2. Political Economy of Economic Policy Lecture 2 Property Rights Theory and Property Rights Institutions Chenggang Xu copyright@Chenggang Xu

3. Institutions and ownership Ownership of means of production as the cornerstone dividing two types of institutions: –Socialist institutions: public ownership (Marx, 1870; von Mises, 1920; Lange, 1930; Hayek, 1940; Kornai, 1980) e.g. former Soviet Union (before 1990), China before mid 1990s, etc. –Capitalist institutions: private ownership e.g. private ownership dominates in US, UK, Western Europe, Japan, South Korea, etc. –Transition: the most fundamental change is to privatize public assets e.g. Russia, China, Central Eastern European countries, etc. A classical socialist economy is a one firm economy –All means of production are owned by this ‘firm’ – no market, no market prices Can state ownership be as efficient as market economy? –Market socialism (Lange, 1930s): keep public ownership; use markets Can incentive problems be solved in a market socialist economy? –Ownership involves incentives (Hayek vs Lange, 1940s)

4. Ownership (Why should ownership matter?) Incentive problems in a team (Alchian-Demsetz): - to produce a product needs efforts from all team members - exerting efforts is costly to team members that every one wants to shirk if possible - if every one shirks there is no production - how to solve the problme? - can hire a manager to monitor team members - but the manager’s efforts are also costly, thus does not want to work hard -Manager does not work: team members do not work

5. Incentive problems in a team How to solve manager’s incentive problem? –who monitors the manager? Allocating assets ownership to some one can solve the problem: –The owner cares residual income of his assets –Thus has ultimate incentives to monitor the manager –The chain of incentives of team members and managers is solved. To solve incentive problems in a team one may not necessarily rely on assigning ownership: –if contracts are complete, an optimal incentive schemes can solve the above problem regardless of ownership structure. –apply to large firms? –if all assets are owned by a dictator, will this be efficient? –separation of ownership and control -- the residual control and residual income are separated;

6. Why should ownership matter? Tragedy in the commons (Demsetz) -A lake is ‘owned’ commonly by a large number of citizens -Protecting the lake -costly to private; benefits to the public -no individual has incentive to protect -over fishing in a commonly owned lake -Negative externalities associated with the commons -allocate private ownership as a solution

7. Tragedy in the commons To solve t ragedy in the commons problems one may not necessarily rely on assigning ownership: -If bargaining is efficient, then who owns what doesn't matter (Coase theorem). -For Coase theorem to work requires zero negotiation cost and zero enforcement cost for all citizens who own the lake -A complete contract achieves efficient solution. -The contract specifies rewards, punishments, charges, maintenance, etc. for all people involved under all contingencies -Requires low costs of negotiating/enforcing the contract

8. Complete Contract model setup Quality of an output of the agent: q = g (e, ε ) –q: observable and verifiable –e: effort of the manager –ε : exogenous shocks realised after choosing e Cost of effort H(e) revenue from the quality: r(g) Principal's utility:U p (r(q)-t) = r(q)- t RN Agent's utility:U A (t,e) = V(t) - H(e) V(t) is concave; Agent is RA there are i = 1, 2, …, N contingencies, each with a probability  i

9. Complete Contract model solution a complete contract {p i } covers all the N contingencies : Max  i  i E{r i (q i (e i, ε i )) – p i (q i (e i, ε i ))} {e i, p i } s.t. e i ε argmax  i  i {E[V(p i (g(e i ', ε i )))]-H(e i )} e i ' (IC)  i  i E{V(p i (g(e i ', ε i ))) - H(e i ) }  U (IR) SOLUTION: { p i }, i = 1, 2, …, N

10. Complete Contract Solution a complete contingent contract that corresponding each contingency i there is p i (.) Pr(contingency i)contract –  1 p 1 (.) –  2 p 2 (.) –  3 p 3 (.) – ………. –  N p N (.)

11. Incomplete Contract and Property Rights Contract complete ==> Ownership does not matter Coase Theorem: As long as bargaining is efficient (e.g. parties can achieve complete contract), the efficient result should always be achieved through bargaining regardless of the initial allocation of property rights (ownership structure doesn't matter). if for some i, p i (.) is missing, or is not unambiguously defined, the contract is not complete.

12. Why is allocating property rights important? Incomplete contracts if writing complete contracts is  too costly  too difficult  not possible some items are non-verifiable or un-observable when contracts are incomplete or cannot be enforced –What to do if unspecified contingencies occur? –Who is in charge if unspecified contingencies occur? –Who has the right to make decisions if unspecified contingencies occur? Residual rights of control: the right to make decisions when unspecified contingencies occur when contracts are incomplete there are residual rights left to be allocated – the owner of assets has the right

13. Hold-up & incomplete contracts Hart (1995), Ch 1-2 Complete contract: with a full coverage of all contingencies –Contract can be enforced effectively Incomplete contract: contingencies not fully covered –Contract cannot be enforced effectively –Knowing this, parties may take advantages in implementation process Relation specific (rs) investments –Two parties both gain from the relationship if both invest With rs investment and incomplete contract –One party may hold up the other when the other party has invested in the relationship –Anticipating this, both parties may reduce rs investments

14. Implications and limitations of Property Rights Theory Implications –How small is a firm too small (e.g. family business) Never be too small if no complementary assets are involved –How large is a firm too large (e.g. a centralized economy) Existence of independent assets in the economy –What should be privatized together or separately Limitations (fail to explain some important phenomena) –Outsourcing in Japanese manufacturing, e.g. car industry Auto maker provide design to subcontractors who make relation specific investments) Contracts are highly incomplete: no details on quality, prices Instead of ownership, long term relationship is a mechanism to avoid holdup

15. Functions of the state: Contracting vs. Property Rights Institutions Two theories of the state (North, 1981) –‘contract theory’ of the state: state as the contracting institution –‘predatory theory’ of the state: state as the property rights institution Contracting institutions: the rules and regulations governing contracting between ordinary citizens –the functioning of the legal system –regulate transactions between private parties, e.g. a debtor and a creditor –the state and associated institutions provide the legal framework that enables private contracts to facilitate economic transactions (i.e., reduce transaction costs.) Property rights institutions: the rules and regulations protecting citizens against the power of the government and political elites –the functioning of the government –Institutions protecting investors against government expropriation –the state is an instrument for transferring resources from one group to another.

16. Unbundling Institutions (Acemoglu and Johnson, JPE, 2005 ) Good institutions will support private contracts and protect private property rights (North, 1981) Contracting institutions affect what kind of contracts can be written and enforced, thus affect efficiency of organizations and societies (Coase, Williamson, Hart) Property rights institutions affect protection of private properties, thus investment and efficiency of economies Which institution has larger impacts to societies/economies? Can we distinguish these two institutions in reality? Can we separate the roles of these two institutions?

17. Measuring Contracting institutions Index of legal formalism (Djankov et al., 2003): –The number of formal legal procedures necessary to resolve a case of collecting on an unpaid check –The larger the higher cost the legal system index of procedural complexity (The World Bank, 2004): –The difficulties in resolving the case of an unpaid commercial debt –The larger the less effective the legal system The number of procedures necessary to resolve a court case involving an unpaid commercial debt (The World Bank, 2004): –The more the worse Example: enforcing a simple commercial debt contract –Dominican Republic: costs 440% of income per capita and requires a process of 495 days –New Zealand: costs 12% of income per capita, and requires 50 days.

18. Measuring property rights institutions Constraint on the executive (the Polity IV dataset) –This measure ranges from 1 to 7: the higher the greater constraints on politicians and politically powerful elites Protection against expropriation by government (Political Risk Services) –A value between 0 and 10 for each country and year: the higher the better protection Private property index (the Heritage Foundation) –The higher the better private property is protected against government and other sources of expropriation.

19. Data 71 former European colonies –25 common law origin countries –46 civil law origin countries Outcomes: –Growth: GDP/capita –Investment: Investment to GDP ratio –Financial development: Credit to private sector; stock market capitalization Contracting institutions –Index of legal formalism –index of procedural complexity –The number of procedures necessary to resolve a court case involving an unpaid commercial debt Property rights institutions –Constraint on the executive –Protection against expropriation by government –Private property index

20. World average of institution measures

22. Basic empirical model Y c = a F c + b I c + Z c ’ g o + e c Y c : outcome for country c –Per capita GDP; –investment/GDP; –private credit/GDP; –stock market capitalization/GDP F c : measure of contracting institutions I c : measure of property rights institutions Z c : vector of other controls. g o : vector capturing effects of the control variables in Z c

23. Contract institutions vs. GDP/capita

24. Property right institutions ‘help’ GDP/capita

25. Establish causalities Y c = a F c + b I c + Z c ’ g o + e c (1) Both institutions are important to outcomes: a and b are both positive and significant From there do we know institutions determine better outcomes? Or outcomes determine institutions? Both contracting and property rights institutions are endogenous (better outcomes may lead to better institutions): –Reversed causality can have the same results – impacts of institutions may reflect omitted characteristics (e.g., geography, religion, etc.) How to determine which causes which?

26. 2SLS with instruments for institutions Estimate equation (1) using Two-Stage Least Squares (2SLS) with instruments for institutions –Instruments should be correlated with the endogenous regressors: Cov (I c ; L c ) > 0, Cov (F c ; M c ) > 0 –uncorrelated with outcomes: Cov ( e c ; L c )=Cov ( e c ; M c )=0 F c = d 1 L c + h 1 M c + Z c ’ g 1 + u 1c I c = d 2 L c + h 2 M c + Z c ’ g 2 + u 2c –M c : instrument for property rights institutions: log mortality rate of European settlers; or log of the indigenous population density in 1500 –L c : instrument for contracting institutions: a dummy for English legal origin –whether or not the country was a British colony

27. Instrument variables for property rights institutions Settler mortality in countries that were colonized by European nations between 1500 and 1900 –Where the mortality rates were low for European settlements, they migrated in large numbers and developed institutions that protect property rights better (e.g., North America, Australia, etc.) –Where the mortality rates were high for European settlements (e.g. >50%), the colonizers exploited the native population and did not protect property rights (e.g., sub-Saharan Africa, South Asia, and Central America, etc.) initial indigenous population density –Where this was high, Europeans were more likely to develop a forced labor system –Where this was low, Europeans were more likely settle themselves, and develop institutions that protect their properties

28. Instrument variables for contracting institution Legal origin –Common law vs. civil law Legal origin is an important determinant of all three measures of contracting institutions –legal origin explains about 40 percent of the variation in legal formalism –for former colonies legal origin is exogenous The British imposed common law on their colonies The French imposed civil law on their colonies –Problem: legal origin affect economic outcomes through channels other than contracting institutions given Cov( e c, L c ) ≥ 0, the estimate of the impact of contracting institutions on economic outcomes is biased upwards

29. 1 st stage regressions with instruments F c = d 1 L c + h 1 M c + Z c ’ g 1 + u 1c I c = d 2 L c + h 2 M c + Z c ’ g 2 + u 2c –M c : instrument for property rights institutions: log mortality rate of European settlers; or log of the indigenous population density in 1500 –L c : instrument for contracting institutions: a dummy for English legal origin –whether or not the country was a British colony

30. First Stage OLS Regressions for Contracting Institutions Dependent variable is measure of contracting institutions (standard errors are in parentheses) Discoveries: English legal origin has a large and significant effect on legal formalism Settler mortality and population density have no significant effect on legal formalism

31. First Stage OLS Regressions for Property Rights Institutions Dependent variable: measure of property rights institutions (standard errors are in parentheses) Discoveries: English legal origin has no significant effect on constraint on executive Settler mortality and population density have a large effect on the constraint on executive

32. Discoveries from 1 st stage regressions English legal origin mainly affects contracting institutions –Plausible explanation: Who colonized (British vs. French/Spanish), but not the details of colonization strategy, shapes contracting institutions. Settler mortality and population density before colonial times mainly affect property rights institutions –Plausible explanation: The way in which countries were colonized (settling vs. exploiting), but not who colonized them, is a robust determinant of property rights institutions

33. 2 nd stage regressions with instruments Y c = a F c + b I c + Z c ’ g o + e c (1) –Where, F c and I c are estimated by the following 1 st stage regressions – F c = d 1 L c + h 1 M c + Z c ’ g 1 + u 1c – I c = d 2 L c + h 2 M c + Z c ’ g 2 + u 2c M c : instrument for property rights institutions: –log mortality rate of European settlers; or –log of the indigenous population density in 1500 L c : instrument for contracting institutions: –a dummy for English legal origin »whether or not the country was a British colony

34. Contracting vs. Property Rights Institutions: Dependent variable is log GDP per capita ( standard errors are in parentheses) 2 nd stage of 2SLS: with log settler mort. as instrument –Contracting institution: Insignificant effects –Property rights institution: Significant effects Equivalent OLS:

35. Contracting vs. Property Rights Institutions: Dependent variable is stock market capitalization ( standard errors are in parentheses) 2 nd stage of 2SLS: with log settler mort. as instrument –Contracting institution: Significant effects –Property rights institution: Significant effects Equivalent OLS:

36. Major discoveries Property rights institutions have a first order effect on income per capita, the ratio of investment to GDP, the level of credit, and stock market development Contracting institutions only have an effect on stock market development For all variables, the effect of contracting institutions is quantitatively much smaller than the effect of property rights institutions

37. Semi-Reduced Form regressions It is possible that legal origin may affect outcomes through channels other than contracting institutions –Using legal origin as instrument for contracting institutions may miss these effects! To address this issue, let legal origin enter the second stage regression directly; whereas property rights institutions are instrumented. Results: –English legal origin has no significant positive effect, except on stock market capitalization –All three measures of property rights have a significant positive effect on the outcomes independent from instrument used No evidence of a direct positive effect of English legal origin on the outcomes

38. Alternative Samples Examine whether there is an effect of property rights institutions within each legal family –Drop contract institutions in regressions –Restrict the sample to common law countries (i.e., former British colonies) –Restrict the sample to French legal origin countries Essentially the same results are retained for both groups of legal family countries –much of the variation in institutions within each legal family countries can be explained by the colonization strategy of European powers

39. General discussion Contracting institutions and legal rules have some effect on the form of finance –Stronger contracting institutions use more equity than debt contracts Contracting institutions have limited or no effects on major economic outcomes –long-run growth (current income levels) –Investment to GDP ratio –The overall amount of financial intermediation in the economy Property rights institutions matter significantly for all these outcomes –determine how the government, politicians, and elites are constrained in their relationships with the rest of the society Question for further thoughts: –What do the proxies (indices) used by the paper capture in reality? –Do they really correspond to property rights institutions and contracting institutions? –What are mechanisms that property rights institutions and contracting institutions affect outcomes?