Why Nations Fail Illustrated

Lecture 2

Inclusive vs Extractive institutions

October 9, 2018

Masayuki Kudamatsu

Chapter 3 (except the last section)

Weeks 2-4: How institutions affect prosperity

October 9

Chapter 3

October 16

Chapter 7

October 23

Chapter 8

North/South Korea

the Congo

How institutions matter for prosperity

Why did

Industrial Revolution

take place

in England?

History of England

from 13c to 19c

Extractive institutions cause poverty

Inclusive institutions lead to prosperity

Ottoman Empire

Austria-Hungary

Russian Empire

Ming/Qing dynasties

Ethiopia

Somalia 

A concept proposed by Douglas North

(Nobel laureate in 1993)

Review 1: Institutions

"humanly devised constraints that structure political, economic and social interactions"

e.g.

When college graduates find a job

Japan

before graduation

Most countries

after graduation

Douglas North (1991) Institutions, p. 3

vs

Review 2: Drivers of Economic Growth

Economic growth

Investment

Innovation

1

Defining Feature of Economics #1

Individuals choose

the best

affordable

option

Optimization

Review 3

Economic Institutions

Political Institutions

Income inequality across countries

Summary of Why Nations Fail's theory

Rich

Poor

Inclusive

Extractive

Inclusive

Extractive

Economic Institutions

Political Institutions

Income inequality across countries

Today's Road Map (1 of 3)

What are inclusive/extractive economic institutions?

How do they affect economic growth?

1

Economic Institutions

Political Institutions

Income inequality across countries

Today's Road Map (2 of 3)

What are inclusive/extractive political institutions?

How do they shape economic institutions?

2

Economic Institutions

Political Institutions

Income inequality across countries

Today's Road Map (3 of 3)

Class discussion (for term paper preparation)

Does this framework helps us understand

Japan's economic growth after WWII ?

3

Economic Institutions

Political Institutions

Income inequality across countries

What are inclusive/extractive economic institutions?

How do they affect economic growth?

Today's Road Map (1 of 3)

1

economic institutions
Secure
for everyone
Property rights Insecure
for majority of people
Free Occupational
choice
Forced labor
Free Entry of new businesses Prevented by monopolies
Unbiased System of laws Biased for
the powerful/rich
Promoted Public service provision Discouraged

Economic Institutions

Inclusive

Extractive

Property rights

Occupational choice

Entry of

new businesses

System of laws

Public service provision

economic institutions
Secure
for everyone
Property rights Insecure
for majority of people
Free Occupational
choice
Forced labor
Free Entry of new businesses Prevented by monopolies
Unbiased System of laws Biased for
the powerful/rich
Promoted Public service provision Discouraged

Economic Institutions

Inclusive

Extractive

Property rights

Occupational choice

Entry of

new businesses

System of laws

Public service provision

Property rights

Incentive to invest & innovate

Secure 

Own land and what it produces

Grow fruit trees, to eat/sell fruits

e.g.

Property rights

Incentive to invest & innovate

Insecure 

e.g.

Thieves will steal what land produces

No incentive to grow fruit trees

Government will confiscate your land

Property rights

Incentive to invest & innovate

Insecure 

e.g. North Korea

Private properties outlawed

No one invest/innovate in agriculture

Frequent famines

Property rights

Incentive to invest & innovate

Insecure 

e.g. The Congo in 15c-16c

Arbitrary taxation

Farmers reluctant to use

wheels / plows

brought by Europeans

e.g.

Everytime

king's beret

fell off

Property rights

Incentive for anyone to invest & innovate

Secure for everyone

Someone

with talent

Invest/innovate

You never know who has talent at any point in time

Someone

without talent

Invest/innovate

Sustained economic growth

Provide better products

Business fails

Property rights

Incentive for a few to invest & innovate

Insecure for many

Someone

with talent

& secure

In short run

Invest/innovate

Provide better products

Someone

with talent

& insecure

Don't invest/innovate

Short-run

Economic

growth

Property rights

Incentive for a few to invest & innovate

Insecure for many

Someone

with talent

& secure

Unsustained Economic growth

Someone

with talent

& insecure

Don't invest/innovate

Someone

without talent

& secure

Keep selling outdated products

In long run

Barbados in 1680 (as an English colony)

175 sugar planters own most of land

Of population of around 60,000

39,000 are slaves

no property rights

for land or even themselves

Secure property rights only for a few

economic institutions
Secure
for everyone
Property rights Insecure
for majority of people
Free Occupational
choice
Forced labor
Free Entry of new businesses Prevented by monopolies
Unbiased System of laws Biased for
the powerful/rich
Promoted Public service provision Discouraged

Economic Institutions

Inclusive

Extractive

Property rights

Secure for everyone

Insecure for

majority of people

Occupational choice

Entry of

new businesses

System of laws

Public service provision

economic institutions
Secure
for everyone
Property rights Insecure
for majority of people
Free Occupational
choice
Forced labor
Free Entry of new businesses Prevented by monopolies
Unbiased System of laws Biased for
the powerful/rich
Promoted Public service provision Discouraged

Economic Institutions

Inclusive

Extractive

Property rights

Secure for everyone

Insecure for

majority of people

Occupational choice

Entry of

new businesses

System of laws

Public service provision

Occupational Choice

Incentive to educate yourself

Free to choose your job

It's a property right on your own labor

Scientific discoveries

+

Make new technologies more usable

Innovation

Occupational Choice

Incentive to educate yourself

Free to choose your job

It's a property right on your own labor

Innovation

e.g. North Korea 

10 years of military services after finishing school

Occupational Choice

Incentive to educate yourself

Free to choose your job

It's a property right on your own labor

Innovation

e.g. The Congo in 15c-16c

Slaves work for the elite's plantations

economic institutions
Secure
for everyone
Property rights Insecure
for majority of people
Free Occupational
choice
Forced labor
Free Entry of new businesses Prevented by monopolies
Unbiased System of laws Biased for
the powerful/rich
Promoted Public service provision Discouraged

Economic Institutions

Inclusive

Extractive

Property rights

Secure for everyone

Insecure for

majority of people

Occupational choice

Free

Forced labor

Entry of

new businesses

System of laws

Public service provision

economic institutions
Secure
for everyone
Property rights Insecure
for majority of people
Free Occupational
choice
Forced labor
Free Entry of new businesses Prevented by monopolies
Unbiased System of laws Biased for
the powerful/rich
Promoted Public service provision Discouraged

Economic Institutions

Inclusive

Extractive

Property rights

Secure for everyone

Insecure for

majority of people

Occupational choice

Free

Forced labor

Entry of

new businesses

System of laws

Public service provision

Entry of New Businesses

Those with best ideas can produce

Free to enter any industry

It's a property right on your company in the future

Innovation

e.g. Book market

Free to enter

in U.S.

Jeff Bezos set up Amazon

We can now buy books online

Entry of New Businesses

Those with best ideas can produce

Free to enter any industry

It's a property right on your company in the future

Innovation

e.g. North Korea 

Markets are banned

Entry of New Businesses

Those with best ideas can produce

Free to enter any industry

It's a property right on your company in the future

Innovation

e.g. The Congo in 15th/16th centuries

King and his associates monopolize

long-distance trade & mercantile activities

economic institutions
Secure
for everyone
Property rights Insecure
for majority of people
Free Occupational
choice
Forced labor
Free Entry of new businesses Prevented by monopolies
Unbiased System of laws Biased for
the powerful/rich
Promoted Public service provision Discouraged

Economic Institutions

Inclusive

Extractive

Property rights

Secure for everyone

Insecure for

majority of people

Occupational choice

Free

Forced labor

Entry of

new businesses

Free

Prevented by

monopolies

System of laws

Public service provision

economic institutions
Secure
for everyone
Property rights Insecure
for majority of people
Free Occupational
choice
Forced labor
Free Entry of new businesses Prevented by monopolies
Unbiased System of laws Biased for
the powerful/rich
Promoted Public service provision Discouraged

Economic Institutions

Inclusive

Extractive

Property rights

Secure for everyone

Insecure for

majority of people

Occupational choice

Free

Forced labor

Entry of

new businesses

Free

Prevented by

monopolies

System of laws

Public service provision

System of Laws

Law-breakers will be punished

Unbiased 

Discourage unlawful behavior

Victims will be compensated

+

Incentive to invest & innovate

Ensure the enforcement of secure property rights etc.

Barbados in 1680 (as an English colony)

175 sugar planters own most of land

Of population of around 60,000

29 of 40 judges

: large planters

8 most senior military officers

: large planters

economic institutions
Secure
for everyone
Property rights Insecure
for majority of people
Free Occupational
choice
Forced labor
Free Entry of new businesses Prevented by monopolies
Unbiased System of laws Biased for
the powerful/rich
Promoted Public service provision Discouraged

Economic Institutions

Inclusive

Extractive

Property rights

Secure for everyone

Insecure for

majority of people

Occupational choice

Free

Forced labor

Entry of

new businesses

Free

Prevented by

monopolies

System of laws

Unbiased

Biased for

the powerful / rich

Public service provision

economic institutions
Secure
for everyone
Property rights Insecure
for majority of people
Free Occupational
choice
Forced labor
Free Entry of new businesses Prevented by monopolies
Unbiased System of laws Biased for
the powerful/rich
Promoted Public service provision Discouraged

Economic Institutions

Inclusive

Extractive

Property rights

Secure for everyone

Insecure for

majority of people

Occupational choice

Free

Forced labor

Entry of

new businesses

Free

Prevented by

monopolies

System of laws

Unbiased

Biased for

the powerful / rich

Public service provision

Public Service Provision

Provided by govt

The smart but poor can run business

Innovation

Transportation (roads, railways)

Telecommunication

Education

Health care

Public Service Provision

Provided by govt

The smart but poor can run business

Innovation

e.g. South Korea

Government has invested in education

Public Service Provision

Provided by govt

The smart but poor can run business

Innovation

e.g. North Korea

Education = Propaganda to legitimize the communist party

economic institutions
Secure
for everyone
Property rights Insecure
for majority of people
Free Occupational
choice
Forced labor
Free Entry of new businesses Prevented by monopolies
Unbiased System of laws Biased for
the powerful/rich
Promoted Public service provision Discouraged

Economic Institutions

Inclusive

Extractive

Property rights

Secure for everyone

Insecure for

majority of people

Occupational choice

Free

Forced labor

Entry of

new businesses

Free

Prevented by

monopolies

System of laws

Unbiased

Biased for

the powerful / rich

Public service provision

Provided

Limited

economic institutions
Secure
for everyone
Property rights Insecure
for majority of people
Free Occupational
choice
Forced labor
Free Entry of new businesses Prevented by monopolies
Unbiased System of laws Biased for
the powerful/rich
Promoted Public service provision Discouraged

Economic Institutions

Inclusive

Extractive

Property rights

Secure for everyone

Insecure for

majority of people

Occupational choice

Free

Forced labor

Entry of

new businesses

Free

Prevented by

monopolies

System of laws

Unbiased

Biased for

the powerful / rich

Public service provision

Provided

Limited

Incentive

to invest & innovate

Transfer wealth from

one group to another

Evidence for secure property rights leading to prosperity

economic institutions
Secure
for everyone
Property rights Insecure
for majority of people
Free Occupational
choice
Forced labor
Free Entry of new businesses Prevented by monopolies
Unbiased System of laws Biased for
the powerful/rich
Promoted Public service provision Discouraged

Economic Institutions

Inclusive

Extractive

Property rights

Secure for everyone

Insecure for

majority of people

Occupational choice

Free

Forced labor

Entry of

new businesses

Free

Prevented by

monopolies

System of laws

Unbiased

Biased for

the powerful / rich

Public service provision

Provided

Limited

State

= Monopoly of legitimate violence

Economic Institutions

Political Institutions

Income inequality across countries

What are inclusive/extractive economic institutions?

How do they affect economic growth?

Today's Road Map (1 of 3)

1

Economic Institutions

Political Institutions

Income inequality across countries

What are inclusive/extractive political institutions?

How do they shape economic institutions?

Today's Road Map (2 of 3)

2

A concept proposed by Douglas North

(Nobel laureate in 1993)

"humanly devised constraints that structure political, economic and social interactions"

Douglas North (1991) Institutions, p. 3

Economic Institutions

Society

Economic Institutions

Society

Politics

Political Institutions

Inclusive

Extractive

Both

Plurality

and

Centralized

State

Either

Absolutist

or

Lack of

Centralization

Political institutions are ...

Economic Institutions

Political Institutions

if extractive...

(as in 16c-17c Congo)

Slaves

excluded from politics

Slaves have to work for plantation owners

Economic Institutions

Political Institutions

if extractive...

(as in North Korea)

Communist party dominates politics

Non-members have no freedom in economic activities

Economic Institutions

Political Institutions

if inclusive...

(as in South Korea)

The powerful cannot impose their will upon the rest of society

Extractive institutions won't be set up

Economic Institutions

Political Institutions

Income inequality across countries

Today's Road Map (2 of 3)

2

There's feedback

from economic institutions

Economic Institutions

Political Institutions

if extractive...

The powerful gets richer

The powerful can stay in power by violence

e.g. mid-17c Congo

King is free to take anyone's possessions

Standing army of 5,000 troops

Buy guns from Europeans

Economic Institutions

Political Institutions

if inclusive...

Equal distribution of wealth

The powerful cannot stay in power forever

Inclusive Economic Institutions

Inclusive Political Institutions

Synergy

Extractive Economic Institutions

Extractive Political Institutions

Synergy

Inclusive Economic Institutions

Extractive Political Institutions

Why not?

Economic growth

Elite gets richer

as well

Extractive Political Institutions

Why not?

Economic growth

Elite gets richer

as well

Plurality

&

Centralized State

Economic Growth

Winners

&

Losers

Creative destruction

Losers = Powerful

Why not plurality?

Extractive Econ Instit.

to prevent creative destruction

If

Fear of violent opposition to centralize

Evenly balanced power across groups

+

Why not centralized state?

Fear of being exploited by state

Fear of violent opposition to centralize

Evenly balanced power across groups

+

Why not centralized state?

Fear of being exploited by state

e.g. Congo after 1960

National territory includes

many pre-colonial societies

Fear of violent opposition to centralize

+

Why not centralized state?

Fear of being exploited by state

e.g. Congo after 1960

Katanga and Kasai provinces attempted to secede in 1961

Inclusive political institutions

Plurality

for non-violent political power

No plurality

for violent political power

(Monopoly by the centralized state)

+

=

Note that plurality has two dimensions

Economic Institutions

Political Institutions

Income inequality across countries

Today's Road Map (2 of 3)

2

Economic Institutions

Political Institutions

Income inequality across countries

Today's Road Map (3 of 3)

Class discussion (for term paper preparation)

Does this framework helps us understand

Japan's economic growth after WWII ?

3

Class discussion time

Does Why Nations Fail's theory explains

post-WWII Japan's economic performance?

What do we need to know

to answer this question?

Japan's real GDP per capita over 1960-2017

source: World Bank

Yen

(2010)

Mistakes

do not count

In this course...

I want you to 

Fail gracefully

Because...

Pick a country

And discuss whether 

Theory of Why Nations Fail can

explain economic performances

of the country of your choice

Term Paper

Pick a country

And discuss whether 

Theory of Why Nations Fail can

explain economic performances

of the country of your choice

Term Paper

Pick a country

You cannot choose a country of another student's choice

First come, first served

Post which country you've chosen on Prulu discussion board

The following countries cannot be chosen

as discussed in detail by Why Nations Fail 

Argentina

Australia

Botswana

Brazil

China (except since 1979)

Colombia

DR Congo 

Ethiopia (except since the 1990s)

France

Guatemala

Japan

North Korea

Mexico

Russia (except since the 1990s)

Sierra Leone

Somalia

South Africa

United Kingdom

United States

Uzbekistan

Zimbabwe

Pick a country (cont.)

Weeks 2-4: How institutions affect prosperity

October 9

Chapter 3

October 16

Chapter 7

October 23

Chapter 8

North/South Korea

the Congo

How institutions matter for prosperity

Why did

Industrial Revolution

take place

in England?

History of England

from 13c to 19c

Extractive institutions cause poverty

Inclusive institutions lead to prosperity

Ottoman Empire

Austria-Hungary

Russian Empire

Ming/Qing dynasties

Ethiopia

Somalia 

Next Week

Your to-do list until next class

Pick a country for your term paper

and post it on Prulu

Read Chapter 7 (except from last paragraph on page 208) 

and post questions on Prulu

1

2

3

(Also read pp. 102-104, which summarizes Chapter 7)

Keep thinking about whether Why Nations Fail explains Japan's post-WWII economic growth.

Politics through the Lens of Economics (2018): Lecture 2

By Masayuki Kudamatsu

Politics through the Lens of Economics (2018): Lecture 2

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