1. How are the proximate causes of prosperity different from the fundamental causes of prosperity?
Answer: Proximate causes link high levels of prosperity to high levels of factors such as physical capital, human capital, and technology but don’t provide an explanation for why the levels of these inputs are high. On the other hand, the underlying factors that explain the proximate causes of prosperity are known as the fundamental causes of prosperity. Fundamental causes of prosperity explain why some countries are either unable or unwilling to invest in different amounts of physical capital, human capital, and technology.
2. What does the geography hypothesis state?
Answer: The geography hypothesis states that differences in geography, climate, and ecology are ultimately responsible for the differences in prosperity observed across the world. According to this hypothesis, some countries have highly unfavorable geographical, climatic, or ecological circumstances that are outside of their control. These conditions make it impossible or unlikely for such countries to accumulate or effectively use the factors of production.
3. According to the geography hypothesis, what could be done in order to improve incomes in poor countries? Explain.
Answer: If geography is the major fundamental basis of prosperity, then the poor nations of the world have little reason to expect much improvement in living standards. They are permanently disadvantaged and would not be expected to catch up with the rest of the world and become economically developed anytime soon. However, some variations of the geography hypothesis stipulate that large-scale investments in transport technology or disease eradication may partially redress these geographic disadvantages.
4. What does the culture hypothesis state?
Answer: According to the culture hypothesis, different societies respond differently to incentives because of specific shared experiences, religious teachings, the strength of family ties, or unspoken social norms. For example, some societies may have values that encourage investment, hard work, and the adoption of new technologies, while other societies may encourage creative tactics to avoid work or nurture suspicion of new inventions. Because culture is viewed as a key determinant of the values, preferences, and beliefs of individuals and societies, the culture hypothesis maintains that these differences play a key role in shaping economic performance.
5. In the context of this chapter, what is meant by an institution? What are the three important elements that define institutions?
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Answer: As defined by economic historian Douglass North, institutions are the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction. This definition captures three important elements that define institutions:
● They are determined by individuals as members of a society. In contrast to geography, which is largely outside of human control, and culture, which changes very slowly, institutions are determined by man-made factors.
● They place constraints on behavior. The “rules of the game” determine people’s behavior. Policies, regulations, and laws that punish or reward certain types of behavior will naturally have an effect on behavior.
● They affect incentives. The constraints that institutions place on individuals—whether formal constraints, such as banning certain activities, or informal ones, such as discouraging certain types of behavior through customs and social norms—shape human interaction and affect incentives.
6. How does the institutions hypothesis explain the difference in prosperity among nations?
Answer: The institutions hypothesis claims that differences in institutions—how societies have organized themselves and shaped the incentives of individuals and businesses—are at the root of the differences in prosperity across the world. In other words, the institutions hypothesis is based on the notion that it is the way that humans themselves decide to organize their societies that determines whether or not they prosper. Some ways of organizing societies encourage people to innovate, to take risks, to save for the future, to find better ways of doing things, to learn and educate themselves, to solve problems of collective action, and to provide public goods.
7. What does it mean to say that private property rights are well-enforced in an economy? How does it foster economic development?
Answer: Secure private property rights means that a country’s citizens can hold property like businesses, houses, cars, and many other things without fearing that the government or anyone else will arbitrarily take them away. Well-enforced property rights help economic development by encouraging entrepreneurship. Entrepreneurs know that the income they generate belongs to them. This gives them the incentive to borrow money, invest, and start businesses. When property is well-protected, law and order are buttressed and contracts are enforced. All of these factors promote economic activity and development.
8. How do inclusive economic institutions differ from extractive economic institutions?
Answer: Inclusive economic institutions provide secure property rights, set up a judicial system that enforces contracts and upholds the law, allow private parties to sign contracts for economic or financial transactions, and maintain relatively open and free entry into different businesses and occupations. Such institutions are said to be inclusive because they encourage the participation of a majority of the population in economic activities in a way that makes an efficient use of their talents and skills. On the other hand, extractive economic institutions fail to ensure protection of property rights, create barriers to entry in an industry, and restrict the free functioning of markets. Such institutions are often controlled by those who wield political power and extract resources from the rest of the society.
9. What does the return-to-entrepreneurship curve show? What is meant by the opportunity cost of entrepreneurship?
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Answer: The return-to-entrepreneurship curve ranks potential entrepreneurs in descending order according to the return they will make if they enter into the business for which they have a comparative advantage. The opportunity cost of entrepreneurship indicates the value to a potential entrepreneur of her best alternative activity.
10. In what ways should extractive economic institutions be changed to encourage economic development?
Answer: A major problem with extractive economic institutions is that they do not guarantee property rights. This means that entrepreneurs are discouraged from investing as they do not see that their investment or their profits will be guaranteed. Therefore, a primary area of change is to provide guarantees to firms that they will not be taxed unfairly, their profits will not be taken away, and they will not be nationalized. New market entries should also be encouraged and protected.
11. Suppose a country has well-enforced private property rights for entrepreneurs, but a large fraction of the population does not have access to education and thus cannot become entrepreneurs. Moreover, their productivity as workers is low. Would you say that this country has inclusive economic institutions? Is it likely to achieve a high level of economic development?
Answer: Well-enforced property rights are only one element, although a very important one, of inclusive economic institutions. Other components include a disinterested and efficient judiciary and accessibility of businesses and occupations to a wide variety of citizens. However, almost a prerequisite of this accessibility is an educational system that allows people to acquire the training and skills necessary to found and manage businesses successfully. Without this vital element, low productivity and the squandering of entrepreneurial talent are inevitable, and a country’s institutions cannot be called fully inclusive. And in the absence of truly inclusive institutions, economic growth and development might be substantially impeded.
12. What is meant by political creative destruction? How would this concept explain the existence of extractive institutions?
Answer: Political creative destruction refers to the process in which economic growth destabilizes existing regimes and reduces the political power of rulers and monarchs. This would explain why a society adopts extractive institutions even though it seems to lead to relative poverty and a lack of economic development. New technology and economic growth may bring new actors on the scene who may make political demands. New economic activities may fall outside of the control of existing rulers. If the process of economic growth is also associated with political creative destruction, then the politically powerful, who fear losing their privileged positions, will be opposed to this process. This would ensure that extractive institutions remain in place.
13. Parts of the world that were relatively more prosperous 500 years ago have experienced a reversal of fortune and are relatively poorer today. What factors could explain this?
Answer: Taking data on urbanization as a proxy for the prosperity of a nation, we can see that, in 1500, places like Mexico, Peru, North Africa, and India were relatively more prosperous than places such as the United States, Canada, Australia, New Zealand, and Argentina. The areas that were relatively more prosperous have experienced a reversal of fortune and are generally poorer today. This reversal of fortune can be seen as the consequence of an “institutional reversal” attributed to European colonization. The Europeans established more extractive institutions in places that were previously more developed and set up more inclusive institutions in places that were previously less developed. As a result, the lands of the former Aztecs and Inca Empires—Mexico, Peru, and their surroundings—ended up with extractive
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institutions, while Europeans who settled in the lands that were later to become the United States and Canada ended up with more inclusive institutions. This institutional reversal then led to the reversal of prosperity.
Problems
1. In July 2014, the founder of Facebook, Mark Zuckerberg, announced the launch of internet.org, a project aimed at spreading Internet access worldwide. Internet.org encourages mobile service providers to partner with Facebook to provide free, basic Internet services (including, of course, Facebook access) in developing countries. Long-term, Zuckerberg hopes to deploy drones to expand access in remote areas. Discuss how this effort, if successful, might impact proximate and fundamental sources of growth—is free, ubiquitous Internet a growth panacea?
Answer:
Open Internet, as a technology, most clearly contributes as a proximate source of growth—it can increase productivity across industries by allowing for better connections and access to information. In a country with extractive economic institutions, however, this contribution would have limits; without property rights or other institutions conducive to entrepreneurship, citizens would likely be unable to leverage the now-open Internet. In particular, government censorship of the Internet could prevent users from reaching useful websites.
In the long term, however, Internet access could potentially lead to improvements in fundamental sources of growth. Indeed, the website twitter played a key role in some of the Arab Spring uprisings; perhaps a further extension of internet access could provide populations worldwide with a new channel through which to press for democracy.
2. After the Second World War, Germany was divided into two parts, East Germany and West Germany. East Germany was controlled by the former Soviet Union, while West Germany was controlled by the other Allied governments: the United States, the United Kingdom, and France. The war had destroyed most of Germany’s economy. The Soviet Union as well as the Allied occupation forces sought to rebuild the economies of their respective parts. Before the fall of the Berlin Wall reunited East and West Germany in 1990, West Germany’s economy grew at an annual average growth rate of 4.4 percent, which was about three times higher than East Germany’s rate. Draw the parallel between the natural experiment discussed in the chapter and the case of East and West Germany. Based on the information given in the question and your own research, why do you think two otherwise similar areas had such divergent growth rates?
Answer: The case of East and West Germany is similar to that of North and South Korea. Splitting Germany into two separate areas was a natural experiment—an experiment of history. This episode in history illustrates the key feature of a natural experiment: geography and culture were more or less identical, while institutions were the only factor that was different.
The two newly formed areas of East and West Germany exhibited very different levels of development although they were culturally and geographically similar. The war had ravaged both, but West Germany took steps toward becoming a market economy. Price controls were abandoned, currency reforms were undertaken, inflation was brought under control, and tax rates were slashed. East Germany, on the other hand, adopted central planning. Price controls and production quotas were administered by the state. By 1990, East Germany had stagnated, while West Germany showed impressive rates of growth. It is this
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difference in economic and political institutions that stands out as the key explanation for the divergence in growth paths.
3. Suppose that a fictional country called Temria has an abundance of oil and gas. These natural resources were discovered about 40 years ago. Before this discovery was made, the country was a middle-income country with a relatively productive industrial and service sector. However, with exceptional profits due to efficient extraction of oil and gas, the country gained access to a huge amount of capital. Since Temria is a democracy, where people prefer to plan ahead of time, this capital was reinvested into improving education and research and development. Now, due to sound planning, Temria is one of the richest countries in the world.
Using the information given, distinguish between the fundamental and proximate causes of prosperity (or its absence) in Temria.
Answer: The proximate causes of prosperity are high levels of factors such as physical capital, human capital, and technology, which result in a high level of GDP per capita. Fundamental causes of prosperity are factors that are at the root of the differences in the proximate causes of prosperity. In other words, fundamental causes explain why some countries have accumulated more physical capital, invested more in human capital, and developed and adopted better technologies than other countries.
In the case of Temria, three of the proximate causes for prosperity that could be cited are the following:
The oil extraction process is efficient; waste presumably is not tolerated. Earnings from the oil sector are reinvested into education and R&D that can make growth
sustainable. The local industry has not been destroyed by capital flowing into the oil and gas sector instead of
the traditional industry, therefore growth could remain balanced.
The fundamental causes that could explain the proximate causes are as follows:
From the given information, it seems that Temria’s government and people prefer planning ahead as opposed to spending wealth just to buy expensive cars and build ‘prestige investments’.
There was a relatively developed industry in the country, and instead of letting all resources go into the oil sector, the extra inflow of capital was used to regain a competitive edge in the traditional industry in the country.
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4. Look at the following map of Nogales, a twin city that is divided by the U.S. border.
One part of Nogales lies in the United States, in Arizona, and the other part lies in Sonora, Mexico. Life in Nogales, Mexico is very different from life in Nogales, Arizona. The average income in Nogales, Mexico is about one-third the average income in Nogales, Arizona. Education levels, life expectancy, and health conditions are better in Nogales, Arizona than in Nogales, Mexico. Unlike Nogales in Arizona, Nogales in Mexico has only recently adopted political reforms, bringing it closer to functioning as a democracy. Crime rates are also lower in Nogales, Arizona than in Nogales, Mexico. Since both cities are located so close to each other, they share similar geographical conditions and climate. The inhabitants of both cities also share a common ancestry and enjoy the same types of food and music. Based on this information and your own research, what factors do you think can explain why Nogales, Arizona is so much more prosperous than Nogales, Mexico?
Answer: One of the obvious reasons for the difference in prosperity between the two cities divided by the border is the border itself. Nogales, Arizona, is a part of the United States, which has very different institutions compared to those in Mexico. The United States generally has inclusive economic institutions that promote economic activity and development. U.S. citizens can take part in elections that allow them to elect their government democratically and hold it responsible for its actions. Much of the important infrastructure, as well as key public services, are provided by the government. Economic institutions encourage employers in the United States to invest in technology, hire the best talent, and contribute to economic growth in the country. Citizens acquire education and are free to work in occupations to which they are best suited.
Unlike the United States, Mexico does not have many of these inclusive institutions; even where they are present, they are often incomplete or compromised by political factors. It is these institutional factors that could explain why life is so different for people who live in two areas that are otherwise very similar.
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5. Zimbabwe, formerly known as Rhodesia, was a British colony for around ninety years. It became independent in 1980. The prime minister of newly formed Zimbabwe, Robert Mugabe, implemented a forced land redistribution policy, in which commercial farms were confiscated from white farmers. Mugabe also proceeded to confiscate shares in companies owned by whites. In the following years, agricultural production in the country fell sharply. Zimbabwe, the country that used to be called the breadbasket of Africa, is now seeing food shortages in certain parts of the country.
a. Would Zimbabwe be considered to have extractive or inclusive institutions? Explain your answer.
b. Why would a government undertake policies that would adversely affect the lives of its citizens? Explain your answer with reference to the Zimbabwean situation.
Answer:
a. Inclusive economic institutions protect private property, uphold law and order, allow and enforce private contracts, and allow free entry into new lines of business and occupations. Extractive institutions, on the other hand, do not protect private property rights, do not uphold contracts, interfere with markets, and erect significant entry barriers into businesses and occupations. A government, such as Zimbabwe’s under Mugabe, that confiscates private property, whether farms or businesses, is an example of an extractive political institution. Farmers, traders, businessmen, and workers will be discouraged from investing and producing when they have no property rights.
b. Extractive, predatory governments know that capital accumulation, investing in human capital, and technological progress can raise living standards in a country. But it is in their best interests to maintain the status quo because economic growth may shift the center of power in the country. Political creative destruction refers to the process in which economic growth destabilizes existing regimes and reduces the political power of rulers and monarchs. The politically powerful would prefer holding power in a stagnant economy to losing power by reforming institutions and enhancing growth. In the case of Zimbabwe, the Mugabe regime has depended critically on the support of political functionaries, the military, and landless agricultural workers. Hence, a “spoils” system, in which land and other resources were redistributed from white-owned businesses and farms, was very popular with Mugabe’s base of support, although the evidence indicates that it was disastrous for the economy as a whole.
6. Since gaining independence from Malaysia in 1965, Singapore has had an impressive growth performance, achieving an average annual growth rate of real GDP per capita of 7.46 percent. State Owned Enterprises (SOEs) have featured prominently in its burgeoning economy; even today, many of its powerful companies are partially controlled by the highly centralized government.
a. Based on what we learned in this chapter, how would you expect the presence of SOEs to affect the returns to and opportunity cost of entrepreneurship? Use the curves we developed in Exhibit 22.5 to explain.
b. Some of Singapore’s SOEs focused on developing shipping and transportation infrastructure. How might this fact change your answer to part a?
c. Does the example of Singapore contradict what we learned in this chapter about institutions and growth? Explain.
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Answers:
a. As we saw with extractive economic institutions in the example of 22.5, we’d expect SOEs to push up the opportunity cost of entrepreneurship; new entrepreneurs would have trouble competing against powerful, state-supported companies. In addition, we might expect the return-to-entrepreneurship curve to shift to the left; it might be more expensive to conduct business with state-supported monopolies, and, if the state absorbed some of the profits from business ventures, entrepreneurs would not reap all of the returns.
b. While we could still see the same effects for would-be shipping and transportation entrepreneurs, these infrastructure projects could actually reduce the costs of entrepreneurship in other industries—by easing exporting or the integration of supply chains. Thus, we could actually see a reduce in the opportunity cost of entrepreneurship.
c. No—we saw that good institutions can encourage growth. While, as we discussed in this chapter, too much state interference can stymie growth, well-managed, productivity-enhancing SOEs could actually facilitate the development of entrepreneurship.
7. Using a graph like the one in the chapter showing returns to entrepreneurship and the opportunity cost of entrepreneurship, illustrate how each of the following historical events shifted one (or both) of the curves.
a. Between 1959 and 1963, the Cuban government passed a series of laws called the Agrarian Reform Laws. These laws expropriated any landholdings above a certain size and turned them over to peasants and cooperatives.
b. From independence in 1947 until the 1990s, there was in place in India that came to be known as the “Permit Raj.” The term referred to a series of rules and regulations that put strict controls on business, and forced business owners to navigate a bureaucratic labyrinth in order to start and run their companies. For example, one entrepreneur complained that simply to import a computer, he had to make 50 trips to New Delhi to get the necessary permits.
Starting in the 1990s, many of these restrictions were abolished. A series of reforms made it much easier for firms to conduct business. (Based on the series Commanding Heights, PBS, 2002.)
c. In 2007 and 2008, the Venezuelan dictator Hugo Chavez nationalized many large firms in several key sectors of the country’s economy, including telecommunications, electric utilities, steel, and banking. Subsequently, taxes on banking and other activities were also raised significantly.
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Answer:
a. The seizure of private property by the Communist government significantly reduced the returns to be realized from entrepreneurship for any number of entrepreneurs. Recall that the protection of property rights is vital to encourage the development and growth of enterprise. If the government itself does not recognize such rights, there is little reason for anyone to found or grow a business. This results in a leftward shift in the return-to-entrepreneurship curve, as shown below.
b. Bureaucratic red tape, like licenses and permits, increases the cost of doing business. This is reflected in an opportunity cost curve that is quite high, leading to a small equilibrium number of entrepreneurs.
However, with the reforms of the 1990s, the opportunity cost curve shifted down, and the number of business people, and therefore the number of businesses, increased. This is shown in the graph below.
Chapter 8 | Why Isn't the Whole World Developed? 94
c. Chavez’s actions simultaneously reduced returns to entrepreneurship (reflected in a leftward shift of the returns-to-entrepreneurship curve) and increased the cost of doing business (resulting in an upward shift of the opportunity cost curve), changing the equilibrium from E1 to E2.
8. Suppose the return and cost of entrepreneurship curves are described by the following equations (with numbers measured in the thousands):
R = 250,000 – 50,000 N
C = 50,000 + 150,000 N
where
R = returns to entrepreneurship,
C = cost of entrepreneurship,
N = number of entrepreneurs
a. Based on the equations given, how does the cost of entrepreneurship curve differ (in overall shape) from the one drawn in the chapter? Explain how this difference might arise.
b. Find the equilibrium number of entrepreneurs in this economy and the equilibrium returns to entrepreneurship.
c. The government now enacts a license fee of $50,000 to file the paperwork necessary to start a firm. What is now the equilibrium number of entrepreneurs and the equilibrium returns to entrepreneurship?
Answer:
a. The opportunity cost line is now upward sloping instead of horizontal. As the number of entrepreneurs increases, the opportunity cost of entrepreneurship increases. This could be the case for several reasons. For example, it might be that the greater the number of entrepreneurs in an economy, the greater the opportunities for employment of additional entrepreneurs, and hence the greater the opportunity cost.
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c. The new opportunity cost line is described by C = 100,000 + 150,000 N. Hence, it has shifted upward by 50,000. Setting this equal to the equation for returns:
N* = 750,
R* = $212,500.
9.
10. The process of Schumpeter’s creative destruction creates winners and losers in economies. What are some of the options to limit the negative effects on the losers? Why is it imperative to minimize these negative effects?
Answer: The process that Schumpeter called “creative destruction,” which is fundamental to growth, is one that inevitably creates winners and losers in an economy. As new technologies replace older ones, new businesses and new sectors replace existing firms and sectors. Likewise, skills consistent with the new technologies are in higher demand, which results in a disproportionate increase in the rewards to the people possessing those skills.
It should be noted that those who are losers are people and that some may not be able to change the way they operate/live/work without outside assistance. This means that retraining and assistance programs should be provided for those who would not be able to change on their own. If people are left to the forces of the market, it is possible that dissatisfied with how things have turned out for them in their career, they can radicalize and participate in violent action against their compatriots.
11. Which of the three hypotheses developed in the chapter would be most likely to view foreign aid as essential for economic development? Explain.
Answer: The geography hypothesis is most congenial to the view that aid is essential. If the fundamental causes of poverty lie in a country’s geography, then only outside assistance can begin to overcome such geography-related problems as tropical disease, lack of resources, and inadequate infrastructure.
12. Based on the discussions in this chapter, the preceding chapters, and your own readings, what could be some of the conditions under which aid works and can assist the development of the countries of the Global South?
Answer: In order for aid to be efficient, some of the basic economic and political institutions in the country should be present. If we look at the economic miracles of Western Germany and Japan after the Second World War, their success was partially built around the fact that these countries mainly lost human and physical capital during the war but not the institutional setup. Creating an efficient institutional setting can be nigh impossible. Second, aid should be protected from falling into the hands of corrupt officials. Third, the country itself and citizens should also be made “owners” of the development projects that are financed through aid in order to make them complicit in the success.
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