CHAPTER 5:
INSTITUTIONS
AND GROWTH
INSTITUTIONS AND EFFICIENCY
• Institutions are the rules of the game
• Upheld by law, consent, brute force
• Some informal: e.g. trust and commitment
• Some formal: e.g. limited liability corporation
• Institutions usually explained by their efficiency- enhancing effects
• Pareto-efficiency not useful for analyzing institutions,
EFFICIENCY AND PERSISTENCY
• Persistent institutions are not always efficient!
• Institutions can survive because they serve the interests of social groups with political power
– Serfdom – Slavery – Guilds?
WERE GUILDS EFFICIENT?
• Guilds were associations of producers in a particular field, e.g. bakers, within city limits
• Restricted competition, regulated entry, fixed prices
• Critique: rent-seeking institutions, like a cartel
• But no evidence productivity growth slower in towns
• Maintained quality standards
• Trained apprentices
• Developed trade union functions
THE PECULIARITY OF INSTITUTIONAL EXPLANATIONS
• Special causal structure if we want to explain institutions by their efficiency-enhancing characteristics
• Standard causality (cause effect):
– Government cuts taxes consumption increased
• Causality with institutional efficiency (effect cause):
– Private property rights evolve because they evade the inefficiency problem of common access to a resource
• Similarity to Darwinian natural selection
– Birds have light bones to be able to fly and escape predators
THE CHARACTERISTICS OF A MODERN ECONOMY
• 16th century Dutch economy has been described as the
‘first modern economy’ due to its institutional characteristics
– Free access to functioning markets – Advanced division of labour
– Government that respected and enforced property rights
• Markets for factors of production promote TFP growth
– Free labour seeks the best reward
OTHER INSTITUTIONAL FEATURES OF THE NETHERLANDS
• Culture of thrift, since status linked to effort, not birth
• Tolerant mentality, attracted talented immigrants
• Constraints on the political executive, no arbitrary taxation and trading privileges
• Note the contrast between fortunes of Belgium, which remained under Spanish rule
• Note also that England borrowed institutions from the Netherlands: ‘the Glorious Revolution’ 1688-9
RELIGION AND GROWTH
• In 1905 Max Weber suggested the Protestant north of Europe was richer than the Catholic south because of Martin Luther’s promotion of hard work and thrift
• The ‘Protestant ethic’ – controversial and difficult to test!
• Recent work by Becker and Woessmann argues for the importance of Luther’s idea that the Bible should be translated and read promoted literacy
MARKET PERFORMANCE IN HISTORY
• Markets are rarely perfect, performance has varied in history
• Law of one price gives an equilibrium price which is rarely attained, although acts as an ‘attractor’
– High transport costs
– Information asymmetries – Slow adjustment times
• When prices are out of equilibrium, trade and exchange is inhibited: excess supply or demand
MARKET EFFICIENCY OVER TIME
• Through most of history markets were thin: few participants, information costly
• But improvements over time:
– 12th - 14th century Champagne fairs
– 17th century postal system and commercial press – 19th century telegraph
– Etc.
THE RISE AND DECLINE OF SERFDOM
• Example of an inefficient but persistent institution
• Serfdom meant labour was not free
– Serfs given small plot for subsistence agriculture – A percentage of output was given to the lord
– And / or forced work on the lord’s estate
• Medieval period saw the rise and decline of serfdom
WHY DID SERFDOM EMERGE?
• Domar: if land is abundant, marginal product of land is equal to the average product, so landlords could not
extract a land-rent from free peasants
• Solution was to restrict mobility
• Decline of serfdom when labour shortage replaced by land shortage
GEOGRAPHY AND TIMING OF SERFDOM
• No obvious direct link with Roman slave labour
• Gained momentum in ninth century, but not all Europe
– Core between the rivers Loire and Rhine (former Carolingian empire)
– Spread eastwards, but weak or absent in southern France, Scandinavia and Eastern Europe
– Mixed in Italy and England
• Was never the dominant source of agricultural output
CONDITIONS FOR SERFDOM
• Labour shortage (population decline after the collapse of the Roman Empire)
• Small and declining independent peasantry
• High concentration of land in the hands of lay and ecclesiastical landowners
• A state which cooperated with the aristocracy
• Landlords offered lighter burden in areas with higher opportunity income for runaway serfs
DECLINE OF SERFDOM
• Consensual and driven by market forces
• After Black Death landlords were competing for scarce labour
• Growing incentives to defect to cities, other estates,
areas of land reclamation gradual relaxation of labour services
• Earliest decline in the Low Countries
• Led to development of sophisticated land and labour markets (later industrialization)
OPEN FIELD SYSTEM
• Agricultural reforms led to growing importance of small household-based farms
• Before consolidation based on open field system
– Farmers had small plots scattered over a wide area
• Difficult to find an efficiency-enhancing characteristic
– Perhaps reduced risks from local harvest shocks – Allowed for monitoring of effort
– Heavy plough required co-operative work effort
FARMS VS. FIRMS
• In agriculture the worker is the residual claimant
– Output determined by nature, difficult to separate from effort – Owners cannot cheat on themselves
• In industry the factory owner is the residual claimant
– Production constrained by human ingenuity economies of scale
– Systems of reward and control of work effort
– In principle workers could borrow capital to set up labour- managed firms, but capital markets were imperfect
WHY ARE FIRMS STILL USUALLY CAPITALIST?
• Path dependency given previous capital market imperfections
• Capitalist firms more adaptive, because only aim was to maximize returns for the owners
• Labour-managed firms would e.g. also aim not to make owners redundant, delayed introduction of labour-saving machinery
• Exceptions in services where quality of work difficult to
CO-OPERATIVES
• From late-19th century capitalist firms challenged by cooperatives: supplier-managed firms
• Famous example the Danish dairy cooperatives
– Often considered the main reason for Danish success as agricultural exporter
• Other examples: sawmills, paper producers, meat producers, wineries
• But not e.g. car manufacturers or steel producers
DANISH CO-OPERATIVE AND
PROPRIETARY CREAMERIES
DAIRY CO-OPERATIVES AND HOLD-UP
• Milk is perishable, so firms relied on critical mass of suppliers from limited geographical area
• Difficult to punish farmers who cheated on quality
• Hold-up power of suppliers:
– Firm ‘locked in’ by investment in fixed capital with no alternative uses
– Farmers could switch to alternative production
• Solution a form of vertical integration via contracts
– But relied on ability to enforce these
SHARECROPPING
• Was common for peasants to lease land by surrendering a share of the output, rather than paying fixed rent
• Reduced work effort (since only received a share of the marginal output), so how can this be efficient?
– Reduced risks from bad harvests?
– Stopped tenants from over-exploiting the land?
• But fixed rent tenants could postpone rent payments if bad harvests, and would not over-exploit given long
ASYMMETRIC INFORMATION AND SELF-ENFORCING CONTRACTS
• Long-distance trade means that payment and delivery do not coincide
• Merchants typically used agents to complete an exchange principal-agent problem
• Ideal contracts should be self-monitoring, i.e. in agent’s own interest to be honest
– Reputation has to matter, cheating detected – Merchants joined forces to report misconduct
• Networks often based around ethnic groups
SUMMARY
• Researchers not always successful at explaining inefficient institutions
• Institutions explained by their consequences
• Selection mechanism biased towards vested interests
• But many institutions exist because of their efficiency- enhancing properties!
