1. Social Infrastructure and Long-Run Economic Performance Chapter 7
Charles I. Jones

2. Importance of Economic Institutions
Both Solow and endogenous growth models have treated savings rates and the time individuals spend on education to be exogenously given.
What are the determinants of investment rates and of time spent accumulating new skills?
Geography: natural resources abundance, milder climate, sunny weather
Cultural endowment: Protestant ethics, Confucian values
Counterexamples:
South and North Korea
China versus Hong Kong, Taiwan
East versus West Germany
Olson (1996): Economic Institutions

3. Cost-Benefit Analysis
Cost-benefit analysis is a procedure that helps evaluate whether an investment is worth undertaking. It consists of the following steps:
Evaluate the costs associated with the investment, C
Evaluate the benefits associated with the investment, B
If B>C, go ahead with the project; if B<C, abandon the project

4. Cost-Benefit Analysis: an Example
A manager considers launching a business subsidiary, e.g. opening an office in a foreign country.
Costs
A one-time setup cost F
Domestic and foreign business licenses
Establishing business contacts with suppliers and distributors
Construction costs (of a new office building)
Benefits
The present discounted value of the future profits
Suppose your subsidiary will be functioning for 20 years. In the end of each year your overseas project will pay you
(r is the bank interest rate)

5. Manager’s Decision
The manager decides on the investment project according to the following rule:
If , open the subsidiary
If , do not open the subsidiary
Note: the “greater than or equal” sign can be replaced with “strictly greater” without loss of generality. For example, in case one can toss a coin.

6. Technology Diffusion and Skill Acquisition
A lot of technology transfer occurs exactly by means of a manager deciding on opening a foreign subsidiary.
Cost-benefit analysis is also applicable to the area of skills acquisition:
One additional year of schooling will cost you F (the sum of direct costs and opportunity costs), and the benefit will be the present discounted value of your future wages (e.g. 40 years x 12 months x monthly wage).

7. Variation in Benefits and Costs of Investments
Main hypothesis: there is a great deal of variation in F and around the world that explains differences in investment rates and the time individuals spend on education.
This variation is mainly due to the differences in government policies and institutions, otherwise known as social infrastructure.
What is a good government policy?
A good government policy is the one that minimizes F and maximizes since it is encouraging investment.
Alternatively, we can talk about the maximization of

8. The Bribe Curse
Suppose you want to set up a hot-dog stand in the middle of a street.
You will likely have to go through the following steps:
Purchase property (a plot of land, or a small shop building)
Have your stand inspected by the officials for safety
Obtain business permit from the district council
Get connected to the electricity grid
At each step, the government bureaucrats enter the process, which gives them an opportunity to extort bribes.
The last bureaucrat in the chain will want a bribe whose amount is almost equal to Given all the previous bribes, the ex ante decision (i.e. the one before the first bribe is paid) is not to invest!

9. Bribes and the Role of Institutions
In a healthy market economy, the healthy economic institutions, or social infrastructure, minimize concerns related to bribes, which results in a dynamic and thriving business environment.
However, in many countries these institutions are almost absent:
Shleifer and Vishny (1993):
To invest in a Russian company, a foreigner must bribe every agency involved in foreign investment, including the foreign investment office, the relevant industrial ministry, the finance ministry, the executive branch of the local government, the legislative branch, the central bank, the state property bureau, and so on. The obvious result is that foreigners do not invest in Russia. Such competing bureaucracies, each of which can stop a project from proceeding, hamper investment and growth around the world, but especially in countries with weak governments.

10. De Soto’s Story
In the summer of 1983, de Soto and a team of researchers started a small garment factory outside of Lima, Peru, to assess the extent of bureaucratic intervention (red tape).
This is what they had to go through:
Obtain documents
Zoning certificate
Registration certificate with the tax authorities
Municipal license
289 person-days spent on meeting these requirements
Ten bribes requested, “only” two of them paid
The cost of starting a small business is 32 times the monthly minimum living wage

11. Starting a New Business: International Outlook
The World Bank compiles Doing Business report for a range of countries. This is what the report found for 2012:
US: 6 days to register a new company, the cost is 1.4% of income per capita
India: twice as many procedures compared to the US, registration takes 29 days, costs are close to 50% of income per capita
Nigeria: 34 days to register, costs around 70% of income per capita
Honduras: 14 days to register, costs are 63% of income
Korea: 3 days to register, 14% income per capita

12. Investment Profitability
The determinants of profitability fall into three broad categories:
Market size
Extent to which production is favored over diversion
Stability of economic environment

13. Market Size
Windows 8 took hundreds of millions of U.S. dollars to develop.
Selling it to a small market does not make economic sense.
However, the market for Windows 8 is the whole world, so development costs F are justified.
We have already discussed this “scale effect” in a different context.
The extent of openness of an economy to the international trade thus plays a very important role.

14. Production versus Diversion
To favor production, an economy needs social infrastructure encouraging individuals to do business.
Diversion happens when resources are expropriated from production units or individuals.
Theft
Corruption
Racketeering (protection money)
Taxation by the government
Frivolous litigation
Lobbying with the government
The economic effects of diversion are those of a tax: you either pay the bandits or the government, or you invest in order to avoid diversion: e.g. security guards, bribing government officials

15. Diversion and the Government
The economic institutions maintained by the government play the key role in reducing the extent of possible diversion in the economy.
In an economy that favors diversion, the government itself is often the key benefactor of diversion.
In general, taxation laws can be used by the government in order to turn tax proceeds into their private rents. Such rents divert productive resources away from their productive uses, decrease investment rates, provide disincentives to learn new skills, and ultimately thwart economic growth and development.

16. Stability of Environment
Returns to investment are positively influenced by the stability of the market environment.
An economy where rules and institutions change frequently is a risky place to invest.
Wars and revolutions are extreme forms of instability.

17. What is a Business-Friendly Country?
A business-friendly country is the one that attracts investments in the form of capital for businesses, technology transfer from abroad, and skills from individuals. This country will be characterized by:
Institutions and laws that favor production over diversion
Openness to international trade
Stable economic institutions

18. Empirical Indicators
World Bank Governance Indicators Project collects data on
Accountability of politicians
Political stability
Government effectiveness
Regulatory quality
Rule of law
Control of corruption
The World Bank provides ranking of each country in these six areas. We can take an average of these rankings and normalize it to the value of 1 for the country with the highest average.

19. Causality, or Chicken and Egg Problem
Causality problems occur when one can argue that:
A causes B
B causes A
Let A be “good social infrastructure” and B the “high TFP and investment”. We argued that A causes B.
However, we can also argue that B causes A, that is, it is because an economy is productive and invests a lot, it is easy to afford a luxury of having good social infrastructure.
The solution is to look at cases when infrastructure changes exogenously without accompanying changes in TFP or investment rates.

20. Exogenous Changes in Infrastructure
Acemoglu, Johnson, and Robinson (2001): colonization of coutnries by Europeans placed better infrastructure in colonies, which increased incomes per capita that persisted even after independence.
Dell (2010): the mita system based on forced labor enforced by the Spanish from 1573 to 1812 in Bolivia and Peru. The mita areas were found to be those with much worse infrastructure compared to the neighboring areas that share same cultural and geographic background.
The overall conclusion is, the causality runs from infrastructure to investments and TFP, not the other way round.

21. Investments and Social Infrastructure
Countries with good social infrastructure have higher investment rates in physical capital
Returns on investment are higher in countries with good social infrastructure

22. Education and Social Infrastructure
Countries with good social infrastructure invest more in human capital
Better education increases return on investments as well.

23. Migration of Skilled Workers Revisited
One of the stylized facts in Chapter 1 said that both skilled and unskilled workers migrate from poor to rich countries.
The question was, why is it that skilled workers do not migrate to the poor countries where they are scarce, and hence will receive a higher return?
Returns to skill are not fully realized in poor countries because these countries have a lot of problems with diversion.

24. Social Infrastructure and TFP
Higher TFP means you produce more with the same inputs
Better infrastructure is associated with higher TFP
In a country with poor social infrastructure, returns on diversion are higher than returns on production
Differences in the level of social infrastructure I drive differences in output

25. Choice of Social Infrastructure
Why is it that social infrastructure is so different across countries?
Max Weber (1920) “The Protestant Ethic and the Spirit of Capitalism”: belief systems are important
Culture
Climate and geography: the distance from equator theories
Douglass North (1981): how easy is it to replace the governor?
Ownership structures maximize rents to the ruler
Efficient systems reduce transaction costs and encourage economic growth

26. Commitment Problem Acemoglu and Robinson (2012)
Ruling elite have incentives to maximize their rents, which results in diversion rather than production, so they cannot commit to favoring production
The governees cannot commit to remunerate the rulers after they have stepped down
The resulting economic system favors diversion rather than production for lack of commitment on both sides

27. The Chinese Mystery
China was unable to maintain technological lead after the 14th century
Paper, horse harness, printing type, compass, clock, gunpowder, spinning wheel, iron casting
Industrial revolution happened in the West, not in China: why?
Lack of institutions seems to be the reason
The Ming dynasty replaced the Mongol dynasty in 1368
Stable and controlled environment strongly preferred
Innovators and purveyors of foreign ideas considered troublemakers
As a result, lots of inventions were forgotten, some inventions simply never improved

28. Persistence of Social Infrastructure
Acemoglu, Johnson, Robinson (2002)
Reversal of “fortune” in former colonies
Europeans colonized both Africa and North America, but the wealth outcomes are vastly different
In Africa, Europeans instituted a diversionary infrastructure that favored extraction of rents
In North America, Europeans instituted an infrastructure that favored production
Sokoloff and Engerman (2000)
North America versus Brazil: both colonized by Europeans
Economic outcomes differ a lot between the two regions
Sugar production favored large plantationssmall ruling elitesdiversion economy
Family farming favored in the North, more population involved in politicsproduction-oriented economy

29. Growth Miracles and Disasters
Korea
One of the poorest countries in 1945
An industrialized economy now, a technological wonder
Income per capita 62% of the US level in 2012
Japan
Japan’s income 25% of the US level
Income per capita 69% of the US level in 2012
Argentina
End of nineteenth century: as rich as most Western European countries
By 2008 income per worker is only 30% of the US level
Policy “reforms” changed infrastructure in disastrous way

30. Long-Run Income Distribution
Some convergence to the US level at the top of distribution
In the last 40 years more growth miracles than disasters
The world is gradually discovering the social infrastructure conducive to long-run growth
World income distribution still evolving
Years to “shuffle” say how many years will have to pass before the initial conditions cease to matter