Lecture 5

Institutions and growth

Issues discussed today

• What do Institutions do?

• Are persistent ,long-lived institutions necessarily efficient?

• How do institutions emerge?

• Which are the necessary instutions for economic progress.

The function of institutions

• Good institutions tend to stimulate growth because they improve the allocation of resources,for example

• markets stimulate division of labour• money stimulates exchange• banks solve information assymetries

between savers and investors• private property rights are a barrier to

overexploitation of resources

The peculiarity of institutional explanations

• Explanations of the emergence and persistence of institutions often stress the beneficial effect of an institution.

• Standard causal explanations have a time-lag between cause and effect.

• Consequence explanations reverse that order: the effect is the cause

• A selection mechanism is needed: competitive selection or design.

The essential institutions in a modern economy

• Markets for labour,commodities and capital.

• Contract enforcement institutions.

• Law and order.

• Accountable government.

• Trust, commitment and social capital.

Market performance has improved over time

• Thin vs. thick markets.

• The institutionalization of markets and fairs: Champagne in the medieval era.

• Information speed is the key to market efficiency.

• Transparency and collusion.

The law of one price comes with a time lag

Price

110

108

106

104

102

100-1 0 6 12

Months24

Pisa - Ruremonde 17th century

18

Chicago-Liverpool1850’s

Chicago-Liverpool1880’s

The persistence of inefficient institutions: slaverey and serfdom

• Institutions do have distributional consequences and can survive when they serve powerful vested interests.

• Serfdom emerged because landholders could not get a rent from peasants leasing their land when there was free fertile land at the frontier.

• Serfdom was disappearing when population pressure drove down opportunity income of the landless.

Was open field agriculture efficient?

• Peasant households had their land scattered in narrow strips in different parts of the village: insurance against local harvest shocks?

• In agriculture where shocks can bring you down to subsistence ; maximum efforts of all were essential: open field lay-out helped peer monitoring.

• Conclusion: sceptics have the right to remain sceptic.

Firms vs.farms

• Why are firms not labour-managed as most farms.Farms are run by those who work the land, while firms are run by those who own the capital?

• Economies of scale.• Monitoring cost.• Risk aversion and low risk diversification.• Time horizon and firm objectives.• Path dependence and competitive selection

Share-cropping: persistent but in-efficient

Co-operatives vs. capitalist firms

• Vertical integration is a solution when firms face suppliers with hold-up power or suppliers who do not honour contracts.

• Suppliers are residual claimants in co-operatives and have an interest in peer montoring.

• Being residual claimants suppliers to co-operatives are willing to enter long-term contracts.

• Selection mechanism: competitive markets.

Why do ethnic groups often form commercial networks?

• Lombard Street and Rue Juif.• Information asymmetries generate

principal agent problems.• Ethnic groups share common beliefs and a

code of conduct and can sanction members by exclusion: reputation matters.

• Information about misconduct of an agent is swiftly transmitted within the group.

•

Conclusion

• Persistence of an institution is not necessarily a sign of efficiency.

• Institutions often emerge to solve problems linked to

• risk (the limited liability corporation), • information asymmetries (banks) • incomplete contracts (trust and

commitment), • exchange (money and markets).