to choice and persistence of inefficient institutions
in these ways:

1. Hold-up
Basic problem of a person or group with unconstrained political power to commit to respecting the
property rights of producers (in this case another group) once they have invested. (compare hold-up
in the theory of the firm). This naturally discourages investment, monopoly of pol power no
property right for those without pol power, productive investments not undertaken, econ growth
unexploited. These systems also persist due to commitment problems, hard to limit the use of
political power, examples: Reagan administration and Duvalier in Haiti 1986, Pinochet in Chile and
transition from white to majority rule in Zimbabwe.
2. Political losers
Elites wanting to protect their power (and rents) – evaluates potential economic change according to
both economic AND political consequences. i.e. if groups that now are weak grow strong because of
economic growth. Also applies to introducing new technology. Example: the spread of the industrial
rev. , especially in Russia and Austria-Hungary.
3. Economic losers
Stems from basic supposition that different econ inst imply different distributions of incomes – some
groups are worse off, and these will thus have incentive to block or impede the institutional change.
CLEAR example: international trade (why no free trade). Also technological change (those who
already invested trying to block introduction of new and better tech). also this stemming from
commitment problems (promising future compensation to current econ losers difficult in a credible
way). problem of econ losers less important than 1 &2, because whenever present, political concerns
must also be important (If political power eroded, cannot extract gains from the inst change).
CONCLUSION: Inseparability of efficiency and distribution
These commitment problems introduces trade-off btw efficiency and distribution. Since they are
endemic in collective choice and politics, natural to believe that inst change has distributional
consequences conflict over the set of institutions in society.
4. Comparative statics & colonial experience
Causing better econ inst:
a. Constraints on the use of political power/ separation of powers (persistence of the inst that
the Europeans established, if settled – more checks).
b. Political power in the hands of a broad group containing those with access to the most
important investment opportunities. (compare European settlers, broad based group of
Europeans dominating power when they settled – better econ. Inst)
c. Limited rents that power holders can extract (in places with more wealth, Europeans more
likely to opt for “worse” institutions, i.e. less PR for a majority of the pop.).
d. Inst changes that doesn’t strengthen strong opposition groups or destabilize the political
situation more likely to be adopted. (explains why many colonies didn’t attempt to change
their inst durin 19th century with the new econ opportunities: pol power of elites was linked
to existing econ system.)

IN CONCLUSION: the set of institutions and whether or not a society prospers will be determined by
which groups that have the political power to get the institutions that differentially benefit them

Social conflict view

Historical examples, showing that conflict over econ inst is critical to the functioning of the economy
and stems from the impact of econ inst on distribution, that those with pol power have a
disproportionate effect on econ inst & how the distribution of pol power is influenced by allocation
of de jure power and the ability to exercise de facto power:
1. Labour markets
European transformation from feudal to free labour market, rapid development by those who made
such a transition. (difference eastern/western Europe). Related to the pol power of the key groups
with opposing interests – peasants and lords. The aristocracy made large rents from the feudal
system – wanted to maintain it. When their power weakened, change was possible.
2. Financial markets
Much correlation found btw depth of financial markets and growth. So, why do financial systems
differ? Case of American banks compared to Mexican ones. The US allocated pol power to people
who wanted access to credit and loans, thus no monopoly. In Mexico central gvt granted monopoly
rights – restrict credit to maximize profits – increased revenue for gvts. Economic efficiency was hurt
by regulations, but those with pol power were able to sustain them.
3. Regulation of prices
In agricultural markets. Comparison Africa and Latin America. Gvt controlled marketing boards
(Ghana, Nigeria & Zambia) systematically extracting rents from farmers by paying low, determined
domestic prices and selling to higher world prices, form of taxation. – investment collapsed. Main
motivation to generate resources that could be expropriated or redistributed to maintain power.
More pro-farmer in Kenya and Colombia because of different power relations. (close ties and the
ability to make or break the gvt respectively).

Conclusion: features in common

 a. Outcomes of conscious choices
b. Driving force behind: econ inst are chosen for their distributional consequences, depending
on who has the pol power.

Theory of institutions and its implementation

Where does pol power come from and who has it? The theory is based on social conflict and econ
inst are endogenous, so differences in pol inst & the distribution of pol power is what explains
variation in econ inst.

SOURCES: de jure + de facto = actual pol power. In the examples, previous combination of these
determined the econ inst, that then determined the future distribution of de facto power also after
dramatic changes in de jure power (like independence). They are therefore examples of the model
presented in the introduction. Power and inst often evolve over time in ways that reinforce initial
conditions.

POWER – INST: how pol inst evolve over time and how they influence the [future] distribution of pol
power. They are important bcs of the intrinsically transitory nature of de facto power, due to the
problem of collective action. (e.g. chile, Pinochet re-writing the constitution). This dynamic role
explains the desire of agents to change pol inst when they get the chance – alter balance of pol
power in their favour.

THE THEORY:
1. Individuals have preferences over econ inst because they induce allocation of resources
2. These preferences don’t agree because efficiency and distribution cannot be separated
3. The inseparability is explained by the problem of commitment. (collective choices, sustained
by the state, no third party to control)
4. Equilibrium structure of econ inst will be determined by the agent(s) that has the political
power to create and sustain inst that benefit themselves, affecting the allocation of
resources and rate of econ growth.
5. The 2 forms of pol power: de jure & de facto. The latter determining how inst work in
practice.
6. Distribution of de facto power influenced by distribution of resources in society. These are in
turn influenced by econ inst and outcomes in the past.
7. Pol inst also endogenous: current balance of pol power determining future pol inst. Because
of collective action problem, de facto power is transitory and thus pol inst are often crucial in
creating a source of durable political power. I.e groups often use de facto power to change
pol inst in order to modify the distribution of future pol power in their favour.

“the theory in action”: Putting it together, extended examples

1. constitutional rule in early modern Europe
2. mass democracy in Britain 1800-2000).

Discussion, conclusion
 Most economic growth theory only focuses on proximate determinants of prosperity, not
fully satisfactory explanation
 Need to go beyond neoclassical growth models – deeper causes.
  This article argued that available evidence shows that the growth of a society is determined
by how its economy is organized.
 Also, a theory about difference in econ inst must be based on politics.

Further research:
1. Formalizing the model
2. Increased understanding of how and why inst persist or change
3. Increased understanding of the role of policy and interventions in changing inst equilibrium,
in order to eventually reach policy conclusion on how to improve inst, lives and welfare.