Q4: Differentiate between Institutions and Institutional Quality. How strong are the links between
institutional quality and economic performance? Explain.
Answers
Answer:
The inquiry into the nature and causes of the wealth of nations dates back at least to 1776, when Adam Smith published his similarly titled landmark book (Smith, 1776). Smith eloquently describes how well-organized market places allow individuals, solely pursuing their personal interests, to collectively maximize economic welfare. This is the famous ‘invisible hand.’ While this principle has generated heated debates over the course of history as to the parameters within which a market is ‘properly organized’ as well as what ‘economic welfare’ is or should be, it has also raised many open questions that have spurred scholarly interest to this very day.
Fast forwarding to the second half of the twentieth century, Robert Solow (1956) made a landmark contribution, explaining that long-term economic growth is limited to the rate of technical progress, which at the time he assumed to be exogenous. His crucial revelation was that given constant returns to scale production technology all countries can converge to the income levels of the most productive nations and henceforward grow at the exogenous rate of technical progress. Gregory Mankiw, David Romer and David Weil (1992) in the early nineties made the point that this conclusion also extends to an augmented Solow model that includes human capital in addition to physical capital.
By that time, an equally heated debate had started about the endogeneity of technical progress. Paul Romer (1986) floated the idea that knowledge might be an input into production that has properties of increasing returns to scale. Robert Lucas (1993) extended this view with learning by doing, to operationalize the increasing returns properties of knowledge. This generated a vast enquiry into the production of knowledge, the distinction between codified and tacit knowledge, about publicly available ‘knowledge pools’ from which entire societies can benefit.
It is the leap of the economic growth literature to knowledge as a central input that has put the enquiry into the role of the institutional context to the forefront. Indeed, if knowledge is central to potential increasing returns to scale in production, yet at the same time can be freely copied and adopted by anyone at any time: i) how can we explain individuals’ investment in knowledge production, ii) why don’t we see frontier knowledge spread much faster over the whole world, to lift productivity levels of all countries to those at the frontier? Indeed the Solow prediction of structural convergence between economic welfare between countries has not been validated by the data since. The answer lies in how societies and markets are organized and institutions are front and center in that sense.
We assess the importance of institutional quality for economic development below in three chapters. We first address the definition and operationalization of institutional quality and argue why institutional quality leads the virtuous circle between institutional development and economic performance. We then elaborate on how exactly institutional quality transmits into economic growth and find that it shapes an enabling environment for individuals and firms to invest, innovate and grow. Third, we global data on institutional quality and economic performance and find evidence of institutional quality associating with faster rates of income convergence to the global frontier of productivity and economic welfare.