1. Why Isn’t the Whole World Developed?
Chapter 8
Why Isn’t the Whole World Developed?
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2. 8.1 Proximate Versus Fundamental Causes of Prosperity
8 Why Isn’t the Whole World Developed?
Chapter Outline
8.1 Proximate Versus Fundamental Causes of Prosperity
8.2 Institutions and Economic Development
EBE Are Tropical and Semitropical Areas Condemned to Poverty by Their Geographies?
8.3 Is Foreign Aid the Solution to World Poverty?
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3. 8 Why Isn’t the Whole World Developed?
Key Ideas
Proximate causes of prosperity link prosperity and poverty of nations to the levels of inputs, while fundamental causes look for reasons why there are such differences in the levels of inputs.
The geography, culture, and institutions hypotheses advance different fundamental causes of prosperity.
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4. 8 Why Isn’t the Whole World Developed?
Key Ideas
Inclusive and extractive economic institutions affect economic development.
Creative destruction is integral to economic growth through technological change.
Reversal of fortune evidence provides support for the institutions hypothesis.
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5. Proximate causes of prosperity
8.1 Proximate Versus Fundamental Causes of Prosperity
Proximate causes of prosperity
High levels of factors of production such as physical capital, human capital, and technology that result in a high level of GDP per capita.
The factors of production are proximate causes because they link high levels of prosperity to high levels of the factors, but without providing an explanation for why these factors are high.
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6. Fundamental causes of prosperity
8.1 Proximate Versus Fundamental Causes of Prosperity
Fundamental causes of prosperity
The root reasons for the differences in the proximate causes.
The fundamental causes are ultimately the deep determinants of economic development.
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7. 8.1 Proximate Versus Fundamental Causes of Prosperity
Exhibit 8.1 Fundamental and Proximate Causes of Prosperity
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8. Institutions hypothesis
8.1 Proximate Versus Fundamental Causes of Prosperity
Fundamental causes can be classified into three categories or theories:
Geography hypothesis
Culture hypothesis
Institutions hypothesis
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9. 8.1 Proximate Versus Fundamental Causes of Prosperity
The geography hypothesis claims that differences in geography, climate, and ecology are ultimately responsible for the large differences in prosperity observed around the globe.
The following map of the world reveals that economies with low levels of GDP per capita are located in tropical areas, while those with high levels are in temperate areas (outside the tropics).
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10. 8.1 Proximate Versus Fundamental Causes of Prosperity
Tropic of Cancer
Tropic of Capricorn
Source:
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11. 8.1 Proximate Versus Fundamental Causes of Prosperity
In the past, the French philosopher Montesquieu and the British economist Alfred Marshall argued that tropical climates decreased work effort.
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12. that tropical climates are more prone to infectious
8.1 Proximate Versus Fundamental Causes of Prosperity
Economist Jeffrey
Sachs and geographer
Jared Diamond argue
that tropical climates are
more prone to infectious
diseases such as malaria
and dengue fever, which
result in poverty.
The following graph tests the geography hypothesis using cross-country data.
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13. 8.1 Proximate Versus Fundamental Causes of Prosperity
Instructor: The graph examines the relationship between malaria exposure in 1966 (horizontal line) and real GDP per capita (vertical line) in Each dot represents a different country, with the red dots labeled. The blue line is the exponential fitted line.
If the geography hypothesis is correct, there should be a negative relationship between the two variables. The data seem to support the hypothesis, although the numerous countries with 0% and 100% make it difficult to interpret.
Sources: Malaria data is from Gallup, John, and Jeffrey Sachs (1998); “Geography and Economic Development”; Brookings Papers on Economic Activity and GDP data is from Penn World Table Version 7.1
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14. 8.1 Proximate Versus Fundamental Causes of Prosperity
The culture hypothesis claims that different values and cultural beliefs are ultimately responsible for the large differences in prosperity observed around the globe.
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15. 8.1 Proximate Versus Fundamental Causes of Prosperity
In 1905, the German socialist Max Weber argued that Protestant beliefs lead to a greater work effort, higher savings, and increased income.
The following graph tests the Protestant work ethic hypothesis using cross-country data.
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16. 8.1 Proximate Versus Fundamental Causes of Prosperity
Instructor: The graph examines the relationship between the percentage of the population that is Protestant in 1900 (horizontal line) and real GDP per capita (vertical line) in Each dot represents a different country with, the red dots labeled. The brown line is the exponential fitted line.
If Weber’s Protestant Work Ethic hypothesis is correct, there should a positive relationship between the two variables. There is little evidence in support of this hypothesis given the many rich countries with 0 Protestants.
Sources: Religion data is from the World Religion Database and GDP data is from Penn World Table Version 7.1
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17. 8.1 Proximate Versus Fundamental Causes of Prosperity
Almost 20 years ago, the Harvard political scientist Samuel Huntington talked of a “clash of civilization” between the West and Islam.
The following graph tests the Clash of Civilization hypothesis using cross-country data
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18. 8.1 Proximate Versus Fundamental Causes of Prosperity
Instructor: The graph examines the relationship between the percentage of the population that is Muslim in 1900 (horizontal line) and real GDP per capita (vertical line) in Each dot represents a different country with the red dots labeled and blue line is the exponential fitted line.
If Huntington’s clash of civilization hypothesis is correct, there should be a negative relationship between the two variables. There is no evidence in support of this hypothesis, given that the fitted brown line has a zero slope.
Sources: Religion data is from the World Religion Database and GDP data is from Penn World Table Version 7.1
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19. 8.1 Proximate Versus Fundamental Causes of Prosperity
The institutions hypothesis claims that differences in the way societies organize themselves and shape the incentives of individuals and businesses (so-called economic rules of the game) are ultimately responsible for the large differences in prosperity observed around the globe.
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20. 8.1 Proximate Versus Fundamental Causes of Prosperity
Instructor: The graph examines the relationship between the rule of law in 1995 (horizontal line) and real GDP per capita (vertical line) in Each dot represents a different country, with the red dots labeled. The blue line is the exponential fitted line.
If the institutions hypothesis is correct, there should a positive relationship between the two variables. There is strong evidence in support of this hypothesis, given that the fitted blue line is positively sloped, with the observations clustered close to it.
Sources: Rule of law data are from Daniel Kaufmann, Aart Kraay, and Pablo Zoido-Lobatón (1999), "Aggregating Governance Indicators," World Bank Policy Research Working Paper No. 2195, and GDP data are from Penn World Tables 7.1
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21. Institutions have three important features:
8.1 Proximate Versus Fundamental Causes of Prosperity
Institutions have three important features:
They are determined by individuals.
They place constraints on behavior.
They shape human behavior by determining incentives.
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22. 8.1 Proximate Versus Fundamental Causes of Prosperity
The “natural experiment” of the two Koreas provides a test of the institutions hypothesis.
In the 1940s, North and South Korea were a single country, with a unified language, culture, and geography.
In 1947, the country was split into two countries along the 38th parallel by an agreement between the United States and the Soviet Union.
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23. 8.1 Proximate Versus Fundamental Causes of Prosperity
Exhibit 8.2 GDP per Capita in North and South Korea (in PPP-adjusted 2005 constant dollars)
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24. Was it geography? Was it culture? Was it institutions?
8.1 Proximate Versus Fundamental Causes of Prosperity
By 2010, North Korea was an economic “disaster,” with a GDP per capita of $1,500, while South Korea was an economic “miracle,” with a GDP per capita of close to $30,000.
What happened?
Was it geography? Was it culture? Was it institutions?
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25. 8.1 Proximate Versus Fundamental Causes of Prosperity
The South Korean autocratic government of Syngman Rhee and Park Chung-hee adopted a market-based economy, providing incentives for investment in physical and human capital.
The North Korean dictatorship of Kim Il-Sung and his son Kim Jong-Il adopted a strict communist system (called Juche) that outlawed private property and banned markets.
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26. Economic institutions
8.2 Institutions and Economic Development
Economic institutions
Aspects of society’s rules that concern economic transactions.
Economic institutions include:
Protection of property rights and ownership
Impartiality of the justice system
Financial arrangements between savers and borrowers
Regulations concerning new businesses or occupations
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27. Inclusive economic institutions
8.2 Institutions and Economic Development
Inclusive economic institutions
Institutions that support and encourage economic transactions and, as such:
Protect private property
Uphold law and order
Allow and enforce private contracts
Allow free entry into new lines of business and occupations
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28. Extractive economic institutions
8.2 Institutions and Economic Development
Extractive economic institutions
Institutions that remove resources from the economy and, as such:
Do not protect private property
Do not enforce private contracts
Interfere with the workings of markets
Restrict entry into new lines of business and occupations
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29. Political institutions
8.2 Institutions and Economic Development
Political institutions
The aspects of society’s rules that determine who holds political power and what types of constraints are placed on them.
In North Korea, political power in the past lay completely with Kim Il-Sung and then Kim Jong-Il, and it now lies with Kim Jong-Un.
In South Korea, political power is spread between an elected president and Parliament.
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30. 8.2 Institutions and Economic Development
The experience in Eastern Europe provides another example of the institutions hypothesis.
In 1948, Czechoslovakia (forcibly) became communist, with extractive institutions, while Austria followed a market system with inclusive institutions.
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31. 8.2 Institutions and Economic Development
Exhibit 8.3 GDP per Capita in Austria and the Neighboring Czechoslovakia Since 1948 (in PPP-adjusted 2005 constant dollars)
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32. Was it geography? Was it culture? Was it institutions?
8.2 Institutions and Economic Development
By 1989, Czechoslovakia had a GDP per capita of $12,066, while Austria had a GDP per capita of $22,514—almost twice as high!
What happened?
Was it geography? Was it culture? Was it institutions?
Instructor: The real GDP per capita data are from Penn World Tables 7.1
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33. 8.2 Institutions and Economic Development
After the fall of Communism, the Czech Republic and Slovakia with their inclusive institutions are starting to close the GDP per capita gap with their neighbor Austria.
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34. 8.2 Institutions and Economic Development
Extractive economic institutions tend to support inefficient firms and prevent entrepreneurs with new ideas from entering the market.
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35. 8.2 Institutions and Economic Development
We rank potential entrepreneurs in descending order, according to the return they could earn by starting a business.
The return-to-entrepreneurship curve is the downward-sloping blue line on the next slide, which shows the number of entrepreneurs (horizontal axis) against their return (vertical axis).
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36. 8.2 Institutions and Economic Development
Instructor: The downward-sloping blue line is the return-to-entrepreneurship curve, which shows the number of entrepreneurs against their return.
Exhibit 8.4, Panel (a) How Extractive Economic Institutions Reduce the Number of Entrepreneurs
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37. 8.2 Institutions and Economic Development
We then add the opportunity cost of the entrepreneurship, which is assumed to be the same for all entrepreneurs.
The opportunity cost line is the red horizontal line drawn at a constant opportunity cost.
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38. 8.2 Institutions and Economic Development
Instructor: The horizontal red curve is the opportunity cost schedule, which indicates the value to the entrepreneur of her best alternative.
Exhibit 8.4, Panel (a) How Extractive Economic Institutions Reduce the Number of Entrepreneurs
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39. 8.2 Institutions and Economic Development
The intersection of the two lines gives us the equilibrium return and the equilibrium number of entrepreneurs.
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40. 8.2 Institutions and Economic Development
Instructor: The intersection of the two curves at point E1 gives the equilibrium where 700 entrepreneurs choose projects with a return of $50,000 or greater.
Exhibit 8.4, Panel (a) How Extractive Economic Institutions Reduce the Number of Entrepreneurs
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41. Extractive institutions have two main impacts:
8.2 Institutions and Economic Development
Extractive institutions have two main impacts:
Weak property rights and legal enforcement prevent the entrepreneur from capturing the full returns they create.
This shifts the return-to-entrepreneurship line to the left.
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42. 8.2 Institutions and Economic Development
Instructor: Extractive economic institutions shift the return-to-entrepreneurship curve to the left due to (a) weak property rights and (b) lack of contract enforcement. As a result, the new equilibrium is E2, where only 300 entrepreneurs undertake projects.
Exhibit 8.4, Panel (b) How Extractive Economic Institutions Reduce the Number of Entrepreneurs
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43. This shifts the opportunity cost line upward.
8.2 Institutions and Economic Development
Barriers to entry in the marketplace increase the cost of entering the market.
This shifts the opportunity cost line upward.
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44. 8.2 Institutions and Economic Development
Instructor: Extractive economic institutions also shift the opportunity cost curve upward because they erect barriers to entry for entrepreneurs. As a result, the new equilibrium is E3, where only 100 entrepreneurs undertake projects.
Exhibit 8.4, Panel (c) How Extractive Economic Institutions Reduce the Number of Entrepreneurs
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45. 8.2 Institutions and Economic Development
Why would a country adopt extractive economic institutions if they retard economic growth?
The notion of political creative destruction predicts that economic growth destabilizes existing regimes and reduces political power.
Therefore, rulers such as Kim Jong-Un of North Korea use extractive economic institutions to maintain political power.
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46. 8.2 Institutions and Economic Development
Inclusive economic institutions allowed the Industrial Revolution, with all of its complex social and economic processes, to occur in England in the late 18th century and in the United States in the 19th century.
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47. Evidence-Based Economics Example
8 Why Isn’t the Whole World Developed?
Evidence-Based Economics Example
Question: Are tropical
and semitropical areas
condemned to poverty by
their geographies?
Data: Urbanization and population density rates in 1500 and urbanization rates and GDP per capita in 2010.
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48. 8 Why Isn’t the Whole World Developed?
In late 15th century, the European powers “colonized” Africa, Asia, Australasia, Latin America, and North America.
Although there is no GDP per capita data for that time, we can measure the living standards of these former colonies by using urbanization and population density rates in 1500.
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49. 8 Why Isn’t the Whole World Developed?
Countries that generate sufficient agricultural surplus and a transportation and trading network can support a larger population per square mile in general and a larger urban population in particular.
What, then, is the relationship between prosperity in 1500 and prosperity today, measured as GDP per capita?
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50. 8 Why Isn’t the Whole World Developed?
Instructor: The data for urbanization rates in 1500 do not contain the former colonies in sub-Saharan Africa.
Exhibit 8.6 The Reversal of Fortune Using Urbanization
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51. 8 Why Isn’t the Whole World Developed?
Instructor: The data for population density rates in 1500 do contain the former colonies in sub-Saharan Africa.
Exhibit 8.7 The Reversal of Fortune Using Population Density
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52. 8 Why Isn’t the Whole World Developed?
The two graphs show what we call “reversal of fortune”: Former colonies that were poor in 1500 are rich today, while former colonies that were rich in 1500 are relatively poor today.
What happened?
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53. 8 Why Isn’t the Whole World Developed?
The settlers in the poor, temperate areas of North America, Australasia, and Argentina developed inclusive economic institutions due to low settler mortality rates.
The settlers in the rich tropical areas of Mexico, Peru, India, and Morocco adopted extractive institutions due to high settler mortality rates.
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54. Evidence-Based Economics Example
8 Why Isn’t the Whole World Developed?
Evidence-Based Economics Example
Question: Are tropical and semitropical areas condemned to poverty by their geographies?
Answer: No. Although tropical areas tend to have lower GDP per capita levels today, the reason is not the geography of the tropics but rather the fact that extractive institutions were adopted in these areas.
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55. Many people, like the singer Bono, actress Angelina
8.3 Is Foreign Aid the Solution to World Poverty?
Many people, like the singer
Bono, actress Angelina
Jolie, and economist Jeffrey
Sachs, argue that increased
spending on foreign and
development aid by the
West is needed to alleviate
poverty around the world.
In the book The End of Poverty, Sachs argues that extreme poverty can be eliminated by the year 2025 through carefully planned and targeted development aid.
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56. 8.3 Is Foreign Aid the Solution to World Poverty?
Surprisingly, most economists contend that foreign aid has been ineffective, on the whole, in alleviating poverty.
Dambisa Moyo states in her book Dead Aid that more than $1 trillion of aid has gone to Africa, and yet most of the recipients of this aid are not better off, and some are even worse off.
Why?
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57. 8.3 Is Foreign Aid the Solution to World Poverty?
1. The amount of foreign aid provided is not large enough to lead to sizable increases in physical capital and educational attainment and, more importantly, does not impact technology or the efficiency of production.
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58. 8.3 Is Foreign Aid the Solution to World Poverty?
2. In practice, much foreign aid does not get invested in education or new technologies but is captured by corrupt government officials.
Many studies indicate that only about 10% to 15% of foreign aid actually reaches its intended destination.
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59. 8.3 Is Foreign Aid the Solution to World Poverty?
3. If the root of poverty is extractive economic institutions, then foreign aid given within these institutions will not fix the fundamental causes of poverty.
Think about why most people insist on donating money through charitable organizations rather than giving directly to the needy individuals.
Instructor: The answer to why most people insist on donating money through charitable organizations is that the donors want a mechanism to ensure that the money is spent on “correct” things, such as food, shelter, and schooling, rather than “incorrect” things, such as alcohol, drugs, and maybe video games.
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