Chapter 7. Social Infrastructure and

Long-Run Economic Performance

Instructor: Dmytro Hryshko

Motivation

Investment rates and the time spent on accumulating skills weretaken as exogenous.

Since they determine the long-run incomes per capita, whysome countries spend more time learning new technologies andinvest more?

There is no \canonical" model for answering this question.

A business investment problem

How one decides whether to undertake investment or not? Use, e.g., thecost-bene�t analysis.

For example, a multinational wants to open up a subsidiary in a foreigncountry. The cost is F (establishing chains for intermediate inputs,distribution chains, obtaining licenses, etc.). Once set up, the subsidiarygenerates the ow of pro�ts that amounts to the PDV of �.

The manager's decision is: if � � F!undertake investment; if � < F!donot invest.

This analysis is applicable to any form of investment (individual investmentin schooling, technological transfer by a multinational, local business, etc.)

There is substantial variation in � and F that may cause variation ininvestments across countries. In large part, this variation arises fromdi�erences in government policies and institutions, called socialinfrastructure.

Determinants of F

Purchasing/renting a property, purchasing licenses, payingbribes, etc. The last bureaucrat may ask for � in bribes orslightly less.

How important are these considerations in developingeconomies? In 1983, de Soto and a team of researchers started asmall garment factory in Peru to measure the costs of settingup a small business. Faced 11 o�cial requirements (e.g.,registering with the tax authority); meeting these requirementstook 289 person-days! The cost was estimated at about 32�themonthly minimum wage.

Determinants of �

The size of the market (the extent of the economy'sopenness to international trade).

The extent to which the economy favors production insteadof diversion. By diversion we mean theft or expropriation ofresources from productive units. First, diversion acts like atax; second, it creates incentives to invest into �nding waysto avoid the diversion (e.g., extra lawyers, security, etc.).

The stability of the economic environment (relates to thestability of social infrastructure).

Social infrastructure is \run" by the government.

Which investments to make?

Social infrastructure a�ects the amount (creation of new ideas;investment in physical capital, foreign investment that transferstechnology) and type of investments (e.g., poor institutions maylead to investment into security systems; public may invest timeinto accumulating skills to become government employees ifworking for government generates rents in form of bribes, etc.).

Empirical evidence

For any country, investments into human and physical capital,and the transfer of technology from abroad will be higher if:

the institutions and laws favor production over diversion;

the economy is open to international trade and competitionin the global market;

the economic institutions are stable.

Hall and Jones (1999) construct an index of social infrastructure (on thebasis of an index of \government anti-diversion policies" and an index forthe economy's openness to international markets). Across countries, highervalues of the index (better social infrastructure) are associated with highervalues for investment rates, average years of schooling, and total factorproductivity.

The choice of social infrastructure

Our analysis motivates the following aggregate productionfunction: Y = IK

�(hL)1��, where I is the \level" ofinfrastructure and h is the individual skill level as in Chapter 6.Economies with the same h, K, and L may produce di�erentoutput levels merely because I may di�er.

Why do countries end up with di�erent I's? Belief systems?Culture? Climate?

Growth miracles and disasters

Fundamental changes in social infrastructure can generate\growth miracles" and \disasters." For example, from 1870until World War II, Japan's income was around 25% of that inthe U.S., today it's about 1/3 of the U.S. income; Argentinawas as rich as western European countries at the end of the19th century, by 1997 its income fell to only 45% of that in theU.S. Both episodes are connected with reforms.

Current world income distribution di�ers from the \long-run"distribution. One possible explanation: countries still learnabout institutions and policies conducive to successful economicperformance. Growth miracles are not that unlikely (e.g.,\Korean experience" of having 10% of income relative to theU.S. and then moving to income above 40% relative to the U.S.might have happened with a 10% probability in 46 years).