Lecture 5

1. Lecture 5 Institutions and growth

2. 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.

3. 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

4. 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.

5. 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.

6. 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.

7. Price 110 108 Pisa - Ruremonde 17th century 106 Chicago-Liverpool 1850’s Chicago-Liverpool 1880’s 104 102 100 6 12 18 -1 0 24 Months The law of one price comes with a time lag

8. 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.

9. 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.

10. 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

11. Share-cropping: persistent but in-efficient

12. 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.

13. 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.

14. 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).