1 Social Infrastructure and Long-run Economic Performance ECON 401: Growth Theory

2 Social Infrastructure and Long-run Performance Why is it that some countries invest more than others? Why do individuals in some countries spend more time learning to use new technologies? Answers to these questions are important but yet there is no consensus among researchers. In this chapter, we will present a basic framework to think about these questions.

3 Social Infrastructure and Long-run Performance Business Investment Problem: You are the manager of a large multinational corporation. You are considering opening a subsidiary in a foreign country How do you decide whether to undertake this project? One approach is cost-benefit analysis. One time setup cost, F Business generates a profit every year. Let  denote the expected present discounted value of profit stream. What is the value of this business subsidiary?

4 Social Infrastructure and Long-run Performance The manager’s decision is:  >=F  Invest  < F  Do not invest What determines the magnitude of F and  in various economies? Is there a sufficient variation in F and  to explain the enormous variation in investment rates, educational attainment and total factor productivity? We will assume there is a huge variation in the costs of setting up a business and in the ability of investors to reap returns from their investments. These variations arises from differences in government policies and institutions, which we call social infrastructure.

5 Social Infrastructure and Long-run Performance Determinants of F: Establishing a business requires multiple steps. Each of these steps involves interacting with another party and if that party has the ability to hold up the business, problems can arise. Fees and bribes (sunk costs) Advanced countries provide a dynamic business environment. De Soto (1983) research in Peru – small garment factory. 11 official requirements. To meet these requirements, it took 289 person-days.s 2 bribes (although 10 bribes were requested) The cost of starting a small business is estimated to be the equivalent of 32 times the monyhly minimum living wage.

6 Social Infrastructure and Long-run Performance Determinants of  : Classify into three categories: (1) The size of the market The relevant market for an investment doesn’t have to be limited by national borders. Openness to trade is a positive factor (2) The extent to which the economy favors production instead of diversion – primarily determined by the government A social infrastructure that favors production encourages individuals to engage in creation and transaction of goods and services. Diversion takes the form of theft or expropriation of resources from productive units. Illegal activity – acts like a tax. Legal – encourages investment in finding ways to avoid the diversion (3) Stability of the economic environment – country risk

7 Social Infrastructure and Long-run Performance Economies in which social infrastructure encourages diversion will typically have: Less investment in capital Less foreign investment that might transfer technology Less investment to accumulate productive skills Less investment to develop new ideas In addition, type of investments undertaken will be impacted.

8 Social Infrastructure and Long-run Performance What empirical evidence supports these arguments? Index of social infrastructure – average of two measures  Index of government anti-diversion policies that captures the extent to which the social infrastructure of an economy favors production over diversion  Fraction of years since 1950 that the economy is classified as open to international trade according to several objetive criteria. Index is normalized so that a value of 1 represents the best existing infrastructure. Figure 7.1 and 7.2 plot investment as a share of GDP and average educational attainment against index of social infrastructure.

9 Fig. 7.1

10 Fig. 7.2

11 Social Infrastructure and Long-run Performance Figure 7.3 plots the TFP level against social infrastructure. It seems that differences in TFP are also related to social infrastructure. So we can re-write the production function as: Where I denotes the influence of an open economy’s social infrastructure on the productivity of its inputs. Economies grow over time because (a) new capital goods are invented and (b) the agents in the economy learn to use the new kinds of capital (captured by h). However, two economies with the same K, h, and L may still produce different amounts of output because the economic environments in which these inputs are used to produce output differ.

12 Fig. 7.3

13 Social Infrastructure and Long-run Performance Why is the social infrastructure in some economies so much better than in others? No firm answers yet. Douglass North (1993 Nobel Prize winner) argues that individuals in power will pursue actions that maximize their own utility. Government officials are self-interested, utility maximizing agents just like the rest of us instead of being benevolent social planners. China is a great example. Technological leader around 14 th century. - lack of institutions supporting entrepreneurship - Ming dynstry replaced the Mongol dynasty in 1368

14 Social Infrastructure and Long-run Performance Fundamental changes in social infrastructure can generate growth miracles and growth disasters. - Japan – growth miracle - Argentina – growth disaster We have had more growth miracles than disasters in the last 40 years. Society is gradually discovering the kinds of institutions and policies that are required for successful economic performance, and these discoveries is gradually diffusing around the world (flow and speed of information?)