DEVELOPMENT AND GROWTH ECONOMICS

Week 3 - Institutions

Mattia Fracchia
January 22, 2024
The Relevance of Institutions

Differences in institutions and property rights across countries have received

considerable attention.

Countries with better institutions, more secure property rights, and less
distortionary policies will invest more in physical and human capital and will
use these factors more efficiently to achieve a greater level of income.

This view is supported by cross-country correlations between property rights

and economic development measures and a few micro-studies investigating the
relationship between property rights and investment or output.

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It May be Obvious that Institutions are Relevant

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The Impact of Institutions

This said, finding reliable causal estimates of the impact of institutions on

economic performance is a different story.

It is quite likely that rich economies choose or can afford better institutions.

Perhaps more important, economies that are different for a variety of reasons
will differ both in their institutions and in their income per capita.

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Acemoglu, Johnson, and Robinson

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Milestone: Acemoglu, Johnson, and Robinson (2001)

The Colonial Origins of Comparative Development: An Empirical

Investigation. AER (Acemoglu, Johnson, and Robinson, 2001)

The background big question:

• What are the fundamental causes of the large differences in income per capita
across countries?

The specific angle they choose:

• The role of institutions (e.g., property rights, government effectiveness).

The main working hypothesis:

• European colonization policies created institutions that persisted over time.

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We Need a Source of Exogenous Variation

They move from correlations to causal claims in a convincing way.

To estimate the impact of institutions on economic performance, we need a

source of exogenous variation in institutions.

They propose a theory of institutional differences among countries colonized

by Europeans and derive a possible source of exogenous variation.

They formulate three hypotheses...

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Hypothesis 1

Different types of colonization policies created different sets of institutions.

At one extreme, European powers set up ”extractive states,” exemplified by

the Belgian colonization of the Congo.
• These institutions did not introduce much protection for private property, nor
did they provide checks and balances against government expropriation.
• In fact, the main purpose of the extractive state was to transfer as much of the
resources of the colony to the colonizer.

At the other extreme, many Europeans migrated and settled in a number of

colonies.
• The settlers tried to replicate European institutions, with a strong emphasis on
private property and checks against government power.
• Primary examples of this include Australia, New Zealand, Canada, and the
United States.
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Hypothesis 2

The feasibility of settlements influenced the colonization strategy.

In places where the disease environment was not favorable to European

settlement, the formation of the extractive state was more likely.

Low mortality encouraged settlement and replication of European-style

inclusive institutions.

High mortality discouraged European settlement and led to extractive

institutions:
• In Bulama, Guinea-Bissau (1792-1793), the mortality among Europeans was 61
percent.
• In the first year of the Sierra Leone Company (1792-1793), 72 percent of the
European settlers died.

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Hypothesis 3

The colonial state and institutions persisted even after independence.

There is evidence of institutional persistence globally.

• Think of the cost and benefits of transitioning from extractive to non-extractive
institutions for those in power.

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Graphically

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The identification strategy

Based on these three hypotheses...

Acemoglu, Johnson, and Robinson use the mortality rates expected by the first
European settlers in the colonies as an instrument for current institutions in
these countries.

What do we mean by instrument?

Let us take a step back.

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Ordinary Least Squares

OLS is a method to estimate the relationship between variables.

The objective is to find the line that minimizes the sum of squared
residuals (differences between observed and predicted values).

Example: Returns (Y ) to college education (X ):

Y = β0 + β1 X + ε

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Ordinary Least Squares

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From Correlation to Causality

We may say that college education is associated with higher earnings.

Can we also say that college has a positive impact on earnings?

In other words, can we claim a causal relationship between college education

and higher earnings later in life?

Or can we think of some factors that might undermine this causal claim?

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The No Endogeneity Assumption

No Endogeneity:
Cov(X , ε) = 0

Intuition: The independent variable (X ) should not be influenced by

unobserved factors (ε) that affect Y .

In our example, people choose to go to college:

• People with higher ability are more likely to go to college: Cov(X , ability ) ̸= 0
• Ability affects earnings independently from college: Cov(ability , ε) ̸= 0

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Why Does Endogeneity Matter?

The issue arises from the fact that if X and ε are correlated, we cannot
credibly defend the causal claim.
• The estimated β1 will be biased.
• We cannot interpret β1 as the causal effect of X on Y .

We need strategies to address endogeneity and isolate causal effects.

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Instrumental Variables (IV)

An Instrumental Variable (IV) is a variable that:

• Is correlated with the endogenous explanatory variable (relevance).
• Is not correlated with the error term (exogeneity).

[Instrument (Z)] → [Endogenous Variable (X)] → [Outcome (Y)]

Two-Stage Least Squares (2SLS):

• Regress X on Z to get predicted values X̂ .
• Regress Y on X̂ to estimate β1 .

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Instrumental Variables in a Picture

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Key Assumptions

Relevance: Cov(Z , X ) ̸= 0
• The instrument must influence the endogenous variable.
• Relevance can be checked with statistical tests (e.g., F -statistic > 10 for
instrument strength).

Exogeneity: Cov(Z , ε) = 0
• The instrument must not be correlated with the error term.
• Exogeneity must be defended.

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Education and Earnings

Problem: Unobserved ability may affect both education and earnings.

Instrument: Distance to the nearest college (Z ).

Assumptions:
• Z affects the likelihood of going to college (X ).
• Z does not directly affect earnings (Y ) except through college.

Key Insight: IV isolates variation in X that is uncorrelated with ε.

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Acemoglu, Johnson, and Robinson defend the plausibility exclu-
sion restriction

”The exclusion restriction implied by our instrumental variable regression is

that conditional on the controls included in the regression, the mortality rates
of European settlers more than 100 years ago have no effect on GDP per
capita today other than their effect through institutional development.”

The primary concern: the mortality rates of settlers could be correlated with
the current disease environment, which may have a direct effect on income.

If this is the case, they may be attributing the impact of diseases on income to
institutions.

”We believe that this is unlikely to be the case and that our exclusion
restriction is plausible.”

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Why is it Unlikely?

The great majority of European deaths in the colonies were caused by malaria
and yellow fever.

These diseases were fatal to Europeans but had limited effect on local adults.

Mortality rates of local troops serving with the British army in Bengal and
Madras are comparable with those of British soldiers serving in Britain.

However, British soldiers serving in Bengal and Madras had mortality rates 5
to 11 times higher than their colleagues serving at home.

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Other Threats to the Exclusion Restrictions

Other factors correlated with the estimates of settler mortality may affect
income per capita.

The results hold once they control for a number of variables potentially
correlated with settler mortality and economic outcomes such as the identity of
the main colonizer, legal origin, climate, religion, geography, natural resources,
soil quality, and measures of ethnolinguistic fragmentation.

The results are also robust to the inclusion of controls for the current disease
environment and the current fraction of the population of European descent.

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Previous Similar Work

Mauro (1995) instruments for corruption using ethnolinguistic fragmentation.

use distance from the equator as an instrument for social

Hall and Jones (1999)
infrastructure since they argue that latitude is correlated with ”Western
influence”.

Acemoglu, Johnson, and Robinson criticize their instruments:

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Conceptually

”The theoretical reasoning for these instruments is not entirely convincing. It is

not easy to argue that the Belgian influence in the Congo, or Western influence
in the Gold Coast during the era of slavery promoted good institutions.”

”Ethnolinguistic fragmentation, on the other hand, seems endogenous,

especially since such fragmentation almost completely disappeared in Europe
during the era of growth when a centralized state and market emerged (see,
e.g., Weber (1976); Anderson (2020)).”

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 And Econometrically

• ”Econometrically, the problem with both studies is that their instruments can
plausibly have a direct effect on performance.”

”For example, Easterly and Levine (1997) argue that ethnolinguistic fragmentation
can affect performance by creating political instability, while De Montesquieu (1989)
and, more recently, Bloom et al. (1998) and Gallup, Sachs, and Mellinger (1999) argue for a
direct effect of climate on performance.”

”If, indeed, these variables have a direct effect, they are invalid instruments
and do not establish that it is institutions that matter.”

”The advantage of our approach is that conditional on the variables we already

control for, settler mortality more than 100 years ago should have no effect on
output today, other than through its effect on institutions.”

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Conclusion

Institutions established during colonization have long-term effects on

development today, measured by GDP per capita and institutional quality
indices.

More work from them on the topic: Acemoglu, Johnson, and Robinson (2002); Acemoglu
(2005); Acemoglu and Robinson (2013).

Improving institutions can be a pathway to development.

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Questions

How do you think institutions could be improved today?

Are there modern examples where institutional changes have significantly

influenced economic outcomes?

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Recommended Material

Reading:
• Acemoglu, Daron, Simon Johnson, and James A Robinson. 2001. “The Colonial
Origins of Comparative Development: An Empirical Investigation.” American
Economic Review 91 (5): 1369–1401.

Listening:
• 124. Daron Acemoglu on Economics, Politics, and Power

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References
Acemoglu, D. 2005. “Institutions as the Fundamental Cause of Long-Run Growth.”
Handbook of Economics Growth .
Acemoglu, Daron, Simon Johnson, and James A Robinson. 2001. “The Colonial Origins of
Comparative Development: An Empirical Investigation.” American Economic Review
91 (5): 1369–1401.
———. 2002. “Reversal of Fortune: Geography and Institutions in the Making of the
Modern World Income Distribution.” The Quarterly Journal of Economics 117 (4):
1231–1294.
Acemoglu, Daron, and James A Robinson. 2013. Why Nations Fail: The Origins of Power,
Prosperity, and Poverty. Crown Currency.
Anderson, Benedict. 2020. “Imagined Communities: Reflections on the Origin and Spread of
Nationalism.” In The New Social Theory Reader. Routledge, 282–288.
Bloom, David E, Jeffrey D Sachs, Paul Collier, and Christopher Udry. 1998. “Geography,
Demography, and Economic Growth in Africa.” Brookings papers on economic activity
1998 (2): 207–295.
De Montesquieu, C. 1989. Montesquieu: The Spirit of the Laws. Cambridge University Press.
Easterly, William, and Ross Levine. 1997. “Africa’s Growth Tragedy: Policies and Ethnic
Divisions.” The Quarterly Journal of Economics : 1203–1250.
Gallup, John Luke, Jeffrey D Sachs, and Andrew D Mellinger. 1999. “Geography and
Economic Development.” International Regional Science Review 22 (2): 179–232.
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Hall, Robert E, and Charles I Jones. 1999. “Why Do Some Countries Produce So Much More
Output Per Worker Than Others?” The Quarterly Journal of Economics 114 (1): 83–116.
Mauro, Paolo. 1995. “Corruption and Growth.” The Quarterly Journal of Economics
110 (3):681–712.
Weber, Eugen. 1976. Peasants into Frenchmen: the Modernization of Rural France,
1870-1914. Stanford University Press.

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