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Chapter 8 Why Isn’t the Whole World Developed?


8 Why Isn’t the Whole World Developed?

Chapter Outline

8.1 Proximate Versus Fundamental Causes of Prosperity

8.2 Institutions and Economic Development

EBE Are Tropical and Semitropical Areas Condemned to Poverty by Their Geographies?

8.3 Is Foreign Aid the Solution to World Poverty?



Key Ideas

1. Proximate causes of prosperity link prosperity and poverty of nations to the levels of inputs, while fundamental causes look for reasons why there are such differences in the levels of inputs.

2. The geography, culture, and institutions hypotheses advance different fundamental causes of prosperity.



Key Ideas

3. Inclusive and extractive economic institutions affect economic development.

4. Creative destruction is integral to economic growth through technological change.

5. Reversal of fortune evidence provides support for the institutions hypothesis.



Proximate causes of prosperity High levels of factors of production such as physical capital, human capital, and technology that result in a high level of GDP per capita.

The factors of production are proximate causes because they link high levels of prosperity to high levels of the factors, but without providing an explanation for why these factors are high.


Fundamental causes of prosperity The root reasons for the differences in the proximate causes.

The fundamental causes are ultimately the deep determinants of economic development.



Exhibit 8.1 Fundamental and Proximate Causes of Prosperity



Fundamental causes can be classified into three categories or theories:

1. Geography hypothesis2. Culture hypothesis3. Institutions hypothesis



The geography hypothesis claims that differences in geography, climate, and ecology are ultimately responsible for the large differences in prosperity observed around the globe.

The following map of the world reveals that economies with low levels of GDP per capita are located in tropical areas, while those with high levels are in temperate areas (outside the tropics).


Tropic of Capricorn

Tropic of Cancer




In the past, the French philosopher Montesquieu and the British economist Alfred Marshall argued that tropical climates decreased work effort.



Economist JeffreySachs and geographer Jared Diamond argue that tropical climates are more prone to infectious diseases such as malaria and dengue fever, which result in poverty.

The following graph tests the geography hypothesis using cross-country data.



0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%200

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Test of Geography Hypothesis

Percentage of the population exposed to malaria in 1966

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United Arab Emirates

Niger

Yemen

Gabon

Angola

Venezuela

Dem. Rep. of CongoZimbabwe

Burundi



The culture hypothesis claims that different values and cultural beliefs are ultimately responsible for the large differences in prosperity observed around the globe.



In 1905, the German socialist Max Weber argued that Protestant beliefs lead to a greater work effort, higher savings, and increased income.

The following graph tests the Protestant work ethic hypothesis using cross-country data.



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Test of Weber's Protestant Work Ethic Hypothesis

Percentage of the population that is Protestant in 1900

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Norway

Luxembourg

United StatesIceland

Dem. Rep. of CongoZimbabwe

Burundi



Almost 20 years ago, the Harvard political scientist Samuel Huntington talked of a “clash of civilization” between the West and Islam.

The following graph tests the Clash of Civilization hypothesis using cross-country data



0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%200

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Test of Clash of Civilizations

Percentage of the population that is Muslim in 1900

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United Arab EmiratesLuxembourg

United States KuwaitBrunei

Singapore

ZimbabweDem. Rep. of Congo

BurundiSomalia



The institutions hypothesis claims that differences in the way societies organize themselves and shape the incentives of individuals and businesses (so-called economic rules of the game) are ultimately responsible for the large differences in prosperity observed around the globe.



-2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0200

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Test of Institutions Hypothesis

Rule of law (-2 is lowest; +2 is highest)

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Norway

Luxembourg

United States

Switzerland

Zimbabwe

Dem. Rep. of Congo

Burundi



Institutions have three important features:

1. They are determined by individuals.2. They place constraints on behavior.3. They shape human behavior by determining

incentives.



The “natural experiment” of the two Koreas provides a test of the institutions hypothesis.

In the 1940s, North and South Korea were a single country, with a unified language, culture, and geography.

In 1947, the country was split into two countries along the 38th parallel by an agreement between the United States and the Soviet Union.




Exhibit 8.2 GDP per Capita in North and South Korea (in PPP-adjusted 2005 constant dollars)


By 2010, North Korea was an economic “disaster,” with a GDP per capita of $1,500, while South Korea was an economic “miracle,” with a GDP per capita of close to $30,000.

What happened?

Was it geography? Was it culture? Was it institutions?



The South Korean autocratic government of Syngman Rhee and Park Chung-hee adopted a market-based economy, providing incentives for investment in physical and human capital.

The North Korean dictatorship of Kim Il-Sung and his son Kim Jong-Il adopted a strict communist system (called Juche) that outlawed private property and banned markets.




Economic institutions Aspects of society’s rules that concern economic transactions.

Economic institutions include: • Protection of property rights and ownership • Impartiality of the justice system• Financial arrangements between savers and

borrowers• Regulations concerning new businesses or

occupations



Inclusive economic institutions

Institutions that support and encourage economic transactions and, as such:• Protect private property • Uphold law and order• Allow and enforce private contracts• Allow free entry into new lines of

business and occupations



Extractive economic institutions

Institutions that remove resources from the economy and, as such:

• Do not protect private property

• Do not enforce private contracts

• Interfere with the workings of markets

• Restrict entry into new lines of business and occupations



Political institutions

The aspects of society’s rules that determine who holds political power and what types of constraints are placed on them.

In North Korea, political power in the past lay completely with Kim Il-Sung and then Kim Jong-Il, and it now lies with Kim Jong-Un.

In South Korea, political power is spread between an elected president and Parliament.


The experience in Eastern Europe provides another example of the institutions hypothesis.

In 1948, Czechoslovakia (forcibly) became communist, with extractive institutions, while Austria followed a market system with inclusive institutions.




Exhibit 8.3 GDP per Capita in Austria and the Neighboring Czechoslovakia Since 1948 (in PPP-adjusted 2005 constant dollars)


By 1989, Czechoslovakia had a GDP per capita of $12,066, while Austria had a GDP per capita of $22,514—almost twice as high!

What happened?

Was it geography? Was it culture? Was it institutions?



After the fall of Communism, the Czech Republic and Slovakia with their inclusive institutions are starting to close the GDP per capita gap with their neighbor Austria.



Extractive economic institutions tend to support inefficient firms and prevent entrepreneurs with new ideas from entering the market.



We rank potential entrepreneurs in descending order, according to the return they could earn by starting a business.

The return-to-entrepreneurship curve is the downward-sloping blue line on the next slide, which shows the number of entrepreneurs (horizontal axis) against their return (vertical axis).




Exhibit 8.4, Panel (a) How Extractive Economic Institutions Reduce the Number of Entrepreneurs


We then add the opportunity cost of the entrepreneurship, which is assumed to be the same for all entrepreneurs.

The opportunity cost line is the red horizontal line drawn at a constant opportunity cost.






The intersection of the two lines gives us the equilibrium return and the equilibrium number of entrepreneurs.






Extractive institutions have two main impacts:

1. Weak property rights and legal enforcement prevent the entrepreneur from capturing the full returns they create.

This shifts the return-to-entrepreneurship line to the left.




Exhibit 8.4, Panel (b) How Extractive Economic Institutions Reduce the Number of Entrepreneurs


2. Barriers to entry in the marketplace increase the cost of entering the market.

This shifts the opportunity cost line upward.




Exhibit 8.4, Panel (c) How Extractive Economic Institutions Reduce the Number of Entrepreneurs


Why would a country adopt extractive economic institutions if they retard economic growth?

The notion of political creative destruction predicts that economic growth destabilizes existing regimes and reduces political power.

Therefore, rulers such as Kim Jong-Un of North Korea use extractive economic institutions to maintain political power.



Inclusive economic institutions allowed the Industrial Revolution, with all of its complex social and economic processes, to occur in England in the late 18th century and in the United States in the 19th century.



Evidence-Based Economics Example

Question: Are tropicaland semitropical areas condemned to poverty by their geographies?

Data: Urbanization and population density rates in 1500 and urbanization rates and GDP per capita in 2010.



In late 15th century, the European powers “colonized” Africa, Asia, Australasia, Latin America, and North America.

Although there is no GDP per capita data for that time, we can measure the living standards of these former colonies by using urbanization and population density rates in 1500.



Countries that generate sufficient agricultural surplus and a transportation and trading network can support a larger population per square mile in general and a larger urban population in particular.

What, then, is the relationship between prosperity in 1500 and prosperity today, measured as GDP per capita?




Exhibit 8.6 The Reversal of Fortune Using Urbanization



Exhibit 8.7 The Reversal of Fortune Using Population Density


The two graphs show what we call “reversal of fortune”: Former colonies that were poor in 1500 are rich today, while former colonies that were rich in 1500 are relatively poor today.

What happened?



The settlers in the poor, temperate areas of North America, Australasia, and Argentina developed inclusive economic institutions due to low settler mortality rates.

The settlers in the rich tropical areas of Mexico, Peru, India, and Morocco adopted extractive institutions due to high settler mortality rates.



Evidence-Based Economics Example

Question: Are tropical and semitropical areas condemned to poverty by their geographies?

Answer: No. Although tropical areas tend to have lower GDP per capita levels today, the reason is not the geography of the tropics but rather the fact that extractive institutions were adopted in these areas.



Many people, like the singer Bono, actress Angelina Jolie, and economist Jeffrey Sachs, argue that increased spending on foreign and development aid by the West is needed to alleviate poverty around the world.

In the book The End of Poverty, Sachs argues that extreme poverty can be eliminated by the year 2025 through carefully planned and targeted development aid.




Surprisingly, most economists contend that foreign aid has been ineffective, on the whole, in alleviating poverty.

Dambisa Moyo states in her book Dead Aid that more than $1 trillion of aid has gone to Africa, and yet most of the recipients of this aid are not better off, and some are even worse off.

Why?


1. The amount of foreign aid provided is not large enough to lead to sizable increases in physical capital and educational attainment and, more importantly, does not impact technology or the efficiency of production.




2. In practice, much foreign aid does not get invested in education or new technologies but is captured by corrupt government officials.

Many studies indicate that only about 10% to 15% of foreign aid actually reaches its intended destination.



3. If the root of poverty is extractive economic institutions, then foreign aid given within these institutions will not fix the fundamental causes of poverty.

Think about why most people insist on donating money through charitable organizations rather than giving directly to the needy individuals.

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