Question

Question 1.

Use one example to explain how bad institutions and policies can raise the cost of investments. (10 marks）

Answer 1

Cross-country empirical analyses, in combination with micro-level studies, provide strong support for the overwhelming importance of institutions in predicting the level of development in countries around the world (Hall and Jones, 1999; Acemoglu, Johnson and Robinson, 2001). Protection of property rights, effective law enforcement, and efficient bureaucracies, together with a broad range of norms and civic mores, are found to be strongly correlated to better economic performance over time. This essay aims to explain why institutions are important to economic development and to provide evidence for the arguments made. It argues that institutions support economic development through four broad channels: determining the costs of economic transactions, determining the degree of appropriability of return to investment, determining the level for oppression and expropriation, and determining the degree to which the environment is conducive to cooperation and increased social capital. Evidence is derived from the literature, from comparison of countries, and from examples at the micro level.Institutions conducive to economic development reduce the costs of economic activity. The costs include transaction costs such as search and information costs, bargaining and decision costs, policing and enforcement costs (Coase, 1992, p 197; Dahlman, 1979, p. 149). They lower transaction costs by providing common legal frameworks (e.g. contracts and contract enforcement, commercial norms and rules), and they encourage trust by providing policing and justice systems for the adherence to common laws and regulations. Communities in LDCs typically rely on kinship or ethnic and religious ties for trade. Norms and networks of common language and religion may be enough to ensure compliance with agreements on economic exchange; collective punishment and social reputation may be enough to ensure the enforcement of (often informal) contracts even in the absence of a third party. Greif (1993) describes the trade networks of Maghribi traders which permitted the sharing of information on dishonest traders and their collective punishment. To take advantage of opportunities for trade with different groups and increase the size of economic transactions, however, cultural ties are not enough. There is need for greater information about trading partners, and for institutions which ensure agreements on the details of exchange and compliance to the agreed conditions. These take the form of contracts, codes of conduct, standardized weights and measures, disclosure agreements, and enforcement through courts and policing. Where transaction costs are small, the private enforcement of contracts may still be preferred. But as economic relations develop and become increasingly impersonal, the role of a third party to enforce compliance to rules is increasingly necessary . Growth can generate virtuous circles of prosperity and opportunity. Strong growth and
employment opportunities improve incentives for parents to invest in their children’s
education by sending them to school. This may lead to the emergence of a strong and
growing group of entrepreneurs, which should generate pressure for improved
governance. Strong economic growth therefore advances human development, which, in turn, promotes economic growth.
But under different conditions, similar rates of growth can have very different effects on
poverty, the employment prospects of the poor and broader indicators of human
development. The extent to which growth reduces poverty depends on the degree to
which the poor participate in the growth process and share in its proceeds. Thus, both
the pace and pattern of growth matter for reducing poverty.
A successful strategy of poverty reduction must have at its core measures to promote
rapid and sustained economic growth. The challenge for policy is to combine growthpromoting policies with policies that allow the poor to participate fully in the
opportunities unleashed and so contribute to that growth. This includes policies to make
labour markets work better, remove gender inequalities and increase financial inclusion.
Asian countries are increasingly tackling this agenda of ‘inclusive growth’. India’s most
recent development plan has two main objectives: raising economic growth and making
growth more inclusive, policy mirrored elsewhere in South Asia and Africa.
Future growth will need to be based on an increasingly globalised world that offers new
opportunities but also new challenges. New technologies offer not only ‘catch-up’
potential but also ‘leapfrogging’ possibilities. New science offers better prospects
across both productive and service sectors.
Future growth will also need to be environmentally sustainable. Improved management of water and other natural resources is required, together with movement towards low carbon technologies by both developed and developing countries. With the proper institutions, growth and environmental sustainability may be seen a complements, not
substitutes. DFID will work for inclusive growth through a number of programmes and continues to spend heavily on health and education, which have a major impact on poor people’s
ability to take part in growth opportunities.
More and better research on the drivers of growth will be needed to improve policy. But
ultimately the biggest determinants of growth in a country will be its leadership, policies
and institutions. Economic diversification remains a challenge for most developing countries and is arguably greatest for countries with the lowest incomes as well as for those whose economies are small, landlocked and/or dominated by primary commodity dependence. For such countries, economic diversification is inextricably linked with the structural transformation of their economies and the achievement of higher levels of productivity resulting from the movement of economic resources within and between economic sectors. Rooted in examples of World Bank Group support, this chapter traces the boundaries of any discussion of economic diversification by advancing a definition that encompasses two related dimensions of diversification: (i) trade diversification (i.e. exporting new or better products, or to new markets) and (ii) domestic production diversification (i.e. cross-sectoral rebalancing of output, driving the reallocation of resources across industries and within industries between firms to increase total factor productivity). The chapter raises awareness on the complexity of the diversification process and the state of knowledge surrounding economic diversification. While the current global environment creates challenges for poor, small, landlocked and/or resource-dependent countries, a range of new diversification routes can be followed. This however requires that policy attention be paid to four key determinants of successful diversification strategies, which development partners and International Organisations can support through targeted Aid for Trade interventions. These are: (i) the supply of appropriate incentive frameworks; (ii) investments and policy reforms targeted at reducing trade costs; (iii) effective policies to support adjustment and the reallocation of resources towards new activities; and (iv) government interventions directed at specific market, policy and institutional failures. The first scenario in the study looked at how much progress
each of these countries could make toward the MDGs by 2015 without significant increases in aid flows or improvements in policies. (The projected outcomes under this scenario and the second scenario with improved policies and
higher aid, described below, reflect the judgments of World Bank country teams, supported by existing analysis.) The left panel of Chart 1 provides a summary of the prospects for the 18 countries under the first scenario. More countries are likely to attain the education and poverty goals than those for health or the environment. In general, this is representative of what can be expected if the countries continue to pursue policies aimed at maintaining macroeconomic stability
and promoting structural reform. The growth payoff from these policies will yield the biggest gains in reducing income poverty and increasing primary school enrollment. However, even among the education goals, while the primary school enrollment target is expected to be met in almost two-thirds of the sample countries, those for primary school completion and gender equality pose bigger challenges. Similarly, while almost half the sample countries would meet the income poverty goal, several of them will not be able to meet the goal of reducing hunger. The child and maternal mortality goals are projected to remain unmet almost universally in the sample .Only Bangladesh, Indonesia, and Vietnam are likely to meet the child mortality goal. And on maternal mortality, probably only Vietnam will meet the MDG. Reaching these goals is made more difficult in many of the sub-Saharan countries in the sample because of the spread of the HIV/AIDS epidemic in the 1990s.How would significantly better policies and more aid interact in stepping up the pace of these countries’ progress toward
the MDGs. The outcomes for each country under this second scenario are summarized in the right panel of which shows how powerful this combination could be. For example, it would probably allow all 18 sample countries to achieve the poverty goals, and several of them, including Mozambique,Uganda, and Vietnam, could make even sharper reductions in poverty than called for by the MDGs. Significant progress could also be expected on the education goals, with almost two-thirds of the sample countries attaining the targets even for primary school completion and gender equality. However, progress on the health and environmental goals would remain a challenge . Only a third or fewer of the countries would achieve all the targets in either area, and some would not meet any of the goals. For improvements to occur at this faster pace, substantial policy and institutional reforms will be necessary to accelerate growth and improve service delivery. The needed reforms fall into three broad areas: improving the environment for private sector activity, particularly in terms of the rule of law and infrastructure; enhancing the quality of governance and capacity in the public sector; and delivering more effective human development and other basic services to poor people.