Unit 9 Uneven development on a global scale
9.7 Institutions (rules of the game) and catching up
- institution
- An institution is a set of laws and informal rules that regulate social interactions among people, and between people and the biosphere; sometimes also termed ‘the rules of the game’.
Research in the past few decades shows that the quality of institutions matters for growth. Institutions are the rules of the game through which households, firms, and governments interact to get things done. More concretely, they are the various sets of laws and social customs regulating production and distribution. In Unit 1 of the microeconomics volume, capitalism was defined as an economic system that combines three institutions: markets, firms, and private property. When the institutions work poorly, the expected profits from investment in productive capital are low and unpredictable, and the economy remains trapped with low capital per worker and low living standards. It is not able to take advantage of technologies used elsewhere in the world.
The post-Soviet transition to new economic institutions
In a book called The Coming Russian Boom: A Guide to New Markets and Politics published in 1996, economists Richard Layard and John Parker forecast: ‘Russia is now a market economy […] The conditions are therefore in place for a period of strong economic growth […] We expect Russian output to grow by at least 5 per cent a year for the foreseeable future. This may sound optimistic to those who focus on the mafia and the mess. But it is a common experience for countries which have stabilized after a major period of economic reform.’
The dramatic collapse of the planned economic system in the Soviet Union and in Central and Eastern Europe at the end of the 1980s provided an opportunity to learn about the role institutions play in economic growth. It was widely believed at the time that a thriving capitalist economy would emerge swiftly if rapid reforms were implemented to change the rules of the game, often referred to as ‘shock therapy’. Those advocating shock therapy were worried about the path to a well-functioning market economy being derailed by ‘a slide into populism, macroeconomic chaos, and the ultimate collapse of the reform effort’,1 but they underestimated the difficulty of creating the institutions of a capitalist economy.
Figure 1.19 in the microeconomics volume shows that output per capita fell dramatically in the first five years of transition in all former planned economies, and it was a decade and a half in the Russian Federation before the previous level was restored. The only countries that regained pre-transition levels of GDP in less than a decade were Poland, Czech Republic, Romania, Hungary, and Slovenia.
To learn more about institutions and economic growth, read Sections 1.10 and 1.12 of The Economy 2.0: Microeconomics.
The institutions of a planned economy were completely different from those of a capitalist economy: government officials decided on the central allocation of resources to mainly state-owned enterprises. The plan dictated the extent of specialization and the division of labour (including in foreign trade), the scale of production, and what was produced. Private property, markets, and capitalist firms (where private owners employ workers with the intention of making profits) were largely absent. In shops and restaurants, there was limited choice and prices were controlled.
In a capitalist economy, the state plays a key role by establishing and supporting the laws around:
- private property (including contracts, bankruptcy, and intellectual property)
- markets (competition policy and regulation)
- firms (through employment law, limited liability, and health and safety at work and for products).
The government is a complement to the institutions of capitalism, whereas it is the defining institution of a planned economy.
Exercise 9.9 The rule of 70 and Russian economic growth
In 1996, economists Richard Layard and John Parker predicted that Russian output would grow by at least 5% annually.
- Based on this growth rate prediction, use the rule of 70 to calculate when Russia’s GDP would have doubled.
- Download GDP data for Russia from Our World in Data. Use this data to determine how accurate this forecast was. Discuss some reasons why the forecast was (or was not) accurate, referring to events and policies that happened in Russia since 1996.
Comparing planned and market economies
The large-scale experiment with a planned economy began with the introduction in 1928 of the first Five-Year Plan in the Soviet Union.2 Research shows that if we compare GDP per capita in 1988 (just before planned economies collapsed) in the countries that adopted planning (or had it imposed on them) with other countries initially at the same level of per capita GDP (in 1928), a striking pattern emerges. Poor countries in 1928 that became planned economies had higher per capita GDP in 1988 than did equally poor ones that remained market economies over that period. By contrast, richer countries in 1928 that became planned economies did worse than those that remained market economies over the period to 1988.
These results suggest that there were benefits of a planned economic system for countries that had not already had a phase of ‘hockey stick’ growth. Under communist planning, the state mobilized resources to invest in electrification and schooling. This result echoes the way the state can overcome barriers to development (infrastructure and education) set out in the previous section.
For countries that were already industrialized by 1928, however, the shift from a capitalist to a planned economy took away the incentive for the adoption of higher productivity technologies. In a capitalist economy, the incentive comes from the prospect of gaining the innovation rents from being the first to adopt new methods of production or being ‘first to market’ with new products. The threat of business failure from not innovating is potent as well. Both are absent under planning and the consequent lags in living standards behind those in the West ultimately brought down the communist regimes. East Germans in the regions bordering West Germany could watch West German television: the East German Trabant car compared very unfavourably with West German Volkswagens, Audis, and BMWs.
Left: A DDR-specification Trabant 601 S. Right: 1986 Volkswagen Polo C Formel E 1.3.
From the collapse of the planned economies we learn that eliminating one set of institutions (planning) and permitting another set (private property, markets, and capitalist firms) does not immediately produce a well-functioning capitalist economy. Going further back in economic history provides additional lessons on institutions and growth.
Evidence that higher-quality institutions lead to higher growth
In 2024, the Nobel Prize in Economic Sciences was awarded to a trio of economists—Daron Acemoglu, Simon Johnson, and James Robinson—who broke new ground by providing credible empirical evidence that better-quality institutions cause stronger growth. This may seem obvious since we observe better-functioning institutions in richer countries. The empirical challenge is to take account of the potential causal chain that runs in the opposite direction, namely that richer countries are capable of establishing and maintaining higher-quality institutions.
Their method for establishing a causal link between current institutions and current living standards is ingenious: they had to find a variable that was causal in determining the quality of early institutions but that has no direct effect on current living standards. By selecting a sub-sample of countries in the world that had been colonized, they are able to use the fact that the likelihood of European colonizers dying from local diseases varied by region to uncover a causal link.
The hypothesis is that where the disease environment was conducive to European settlement, so-called settler colonies were established. Settlers replicated their home institutions, which were associated with secure property rights and successful capitalist development. (Section 9.9 will show that for the case of Botswana, good-quality institutions are not necessarily European ones.) The persistence of these high-quality institutions is reflected in high current levels of institutional quality. By contrast, in places where the disease environment for Europeans made settlement hazardous because of the presence of malaria and yellow fever, so-called extractive colonies were set up with the main purpose of transferring resources back to the colonial power.
Australia is a classic example of a settler colony in which institutions to enforce the rule of law were paramount—many of the early white residents were convicts from England sent there to serve prison sentences. Its climate was conducive to European settlement and European institutions proved long-lasting. The Belgian Congo is a classic extractive colony with valuable rubber and ivory, but a high disease burden. The colonizers did not have the incentive to invest in creating high-quality institutions because they did not want to live there.
Figure 9.15 The causal relationship between quality of institutions and economic growth.
For a 2025 comprehensive review of the very large body of research on the persistence of institutions and its effect on growth stimulated by the 2001 Acemoglu, Johnson, and Robinson paper, read ‘Colonial persistence’ by James Fenske, Bishnupriya Gupta, and Anwesh Mukhopadhyay.
To complete the argument, Acemoglu, Johnson, and Robinson point out that the disease environment at the time of potential settlement is not related to living standards today because, on the one hand, indigenous populations are largely immune to the diseases that killed Europeans and, on the other, these diseases are no longer major killers. Showing this is important because it implies that it is the persistent effect on growth of good or bad institutions long after colonization that matters—not the state of the disease environment today.
For another application of this method of establishing causal links, read the ‘How Economists Learn From Facts’ box in Section 14.7 of The Economy 1.0.
The magnitude of the effects of institutions estimated by these authors is large: their results suggest that improving Nigeria’s institutions to the level of Chile’s would produce a long-run up to sevenfold increase in Nigeria’s per capita income. This accounts for over 60% of the existing gap between these two countries.
Figure 9.16 provides suggestive evidence that the relationship between institutional quality today (as measured by an average of indicators of rule of law, bureaucratic quality, and protection against corruption) and GDP per capita is similar for countries that were not colonized by Europeans. Their estimates suggest that between 50% and 70% of the differences in levels of GDP per capita today are caused by the quality of a country’s institutions. The accumulation of evidence from studies conducted over the 25 years since the article published by Acemoglu, Johnson and Robinson was published in 2001 supports the conclusion that institutional quality matters for long-run growth.
Figure 9.16 Living standards and institutional quality today. The scatterplot distinguishes between countries that were former European colonies and others.
World Bank Group. 2025. World Development Indicators.; The PRS Group. 2022. ICRG Risk Ratings.
Sections 5.7 and 5.13 of the microeconomics volume also discuss the important role of land tenure institutions as well as institutions that support contract enforcement, such as affordable access to unbiased courts.
We have learned that the quality of a country’s institutions matters greatly for their long-run economic development. Some of the most important institutions include:
- Economic institutions: secure private property rights, markets where firms compete for market share and where failing firms exit, and public goods that complement growth in the private sector. These are discussed further in Section 1.12 of the microeconomics volume.
- Political institutions: a well-functioning legal system, political stability and rule of law, and, as explained in Section 10.9 of this volume, political competition.
- Equality of opportunity in the competition for leadership positions in firms and in society.
In our ‘Economist in Action’ video, Simon Johnson discusses how good institutions influence economic growth.
Question 9.4 Choose the correct answer(s)
Based on the information in Simon Johnson’s Economist in Action video, read the following statements and choose the correct option(s).
- Labour and ideas can move between countries, so Simon Johnson and his co-authors wanted to investigate why large income differences still persist across countries despite this movement.
- As Simon Johnson mentions in the video, one hypothesis is that institutions may cause economic growth, but another hypothesis is that richer countries can ‘buy’ better institutions.
- Simon Johnson and his co-authors found that institutions can explain 50–70% of the variation in GDP per capita in former colonies.
- The relationship they found for former colonies also holds for countries that were never colonized by Europeans.
Economists have investigated not only the impact of different types of colonies—settler versus extractive—on growth but also the long-lasting effect of the slave trade. Leonard Wantchekon explains how the Atlantic slave trade pitted coastal communities against their neighbours, creating a culture of mistrust lasting for generations, which has held back economic growth in parts of Africa.
In our ‘Economist in Action’ video, Leonard Wantchekon discusses how the slave trade created mistrust and held back GDP growth in West Africa.
Question 9.5 Choose the correct answer(s)
According to Leonard Wantchekon’s research discussed in the Economist in Action video:
- Communities were made to believe that to protect themselves from being enslaved, they had to sell others into slavery, which resulted in mistrust that was passed down across generations. (Leonard Wantchekon gives some examples of modern-day cultural expressions that link the slave trade to trust.)
- Distance from the coast is a suitable instrument because it is exogenous: it only affects trust via the likelihood of being part of a slave population.
- This relationship is only found in Africa, the continent most affected by the slave trade. This relationship does not hold in India or other Asian countries.
- Leonard Wantchekon found that involvement in the international slave trade could explain 16-25% of the variation in trust levels and economic development; the remaining variation could be explained by non-historical factors.
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Sachs, Jeffrey. 1990. ‘What is to be done?’ The Economist. 13 January. ↩
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Carlin, W., Schaffer, M. & Seabright, P. (2013) ‘Soviet power plus electrification: what is the long-run legacy of communism?’. Explorations in Economic History 50(1): pp. 116–147. ↩
