The Wealth of Nations

THE WEALTH OF NATIONS
A collection of papers on the theory, empirics and policy

implications
December 2004
Tilburg University
With contributions from

Ament, J.
Bresser, H. de
Broersma, J.
Chen, Y.
Erp, P.F. van
Gevel, B.J.C. van de
Gielissen, R.
Gille, P.
Gils, B.W.H. van
Glowacki, Jakob F
Heijboer, M.R.
Hekken, J.C. van
Hendrix, H.J.J.
Jonker, M.F.
Kerstholt, W.J.N.
Ketelaars, M.E.M.A.
Kitzen, S.W.C.M.
Kok, R.
Moorsel, P van
Mulken, M.A.H. van
Oudeman, J.R.
Oudheusden, P. van
Pei, N.
Peters, N.K.A.
Rooijackers, M.M.
Smulders, S. (editor)
Spellen, G.
Urlings, N.M.A.
Verkooijen, L.
Verschuren, L.B.C.
Zhou, B.
Reading Guide
The following text introduces the main concepts, sketches the connections among the
different papers and summarizes the main arguments of the papers.
I. Why are some countries so rich and some so poor?
Introduction
Income differences between countries are huge. For example, in 1988 per capita
income in The Netherlands was only 80 per cent of that in the USA. Even more
extreme, as a percentage of USA per capita GDP, this figure equals 32 % in Brazil,
19% in Egypt, 6% in India and 3% in Central African Republic. (See G15 for further
details)
Growth rates differ widely among countries. For example, over the period 1960-2000,
Singapore grew at an average annual rate of 7%, the USA at a rate of 2.8%, the
Central African Republic at a rate of –2%.
Economists have tried to explain this kind of differences at various levels of
abstraction. Table I.1 gives an overview of the types of explanation.
Table I.1 Sources of growth and income differences - Classification

Proximate sources
Production factors (quantity, quality, composition, utilization)
Physical capital
Labor, human capital
Natural resource inputs
Productivity
Efficiency
Technology
Ultimate sources (“fundamentals”)
Geography
Policy
Institutions
Some countries are richer than other countries, because they have more capital, a
better educated labor force, they work longer, or they have more natural resources.
Economists call these elements production factors. Countries that accumulate more
production factors per capita can be expected to have higher income per capita. A
second source of income differences is productivity: access to more advanced
technologies, more efficient use of technology or more efficient use of production
factors in general leads to higher production levels. These two classes of sources
behind income differences, viz production factors and productivity, are the so-called
“proximate causes”. They follow directly from a production function approach to
national income in which GDP is a function of a nation’s production factors and the
productivity (total factor productivity) of these inputs.
Ultimate sources of growth or income differences explain why productivity is high or
why a country has many production factors. Thus, ultimate sources are the
fundamentals behind the proximate sources. The proximate sources we are going to
discuss are geography (related to geographical and ecological characteristics of the
country), institutions, and policies.
1. Proximate sources of growth and income differences
To study the proximate sources, economists perform growth or level accounting

exercises. Furthermore, a number of important economic growth models have been
developed to link factor accumulation and productivity to economic growth.
Empirical studies: growth and level accounting.

In G16, Europe is compared to the USA. First it is shown that Europe’s per capita
income diverged from the USA’s per capita income from 1820 to 1950, then caught
up until 1990. From then on, the income gap remains more or less constant. Next, per
capita income differences are decomposed into labor productivity, hours worked, and
participation. Systematically, the Europeans work less than the Americans but labor
productivity (GDP per hour) is not always lower.
G16 also studies the differences between R&D investments in Europe and the USA.
The differences might explain the differences in total factor productivity growth.
In G15, developed countries (DCs) are compared to less developed countries (LDCs).
In the level accounting exercise it turns out that poor countries not only have low per
capita capital, but also low levels of human capital and low levels of total factor
productivity. Hence, the proximate sources are positively correlated. In the growth
accounting exercise, it turns out that the growth rates of total factor productivity
(TFP) do not differ systematically across DCs and LDCs. Combined with the
existence of large TFP level differences, this implies that these differences are
persistent over time.
Models of factor accumulation, productivity, and growth

The Solow model explains how capital accumulation and exogenous technological
change might lead to long-run per capita growth and how income levels of rich and
poor countries might converge. G11 discuss the Solow model, as well as the extended
Solow model (the Makiw/Romer/Weil model). Notice that both models take total
factor productivity as an exogenous variable. In contrast, in the models by Romer and
Jones, TFP follows from investment in R&D. G11 investigates how realistic this
assumption is. Indeed, empirical studies find a strong and significant link between
R&D and output.
Other models have stressed the fact that growth develops in stages. This is elaborated
in G17. In early periods of history, many economies have experienced growth in
GDP, but not in per capita GDP. Higher GDP growth was accompanied with higher
population growth. This is called the Malthusian trap. A challenges for economists
and historians has been to explain why for example the UK and France escaped the
Malthusion trap in the 19th century. At that time, per capita income started to rise and
population growth to fall. There was a transition from growth a la Malthus tot growth
a la Solow.
For development economists the question has been what determines when a country
takes off in terms of starting to invest sufficiently to increase economic growth. The
Solow model models an economy that invests at a given rate. However, in practice,
long periods of low investment precede the stage in which investment is high. This is
Rostov’s theory of growth in stages.
2. Ultimate sources of growth and income differences
What determines high rates of factor accumulation or high rates of productivity? This
is the question of ultimate causes behind growth. G14 distinguishes between
geography, institutions and policy as fundamental determinants of growth. Empirical
research is presented in order to sort out which of these three factors is most
important. It turns out that the role of institutions is so important, that not much is left
for policy or geographical conditions to affect growth or income in a way that is
independent of institutions. In contrast, geographical conditions may be an important
determinant of institutions, and thus only indirectly affect growth through institutions.
For example, in colonies where climatic conditions caused high mortality rates under
European settlers, extractive institutions were introduced and property right were not
established. These countries are left with bad economic institutions until now, which
results in low income levels.
3. Endogenous institutions
Economic institutions, like the protection of property rights, not only have a major
impact on economic growth and income levels, they are also likely to be shaped by
economic conditions. Thus, institutions are endogenous.
Modern political economy models study the consequences of differences in
institutions on economic growth. [At the time of Adam Smith, the term political
economy had a different meaning: it comprised the study of national income and
distribution in general]. In particular, a stream of economics literature called the “New
Institutional Economics” devotes special attention to the role of institutions and the
endogenous nature of institutions. G13 explains how Nobel prize winner Douglas
North has contributed to this literature.
In the theory of Acemoglu, Johnson and Robinson (2004), the interaction between
political institutions (the institutions that determine de facto and de jure political
power) and economic institutions determines income distribution and the evolution of
institutions over time. In G12, this theory is used to explain and compare economic
and institutional developments in UK, France, USA and Argentina. In G13, European
history is reviewed. It is shown how changes in economic conditions led to changes in
institutions and the other way around.
I. 1 (G15) Proximate sources
Noortje Urlings (statistician)
Lona Verkooijen (manager)
Marielle Ketelaars (analyst Growth accounting)
Hilde de Bresser (analyst Level accounting)
GROWTH AND LEVEL ACCOUNTING:

DC’S VERSUS LDC’S
Introduction
There are various ways to compare income across countries, such as growth accounting and
level accounting. Growth accounting is a set of theories used in economics to explain
economic growth. The total national income in an economy may be modelled as being
explained by various factors. In a simple model, these might be:
• the total stock of capital available, K

• the size of the labor force, L
• the total factor productivity, A
The most used equation to measure growth of national income is as follows:
Yˆ = Aˆ + αKˆ + (1 − α ) Lˆ
An increase in national income can be explained by an increase in the capital

available, an increase in the labor force, or an improvement in the technology used.
In level accounting studies the basic objective is to divide the differences in income levels to
differences in levels of total factor productivity and factor inputs. This method focusses only
on the levels of economic variables. It will provide a better view on the difference of the
values of income between the less developed and the developed countries.
In this section we will deal with the question: Why do less developed countries perform less
than developed countries? We also make a comparison of the growth rates and the levels of
economic variables between LDC’s and DC’s.
Level accounting
In this section we will try to get a better view on the difference of the values of income
between the less developed and the developed countries. Figure 1 shows productivity levels
across countries plotted against output per worker. The figure illustrates that differences in
productivity are very similar to differences in output per worker. This means that countries
with a low level of productivity also have a low output per worker and countries with a high
level of productivity also have a high output per worker. The productivity levels of the
countries are ratios to U.S. values. The relationship in Figure 1 is positive and significant.
Figure 1. Productivity and output per worker
Source: Hall and Jones, Why do some countries produce so much more output per worker than others?
The countries with the highest levels of productivity are Italy, France, Hong Kong, Spain and
Luxembourg. The position of Puerto Rico is remarkable, but in short it is a result of an
overstatement of real output.1 The figure shows that most OECD countries are on the right
side; this means that these countries have higher productivity and higher levels of output per
worker. There are also a couple of LDC’s on the right side, such as Saudi Arabia and Jordan,
but these countries belong to the OPEC. This is an explanation for their high positions in the
figure.
Those countries with the lowest levels of productivity are Zambia, Comoros, Burkina Faso,
Malawi and China. These countries are less developed countries and therefore they can be
found on the left side of the figure. The difference in output per worker between developed
and less developed countries might be partially explained by the difference in productivity
levels.
Comparison of OECD with LDCDifferences in output per worker

The measure we use for calculating economic performance is the level of output per worker.
In this section we make a comparison of the determinants of output per worker between
OECD’s and LDC’s. We have chosen five developed countries and twelve developing
1
Further explanation, see Baumol and Wolff, 1996.
countries to show the differences in the level of output more clearly. To make the comparison
easier, all terms are expressed as ratios to U.S. values.
Table 1
Productivity calculations: Ratios to U.S. values
Y/L (K/Y)a/(1-a) H/L A
United States 1,000 1,000 1,000 1,000
Netherlands 0,806 1,060 0,803 0,946
France 0,818 1,091 0,666 1,126
Italy 0,834 1,063 0,650 1,207
UK 0,727 0,891 0,808 1,011
Brazil 0,319 0,873 0,482 0,758

Colombia 0,264 0,818 0,544 0,593
Peru 0,237 0,935 0,618 0,409
Venezuela 0,495 0,994 0,593 0,839
China 0,060 0,891 0,632 0,106

India 0,086 0,709 0,454 0,267
Iran 0,295 0,981 0,467 0,642
Malaysia 0,267 1,004 0,592 0,450
Central Africa R. 0,033 0,582 0,339 0,159

Egypt 0,187 0,454 0,576 0,716
Madagascar 0,041 0,299 0,514 0,264
South Africa 0,250 0,959 0,568 0,460
Source: Hall and Jones, Why do some countries produce so much more output per worker than others?
The determinants of output per worker are physical capital intensity ((K/Y)^a/(1-a)), human
capital per worker (H/L) and total factor productivity (A). The total factor productivity is
calculated as a residual. For example, this table shows that the output per worker of the
Netherlands is about 81 percent of that in the United States. The Netherlands have about the
same amount of capital per worker, but the human capital per worker is only 80 percent of
that in the United States. The productivity is also somewhat lower in the Netherlands
compared to the United States. The difference between the level of output per worker in the
Netherlands and the United States is primarily explained by the difference in inputs and partly
by the level of productivity. The output per worker in the developed countries (France, Italy,
Netherlands, UK) is lower than in the United States, because of the differences in human
capital per worker. In the UK differences in capital intensity also play a determinant role.
For some developing countries in the table (Peru, China, India, Malaysia, Central Africa and
Madagascar) differences in productivity are the most important factor in explaining
differences in output per worker. The differences in output per worker for several other
developing countries (Brazil, Venezuela, Egypt, Iran) are primarily explained by differences
in human capital per worker and partly by differences in productivity. For the remaining
developing countries (Colombia and South Africa) the differences in output per worker are
explained by both human capital per worker and productivity.
By comparing the levels of output per worker between the developed and the developing
countries, we can conclude that developing countries have very low levels of output per
worker relative to the developed countries. In most developing countries the determinants of
output per worker are much lower than in the developed countries, which explains their lower
performance. The main cause of the differences in output per worker is the difference in total
factor productivity. In most of the developing countries the capital intensity doesn’t differ
much from the capital intensity in developed countries, except for Central Africa, Egypt and
Madagascar. There are also differences in the level of human capital per worker between the
developing and developed countries, but these differences are less important than the
differences in productivity.2
Explanation for differences in output per worker between LDCs and developed nations
There are several reasons why the levels of the determinants of output per worker are lower in
the less developed countries than in the developed countries. First of all there is a lack of
physical capital and a low savings rate. They also have little human capital because the labor
force in LDC’s is often illiterate and lack necessary training. The technology that is used in
LDC’s is mostly old fashioned. Developed countries use more modern and more efficient
technology. But in the LDC’s there is no money for modern technology and the labor force
doesn’t have the skills to work with this kind of technology. It is commonly known that
technology and human capital are complements. The simple reason for the limited physical
and human capital and low technology level is that there is not enough money. The reason
therefore is a low savings rate. Thus, there is a vicious circle that is very difficult to get out
off. Another important reason why less developed countries perform less than developed
countries is the political instability and the government policies that discourage production
and investment in less developed countries. Less developed countries are sometimes plagued
by political insurgence and political corruption which create the wrong environment for
investment and production. All these problems are linked with each other and may require
assistance from international organizations.3
Growth Accounting
Growth accounting is a way to explain economic growth. The growth of national income is
determined by several factors, such as growth of capital, growth of labor and growth of total
factor productivity. We can derive the widely used growth accounting equation from the level
accounting equation as follows:
Y = AKα L 1-α in levels

Ln Y = Ln A + α Ln K + (1- α) Ln L in logarithms
dLn Y = dLn A + α dLn K + (1- α) dLn L in growth rates
The term dLn Y can be written shorter, namely Yˆ . The whole growth accounting equation
can be written as:
Yˆ = Aˆ + αKˆ + (1 − α ) Lˆ
Using growth accounting one can measure what explains the growth of national income. It
can be explained by the growth of input factors, capital and labor, or by the growth of total
factor productivity, also known as the residual. A change in the total factor productivity
represents the change in national income that is not explained by changes in the level of
inputs (capital and labor) used. This is normally taken as a measure of the level of technology
employed. To detect the growth of the residual, growth accounting has to be done. The levels
of national income, capital and labor are known for several years, so one can determine the
growth of these variables. If these growth rates are known, one can determine the growth rate
of the total factor productivity by rewriting the growth accounting equation:
Hall and Jones, Why do some countries produce so much more output per worker than others?, 1999
3
http://www.globalchange.umich.edu/globalchange2/current/lectures/dev_pov/dev_pov.html,
University of Michigan, 2001
Aˆ = Yˆ - α K̂ - (1- α) L̂
To calculate the growth of the total factor productivity we have to substract the growth of
input factors from the growth of national income. If the growth of national income is
explained by the growth of input factors, than we say that national income grows because of
factor accumulation.
If national income grows because of factor accumulation we speak of extensive growth. This
means the growth is not caused by an improvement in technology, but by putting more input
factors in the production. If national income grows because of an increase in total factor
productivity we speak of intensive growth. This means there has been an improvement in
technology and so production becomes more efficient. This means that we can produce more
for the same costs or we can produce the same amount against a lower price.
Growth accounting in practice

To get a better look at growth accounting we take a sample of 16 countries, four OECD
countries and twelve LDC’s. We apply growth accounting on those countries. This section
explains the method used. The OECD countries are the Netherlands, France, UK and Italy.
The LDC’s are:
- India, Iran, China and Malaisia from the Asian continent
- Brazil, Colombia, Venezuela and Peru from the South American continent
- Madagascar, Central Africa, South Africa and Egypt from the African continent
In the sample we took a period of 40 years, from 1960 to 2000 and a period of 18 years, from
1980 to 1998. For each country we calculated the growth of national income, the growth of
the population, the growth of capital, the growth of labor and the growth of the total factor
productivity for the period of 1960 to 2000 and the period 1980 to 1998. To calculate the
growth of capital, we had to determine the growth of the investment in those years.
Subsequently we calculated the naive estimate, the estimate with correction and the final
growth of the total factor productivity growth. The naive estimate of the total factor
productivity is based only on the observation of the growth of national income per capita. It is
the labor share times the growth of national income per capita. The naive estimation with
correction is based on the growth of national income per worker. It is the labor share times the
national income per worker. The final estimate is also corrected for the capital intensity, it
presents the percentage of the growth of total factor productivity.
Results of growth accounting in practice for the period 1960-2000

This section shows the results of the growth accounting for the 16 countries of the sample. In
the end of this section we can say which countries have grown by factor accumulation or by
technological progress. The next tables show the estimates of the growth of total factor
productivity of each country from the sample in the period 1960-2000, the numbers are in
percentages.
Table 2.1. Results of Europe

Europe:
Naïve estimate corrected tfp
Netherlands 1,619 1,171 0,834
France 1,676 1,587 0,496
UK 1,365 1,244 0,402
Italy 1,789 1,816 1,650
Source: Penn world data
Table 2.2. Results of Asia
Asia:
India 1,755 1,887 0,549
Iran 1,342 1,268 0,571
China 3,027 2,775 1,100
Malaysia 2,510 2,437 0,526
Table 2.3. Results of South America

South America:
Brazil 1,688 1,440 0,919
Colombia 1,211 0,501 -0,798
Venezuela -0,535 -0,821 -2,497
Peru 0,506 -0,093 2,031
Table 2.4. Results of Africa

Africa:
Madagascar -0,637 -0,386 -0,719
Central Africa -1,426 -1,020 -2,112
South Africa 0,586 0,627 0,082
Egypt 1,676 1,588 0,198
Our data shows that the growth of national income of all 16 countries is only by a very small
part determined by growth of total factor productivity. Put another way, our data suggests that
no country in the sample has experienced intensive growth. What we have to take into
account is that the growth of TFP is calculated over a period of 40 years. Every economy
fluctuates, sometimes there is a high growth of TFP and sometimes there is a low growth of
TFP. So the growth rates of TFP in our results can be seen as averages over a period of 40
years. This can explain why the growth rates aren’t that high.
If we compare the TFP growth of the different continents then we can see that the African and
South American countries clearly have a lower TFP growth over this 40 year period. The
Asian countries have quite similar results as the European countries. So these particular Asian
countries can’t be qualified as LDC’s in TFP growth terms.
Growth accounting in practice for the period 1980-1998

This section shows the results of the growth accounting for the 16 countries of the sample. In
the end of this section we can say which countries have grown by factor accumulation or by
technological progress. The next tables show the estimates of the growth of total factor
productivity of each country from the sample in the period 1980-1998, the numbers are in
percentages.
Table 3.1. Results of Europe

1980-1998 Naïve estimate corrected TFP
Netherlands 1,289 0,587 -0,061
France 0,995 0,891 -0,594
UK 1,469 1,344 0,578
Italy 1,235 1,071 0,511
Table 3.2. Results of Asia
India 2,519 2,428 0,782
Iran 1,179 0,978 0,896
China 4,149 3,791 0,535
Malaysia 2,444 2,760 0,132
Table 3.3. Results of South America

Brazil 0,199 0,148 -0,663
Colombia 0,963 -0,511 -2,465
Venezuela -0,553 -0,824 -2,135
Peru -0,275 -1,599 -0,376
Table 3.4. Results of Africa

Madagascar -1,024 -0,723 -1,879
Central Africa -2,200 -1,853 -3,525
South Africa -0,247 -0,354 -0,406
Egypt 1,804 1,460 0,373
The data above shows that the growth of national income of all 16 countries is only by a very
small part determined by growth of total factor productivity. The growth rates of TFP in the
16 countries in a particular period can be seen as an average over that period. The smaller the
period, the more accurate the average will be. So a time period of 18 years says more than a
time period of 40 years. A lot of countries experienced a negative TFP growth during 1980-
1998, especially the African and South American countries. These LDC’s clearly have lower
TFP growth than Asia and Europe during this period, except for Egypt. What also can be said
is that the Asian TFP growth has been stable and reasonably well over the 40 years. The TFP
growth of the other countries have been fluctuating much more over time.
Conclusion
By comparing the levels of output per worker between the developed and the less developed
countries, we can conclude that developing countries have very low levels of output per
worker relative to the developed countries. In most developing countries the determinants of
output per worker are much lower than in the developed countries, which explains their lower
performance. The main cause of the differences in output per worker is the difference in total
factor productivity.
We took a sample of four OECD countries and twelve less developed countries over two time
periods: 1960-2000 and 1980-1998. One would expect that the OECD countries would have
intensive growth, but this isn’t the case. The four OECD countries do have positive TFP
growth during the period 1960-2000, but the Netherlands and France had negative TFP
growth during 1980-1998. The four Asian countries experienced similar TFP growth rates to
the four European countries. Therefore, these four Asian countries cannot be seen as less
developed countries, in our view. The countries in the other two continents (Africa and South
America) clearly experienced lower or negative TFP growth in both time periods. So these
countries can be defined as less developed countries. The growth rates of TFP clearly show
similar rates for the European and Asian continent, but the levels of TFP differ significantly.
The TFP levels of the European continent are higher than those of the Asian continent.
References
Hall and Jones, Why do some countries produce so much more output per worker than
others? Quarterly Journal of Economics, 1999
University of Michigan: Global Change, 2001

http://www.globalchange.umich.edu/globalchange2/current/lectures/dev_pov/dev_pov.html
Penn world Data: http:// www.bized.ac.uk/dataserv/penndata/pennhome.htm

Jeffrey Oudeman (statistican)
Marcel Mulken (analist)
Jasper van Hekken (analist)
Paul Gille (manager)
GROWTH AND LEVEL ACCOUNTING:

USA VERSUS EUROPE
Introduction
This paper is about the gap in income and growth between the US and Europe. When
you look at the economy, America has been the world leader for over a century now.
Theory suggest that Europe or at least Western-Europe should be catching up with the
US. But when we look at GDP per capita ( see figure) we see that this is only three-
quarters of that in the United States.
In this paper were trying to find reasons for the GDP difference between US and
Europe. While doing this we look at two subjects which we find very important and in
which we hope to find some answers. First we take a look at the labour market of both
countries and try to find differences that could have an effect on growth. Second we
take a look at the research and development sector which has become more and more
important the past few decades. R&D can improve the productivity of countries and in
that way can positively affect the welfare of a country.
Labour
One of the proximate sources of growth is labour. So when we want to know why the
US is richer than the EU we have to look at differences with respect to labour between
the US and Europe.
The income gap between Europe and the US is large. Table 1 shows the income gap
with the US for several European countries. The US is in terms of GDP per capita
richer then any country in the EU. GDP per hour, which is a way of noting
productivity, is the same or higher (relative to the US) in Northern and Western
European countries (except for Finland and the UK) and (sometimes much) lower in
Southern European countries. From table 1 can also be seen that US workers work a
lot more hours than European workers. This is not true for Spain, Portugal and
Greece, where people also work a lot.
But there’s more. The employment rate in the US is higher than in the EU, so more
people are working in the US.
Figure 1: The income gap with the US explained
Source: De Groot, Nahuis and Tang, Is the American Model Miss World? Choosing
between the Anglo-Saxon model and a European-style alternative, CPB
So the EU is less productive, people in the EU work less hours and the employment
rate is also lower in the EU. Of course there are differences within the EU. Some
countries are more productive than the US (take a look at Norway), but others are far
less productive (Portugal!). The low productivity in Southern European countries is
the main reason why GDP per capita is very low in this countries.
Figure 2 on the next page shows the facts about labour in another way. This graph
shows that European countries are doing a lot worse then the US is doing. Again it is
clear that in some countries productivity is low and the figure points out that
participation in Europe is very low compared to the US and people work less hours.
Figure 2: Income gap of various European countries explained.
Source: CPB, Four Futures of Europe.
So how do we close the income gap?
Hours
The main reason why the richest countries are behind the US is the number of hours.
By increasing the number of hours income per capita will increase. But will working
more hours also increase welfare? Working more hours automatically means enjoying
less leisure. This social cost should also be taken into account.
Participation
We have already seen that participation in Europe is very low and unemployment is
rather high in most European countries. Many European countries have large pools of
hidden unemployment in, for instance, the disability and sickness schemes. In Europe
social protection is at a high level. The incentives for people to work and to keep
working are much higher in the US. This is proved by the fact that the participation of
people above 55 years old is very low in European countries (see figure 3 on the next
page) compared to the US. So to close the income gap, schemes for early retirement
should be less generous. In fact the European population is becoming older than the
US population. While the population in Europe in the eighties and nineties remained
stable, immigration and higher fertility has caused the population in the US to grow.
This demographic change makes it necessary that people in Europe will work longer
in the future or the ageing problem will have serious consequences for our economic
growth potential.
Figure 3: Employment of people aged 55-64
Source: Speech minister Hoogervorst, Europe: the challenges ahead.
Productivity
Productivity is a problem in some southern European countries as we have already
seen, while in other European countries labor productivity is very high. The gap in
skills and technology is small for these countries. This does not apply for the
countries like Greece, Portugal and Spain and for the Eastern European countries that
have recently joined the union. You can see that there is a huge difference between
the productivity.
Labour market institutions

An important problem for Europe is the fact that the European labour market is not as
flexible as the US labour market is. The European welfare state has limitations,
especially when it comes to adjusting to economic shocks.
The US has a less developed welfare-state. Unemployment benefits are lower and the
average time when the benefit is received is shorter. So by making the labour market
more competitive like it is in the US and raising the incentives to work, the EU could
catch up with the US when we look at growth. Off course we have to notice that
inequality in the US is much larger. There seems to be a trade-off between
participation and income-equality. We can see this relation in figure 4 on the next
page, but looking at this data one could say this isn’t a perfect linear relation. There
might be different lessons to be learned from the different social models.
Figure 4: Equality vs Participation

Source: De Groot, Nahuis and Tang, Is the American Model Miss World? Choosing
between the Anglo-Saxon model and a European-style alternative, CPB
Conclusion
GDP per capita in the US is higher than it is in Europe. Productivity is low in some
European countries, which of course is a reason for this income gap. But there are
also countries in the EU that already have high levels of productivity.
Another reason why GDP per capita in whole the EU is relatively low, is that
participation in the EU is very low and people work fewer hours. GDP per capita will
increase a lot when participation rises and workers work more. By removing these
differences with the US, most of the income-gap disappears. But we have to keep in
mind that inequality might rise due to the actions that will be necessary to achieve
this.
In the next part of this paper we’re taking a look at the research and development
sector. We examing how R&D can affect growth difference between the US and
Europe.
Research and Development
In the long run technological development is seen as the most important factor for
competitive strength and in that way for economic growth. The most important factor
influencing this technological development is Research and Development (R&D).
Characteristic for R&D is that in the research there is a strive for originality and
renewal, mostly with the application of information technology, physics and medical
science.
Europe lags behind the US in R&D expenditure, the R&D in Europe is scattered and
despite the high level of science in Europe there are few innovations. This has
attracted a lot of attention from policy makers. They claim that the EU needs to
narrow down these differences to be able to catch up with the US.
At The European Council in Lisbon in 2000 the strategic goal of transforming the
European Union by 2010 into the most competitive and dynamic knowledge-based
economy in the world, capable of sustainable economic growth with more and better
jobs and greater social cohesion were set. They set some clear and specific targets and
agreed that Member States should try to get 3% of GDP spent on R&D by 2010.
Because R&D is very important for moving towards a knowledge based economy, the
EU has put a lot of attention on R&D in order to help meet the goals set at Lisbon.
But little progress to this 3% target has been made in the years following, as can be
seen by the 1,99% spent on R&D in 2002.
Some data on past R&D

Business expenditure on R&D is rising everywhere. It increased substantially in the
EU, by about 50%, between 1995 and 2001. But growth was even higher in the US.
There, R&D expenditure increased by about 130% between 1995 and 2001. In 2000
the European Union and the individual Member States invested a combined total of
164 billion euros in research, compared with 288 billion euros by the USA. In other
words, R&D expenditure growth in the US and the EU is very different.
Research and Development expenditure represented 1.99% of the European Union’s

Gross Domestic Product (GDP) in 2002 against 1.95% in 2000. The gap relative to
the United States and Japan however, still is very large, as these countries spent
respectively 2.80% and 2.98% of their GDP on R&D.
But not in all countries of the EU are the R&D expenditures as a percentage of GDP
lower than in the US. Some countries like Sweden and Finland for instance, with
respective shares of their GDP of 4.27% and 3.49%, made the greatest research effort.
the lowest R&D ratios were registered in the southern countries (Greece, Portugal,
Spain and Italy).
Figure 5 shows that there are big differences between the US and the European
countries. Only Sweden and Finland spend a higher percentage of their GDP on R&D
than the US. Greece, Portugal, Spain and Italy have levels far below 1% and in this
way they bring the EU average down fast. The EU goal of 3% will be even harder to
achieve now, because a lot of new countries have joined, in which R&D expenditures
are even lower and in this way the EU average will go down even further.
Figure 5:
Source: Ernst & Young, ‘Beyond Borders, The Global Biotechnology Report 2003’
R&D expenditure by sector
The R&D expenditure is usually broken down among four sectors of performance:
1) business enterprises,
2) higher education,
3) government
4) private non-profit institutions serving households
If we look at the R&D expenditure by performing sector we see that in the US the
business enterprises and private non-profit sector contribute a proportionally much
bigger part to total R&D expenditures than in the EU.
In the bottom figure we can again see that the R&D expenditures as a percentage of
GDP are much higher in the USA than in the EU. It is also visible that both in the US
and in the EU the percentages stayed pretty much the same for both sides between
1981 and 1999. And in this way the gap between the US and EU has remained fairly
constant over the past 2 decades. It is also visible that the part of the government
declined in the US in combination with a growing part of the business enterprises,
whereas in the EU there hasn’t been a lot of change between the division between
government and business enterprises. This could therefore partly explain why the US
is doing so much better than the EU: business enterprises in the US started putting
more effort in investing in R&D, whereas the EU has had the same division for almost
20 years now and is very much depending on governments for R&D expenditures.
Figure 6: R&D expenditures by sector
Source: OECD, MSTI database, May 2001, R&D financing and performance
R&D Performance by Industry
The United States, the EU, and Japan are the three largest economies in the
industrialized world, and their industries have been leaders of innovation in the
international marketplace. An analysis of US and EU R&D trends can explain past
success, provide insight into future product development, and highlight shifts in
national technology priorities.
In the US, as can be seen in figure 7 on the next page, in 1987 the total service sector
industries accounted for less than 9 percent of all U.S. industrial R&D. But in years
after that, the amount of R&D performed in the service sector caught up and even got
ahead of that performed by other U.S. manufacturing industries until 1991, when the
service sector accounted for nearly 25% of all U.S. industrial R&D. Manufacturers
regained their position; however, their share declined to 81 percent of total U.S.
industrial R&D by 1996, led by industries making computer hardware, electronics
equipment, and motor vehicles
Figure 7: R&D performance US and European Union
Source: Organisation for Economic Co-operation and Development,

EAS, ANBERD database 2002
The data for the late 1990s and 2000 show a new rise of the U.S. service sector as the
most important performer of industrial R&D. After 1997 a turnaround occurred,
which was followed by large increases each year thereafter. The service sector's share
of total R&D was less than 19 percent in 1996 but 34 percent by 2000.
U.S. manufacturing industries collectively perform nearly two-thirds of the nation's
industrial R&D and include most of the nation's top R&D-performing industries. In
2000, the electronic equipment industry was the most important in the industrial
R&D. This industry has for a long time been among the top five performers, but its
rise to the top coincided with rapid growth in the telecommunication industry during
the late 1990s. Other top R&D performers in 2000 were producers of chemical
products, scientific instruments, motor vehicles and the industries providing computer
services. Computer and office hardware manufacturers fell out of the top five. As well
as the aerospace industry. The R&D performance in the U.S. aerospace industry grew
more slowly during the 1990s than in other U.S. industries. It accounted for 19
percent of total U.S. R&D in 1990, but its share dropped nearly every year throughout
the decade. By 2000, the U.S. aerospace industry accounted for just 5 percent of total
R&D.
The European Union:

As in the United States and Japan, manufacturing industries account for most of the
industrial R&D in the EU. The EU's industrial R&D however, is less concentrated in
specific industries than R&D in the United States. Manufacturers of chemicals and
chemical products have historically been the most important industry in the EU.
Electronics equipment, and motor vehicles have always been among the top five
industrial R&D performers in the EU. The top 5 in the EU has consisted of the same
industries for a reasonable amount of years now. Only the aerospace industry and the
total services have swapped places in between 1995 and 1999. The most striking
difference between the EU and the US is that the service sector comes at the 4th place
in the EU whereas in the US it is by far the most important.
Conclusion:
The EU still has a lot of work to do and a long way to go if it wants to catch up with
the US in reaching the same level of R&D expenditure, and in this way becoming
more competitive with the US and creating more economic growth. This will now
even be harder with the expansion of the EU with a large number of ‘’less
developed’’ countries. The weakness of R&D and the slow accumulation of
knowledge in the EU is probably a major reason why Europe has failed to catch up
with the US productivity performance during recent decades. Yet putting all the
attention on the spending target for R&D could be misplaced, because it’s not only
about increasing the level of R&D, but also about enhancing the efficiency of R&D in
Europe. Further, actively subsidizing investment may not necessarily deliver the
desired results, as a large part of European capital finds it way to the American capital
market and thus does not necessarily benefit innovation in Europe. Consequently,
policy meant to enhance the efficiency and productivity of R&D in Europe should
focus on the level of knowledge of workers and the capacity of entrepreneurs to come
to technological innovation. The relative inefficiency of EU R&D is to a certain
degree the result of the segmentation of public research efforts and overlapping of
competing research programs, which leads to double work and thus not to the full
utilization of the available human resources. The time has now come to create an
integrated EU market for research and researchers.
References
De Groot, Nahuis and Tang (2004), “Is the American Model Miss World? Choosing
between the Anglo-Saxon model and a European-style alternative”, CPB
De Mooij and Tang (2003), “Four Futures of Europe”, CPB
Ahn and Hemmings (2000), “Policy influences on economic growth in OECD

countries: an ecvaluation of the evidence”, economics department working papers
no.246
Gordon (2002), “Two centuries of Economic Growth: Europe Chasing the American
Frontier”, Northwestern University and NBER
“Organisation for Economic Co-operation and Development”, EAS, ANBERD
Brandon Shackelford “U.S R&D projected to have grown marginally in 2003’’
Eurostat “European R&D Limps Behind The Rest Science and technology spending in
Europe still under 2% of GDP’’
Charles F. Larson “R&D and Innovation in Industry’’
Aswath Damodaran “Research and Development Expenses: Implications for

Profitability Measurement and Valuation’’
Simona Frank “R&D expenditure in the European regions’’
Simona Frank “R&D expenditure and personnel in the EU’’

Marc Rooijackers,
Ben van Gils,
Peter van Oudheusden
Bart van de Gevel
SOLOW MODEL
VERSUS
NEW GROWTH MODELS
In this chapter we look at proximate sources of growth. Which sources explain why some
countries are richer than others? To answer this question we look at some of the most used
growth models in economics. By studying these theoretical models we can deduce which of
the proximate sources are important for growth and which not. Growth models can be quite
different in how they describe the process of economic growth. To decide which of these
models describes the real world best is foremost an empirical question. This is why we will
compare some empirical studies to see if predicted source of growth by the models are also in
real life decisive for growth.
In the first section Marc Rooijackers will compare the Solow model (1956) with the human
capital extended version created by Mankiw, Romer and Weil (1992). The mother of all
models is the Solow model. This model explains how capital accumulation causes growth.
Technical progress in this model is exogenous and falls like manna from heaven. This model
explains different levels of growth through different saving rates between countries. The
MRW model extended the Solow model by human capital. First the models are explained
theoretical. Secondly there is an empirical comparison between the two models. Thirdly he
will discuss some alternative growth models with human capital. Lastly this section will also
contain a subsection where Peter van Oudheusden gives some critique on the textbook Solow
model.
In the second section Ben van Gils will treat R&D and Growth. The central question in this
section is if R&D can count for Total Factor Productivity growth? He will answer this
question by looking at two models, which explain R&D as a proximate source of growth. The
first model he deals with is the Romer model (1990). In this model in contrast with the Solow
model technological change is endogenous. The second model is the model by Aghion and
Howitt (1992) in which growth is caused by ongoing innovations. A question which comes to
mind here is if there can be too little or too much R&D. Lastly he will look at the empirical
evidence given by Cameron(1998).
The last section will contain a short conclusion. Were we will try to give some insights given
by models and conclude which proximate sources are important for growth.
-1-
§1.1 The Solow growth model and human capital
by Marc Rooijackers
I Introduction
The purpose of this paper is to compare the Solow-model with new growth models. After
Robert Solow introduced his famous growth theory in 1956, many researchers extended his
production formula. In this paper we describe an important extension: the adding of human
capital. Many researchers have found contradicting empirical evidence in answering the
question: is growth dependent on human capital? We begin with a description of the Solow-
model. Then we describe an extension of this model with human capital, known as the MRW-
model. In chapter three, contradicting empirical evidence will be given of these two models.
We conclude our paper with a short description of other growth models.
II. The Solow Model

This chapter is based on Robert M. Solow’s classic article on growth theory: “A contribution
to the theory of economic growth”, published in 1956. The basis of this theory is a standard
neoclassical production function. In this production function, there is only one commodity,
output as a whole: Y(t). This is the real income of the community. Output is produced with
two factors of production: capital (K(t)) and labour (L(t)). The accumulation of capital
depends on investment (which is equal to savings), population growth n, technological
progress g and depreciation δ. An assumption of full employment at the available stock of
capital is made. At a moment of time there is a given amount of labor supply and capital
stock. Because the real return to factors will adjust to achieve full employment of labour and
capital, we find the current rate of output by using the following production function:
Y(t) = K(t)α (A(t)L(t)) 1-α [1]
In this production function, A denotes the level of technology. Because the value of α is
assumed to be between zero and one, there are decreasing returns to scale. In the Solow-
model, the rates of saving, population growth, and technological progress are exogenous. A
fraction of output is saved at a constant s, so that the rate of saving is sY(t). When we define
k = K/AL and y = Y/AL, then the change in capital stock can be formulated as follows:
dk/dt = sY(t) - (n+g+δ)k(t) [2]
Formula two indicates that there is a steady state level k* According to the following formula,
this steady state level reached when k equals
k* = (s/(n+g+δ)1/(1-α)) [3]
The steady state of capital stock k* is the stock of capital at which investment and
depreciation just offset each other (∆k=0). This reasoning implies that Solow predicts
conditional convergence between countries. One of the shortcomings of the model is that, in
the real world, this has not happened. The Solow-model can be tested empirically by two
methods. The first is growth accounting, which describes different possible growth patterns of
one country. Second, level accounting tries to explain the differences between multiple
countries. This paper compares different growth models, the method used is mostly level
accounting.
III. The MRW-Model

For a long time, economists have stressed the importance of human capital to the process of
growth as a explanatory variable. The very beginning of this work has been done by Krueger
(1968). The first empirical evidence was found from 1988 by Rauch. Azariadis and Drazen
(1990) find that no country was able to grow quickly during the postwar period without a
highly literate labour force. Romer (1989) finds that literacy in 1960 helps to explain
-2-
investment. Also, his findings include that literacy has no impact on growth beyond its effect
on investment.
A famous model in which human capital is incorporated, is the model designed by Mankiw,
Romer and Weil, or the MRW-model. The following is merely based on their article: “A
contribution to the theory of economic growth”, published in 1992. Basically, this model is
equal to the simple Solow-model described in chapter II, with a third production factor:
human capital. This leads us to the function:
Y(t) = K(t)α H(t)β(A(t)L(t)) 1-α-β [4]
In this model H is defined as the stock of human capital. The MRW-model assumes free
substitution of production factors, one unit of consumption can be produced by either one unit
of physical or human capital. The MRW-model assumes α + β < 1, which implies that there
are decreasing returns to both physical and human capital. It’s important that s, n, g, and A are
all exogenous. Because it is now possible to invest in physical and human capital as well, the
amount that the economy saves has to be split. Therefore, sk is the fraction of income invested
in physical capital and sh is the fraction that is invested in human capital. When we define h =
H/AL and y=Y/AL, the accumulation of physical capital is determined by the following
equation:
dk/dt = sKy(t) - (n+g+δ)k(t) [5]
And for the accumulation on human capital counts:
dh/dt = sHy(t) - (n+g+δ)h(t) [6]
IV. The Solow model compared to the MRW-model

As we have seen in the two previous chapters, the difference between the Solow and the
MRW-model is only the addition of human capital in the production function. When we
compare these models with reality it will be clear which model fits best. There is contrasting
empirical evidence of which model fits reality best. The MRW-paper finds a strong positive
relationship between human capital and growth. Benhabib & Spiegel (1994) have not found
any empirical relationship. Krueger & Lindahl (1999) have found a relationship between
human capital and growth but these results are arbitrary.
Section 1: Empirical evidence supporting the addition of human capital in the production
function
This section will summarize the work of MRW regarding to comparing the Solow and MRW-
model. According to Solow, growth depends two important factors. The first is savings, which
account for investment and therefore capital accumulation. This results in a larger stock of
capital and a larger production (thus income) follows. The second is population, a larger
population results in less capital accumulation and therefore in less production. The following
table presents the results of testing the Solow-model in three groups of countries: non-oil
states; intermediate states and OECD countries.1
1
The first group (non-oil) consists of all countries excluding those for which oil production accounts for most of
GDP. It’s not to be expected that standard growth models integrate this production of oil. The second group,
intermediate, includes only countries with a population larger than one million. Small countries’ GDP is
dependent on influential factors and measurement of data is often not precise. Therefore, the small countries are
omitted in the second group. The third sample consists of 22 OECD-countries with population > 1mn. The data
are consistent and of high quality, disadvantages are that the sample size is small. For more information, see
Mankiw, Romer, Weil (1992) p.413.
-3-
Sample Non-oil Intermediate OECD
Observations 98 75 22
Constant 5.48 5.36 7.97
2
s.e. constant 1.59 1.55 2.48
3
Savings 1.42 1.31 0.50
s.e. savings 0.14 0.17 0.43
4
Population -1.97 -2.01 -0.76
s.e. population 0.56 0.53 0.84
2
Adjusted R 0.59 0.59 0.06
Table 1 : estimation of the Solow-model. Dependent variable: log GDP per working-age
person in 1985.5
The main conclusion from this table is that differences in saving and population growth,
account for a large fraction of the cross-country variation in income per capita. The adjusted
R-square is equal to 0.59. Important to keep in mind is that these results are an example of
growth accounting and not level accounting. Other conclusions are that:
- savings account positively to growth while population growth has the predicted
negative effect;
- the effect of savings and populations are highly significant: the standard error is low
compared to the actual value coefficient.
Besides this theory supporting empirical results, is the model not completely successful. The
implied α by the coefficients is: 0.60 for non-oil, 0.59 for intermediate and 0.36 for OECD-
countries. Actually, the implied α should be equal to the capital’s share in income, which is
about one third. The data strongly contradict this prediction.
The same test, using the same data sets and the same countries is performed using the MRW-
model. These results are shown in table 2.
Sample Non-oil Intermediate OECD

Observations 98 75 22
Constant 6.89 7.81 8.63
s.e. constant 1.17 1.19 2.19
Savings 0.69 0.70 0.28
s.e. savings 0.13 0.15 0.39
Population -1.73 -1.50 -1.07
s.e. population 0.41 0.40 0.75
6
Human capital 0.66 0.73 0.76
s.e. human capital 0.07 0.10 0.29
2
Adjusted R 0.78 0.77 0.24
Table 2 : estimation of the MRW-model. Dependent variable: log GDP per working-age
person in 1985.
2
S.e. stands for the standard error.
3
MRW used ln (I/GDP) which is the growth rate of investment divided by GDP. Basically, this is s.
4
MRW used ln (n+g+δ) which is the growth rate of gross growth. (n+g) was assumed to be 0.05. Population
growth remains.
5
Actually, the real OLS regression is performed by estimating GDP per working-age person, according to the
following formula which is derived from the basic Solow-model:
Y α α
n = α + + n( s ) − n(n + g + δ ) + ε
L 1−α 1−α
6
The proxy for human capital is a school variable.
-4-
The main conclusions from this table are:
- Adding the human capital variable is highly significant. We identify a human capital
coefficient of 0.66 ranging to 0.76, with standard errors ranging from 0.07 to 0.29;
- The adjusted R-square value is much higher compared to the Solow-model. Hence, human
capital is important for explaining growth;
- In the Solow-model, the implied α was deviating from the predicted one third. Here, the
implied α is consistent with this prediction, MRW found α to be 0.28, 0.30 and 0.17
respectively.
Section 2: Empirical evidence contradicting the addition of human capital in the production
function
Some researchers have found empirical evidence that human capital does not contribute to
growth. The research done by Benhabib & Spiegel (1994)7 is an example. Their research
points out that human capital is never significant in explaining growth. This is tested in six
different models, using growth accounting as well as level accounting.8 In three of the models
schooling has a linear effect, in the other three a logarithmic effect. This seems to be
surprisingly contrasting with the paper of MRW. But Benhabib & Spiegel found also a
positive relationship between human capital and physical capital. This means that human
capital influences physical capital which influences growth. Thus, human capital has an
indirect effect on growth.
Krueger and Lindahl (1999)9 have found different results. To start with, they extended the
research of Benhabib & Spiegel. They present six different models (regression equations, see
their table 1, p. 1112). In two of the six models, the effect of schooling (as a proxy of human
capital) on growth is significant. Unfortunately, production input factors as capital and labor
are not included in these particular models. This means that the results are doubtful.
Therefore, we have to conclude that human capital is not significant for explaining growth.
Besides the research and results stated above, they did find other evidence that human capital
does not contribute to growth. Their research indicates that initial schooling has no effect on
growth of GDP per capita in OECD-countries. Their results are shown in table 3:
Variable 5-Year growth 10-year growth 20-year growth

Sample size 138 69 23
Initial schooling .000 .000 .000
s.e. (.001) (.001) (.001)
R2 .43 .55 .35
Table 3: Effect of schooling on Economic growth in the OECD. Dependent variable:
annualized change in log GDP per capita, various time periods.
Clearly, coefficients and standard errors indicate that schooling is not useful explaining
growth.
7
J. Benhabib, M.M. Spiegel, The role of human capital in economic development. Evidence from aggregate
cross-country data. Journal of Monetary Economics (1994).
8
Six different models are used, performing the same test at different groups of countries.
9
Krueger, Lindahl, Education in Sweden and the world. (1999)
-5-
V. Other Growth models
The simplest model is the AK-model. Here, production (Y) is dependent on technology (A)
and capital (K). The production function is: Y=AK. In the Solow-model, we saw decreasing
returns to scale (DRS) unless α is equal to 1. In this case Solow predicted constant returns to
scale (CRS). In the AK-model, there is always CRS.
Other empirical growth models are the Baumol-type and the Barro-type equations. The most
important conclusion from the Baumol-type equations is that one (new) variable explains
growth for the biggest part. This variable is the country’s initial GDP. Other variables have
only minor influence. Barro-type equations were introduced one year before MRW. These
equations contained more than one proxy for human capital. School enrollment (similar to
MRW) formed the basis, but adult literacy rates and initial student-teacher ratio were added.10
This equation was subject to the critique of Levine and Renelt who found that a large variety
of economic and political indicators, other than the initial enrollment rate, are not robustly
correlated with growth.
Conclusion
The adding of human capital to the Solow-model in theoretical formulas is easy. But when
testing the formula in the real world, multiple contradicting evidence is found whether human
capital should be added to growth production functions or not. Unfortunately, we cannot give
a standard solution to this question. Probably, the actual growth ratio’s of countries are
dependent on many factors, including human capital, but cannot be integrated in one standard
formula which applies for all countries.
10
Barro, R.J. “Economic growth in a cross-section of countries”, Quarterly Journal of economics (1991).
-6-
§1.2 Critique on the Solow model
by Peter van Oudheusden
In this box we will look at the standard textbook Solow model and try to deliver some critique
on the assumptions that this model makes. We will do this to look at the variance of the
explanatory variables and the variance of the productivity and then calculate the elasticity of
capital such that the variance of the first can explain the variance of the latter.
Theory:
The explanatory variables of the Solow model are the investment ratio [s] and the population
growth [n], the assumptions made are that the growth rate of technology [g] and the
depreciation rate [d] are exogenous and are the same for every country. In addition the
assumption of the textbook Solow model is that the level of technology [A] is given and is
also the same for every country.
Our starting point is the formula that calculates the steady state level of productivity:
α
Y  s 1−α
1. = A ∗  
L n+ g +d 
When we take the natural logarithm we get the following formula:

α
2.
Y
ln = ln A + (ln s − ln(n + g + d ))
L 1−α
For calculating the variance we use the general formula:
3. VAR(aX + bY ) = a 2VAR( X ) + b 2VAR(Y ) + 2abCOV ( X , Y )
Applying this to formula 2 we get the following:
2
 Y  α 
VAR ln  = VAR(ln A) +   [VAR(ln s − ln (n + g + d ))] +
4.  L 1−α 
 α 
2 COV (ln A, (ln s − ln (n + g + d )))
1 −α 
Because the Solow model makes the assumption that the level of technology is exogenous and
the same for every country this results in a variance of zero. Because the level of technology
is given we may assume that there is no covariance with any variable. Taking this in account
this results in the formula:
2
 Y  α 
5. VAR ln  =   [VAR(ln s − ln (n + g + d ))]
 L  1−α 
We can rewrite this as:
 − ln(n + g + d ) +
2
 Y  α   
5a. VAR ln  =   VAR(ln s ) + VAR 
 L  1 −α    2COV (ln s,− ln(n + g + d )
-7-
We mentioned before that the growth of technology and the depreciation rate are given and
the same for every country, we can say now that:
6. VAR (ln(n + g + d ) = VAR (ln n)
Results data MRW:

For the data we used the data of Mankiw, Romer, Weil (1992). We only have taken the non-oil
producing countries for the reason that the productivity in those countries cause outliers and
are significant contributors to a larger variance in the productivity. Further we have taken two
situations, in the first we took the covariance between de investment ratio and the population
growth from the data. In the second case we set the covariance equal to zero. In table 1 are the
results for the data MRW.
Table 1 Variance
ln s 0.260
(-) ln n 0.338
ln Y/L 1.165
ln g + d 0.000
ln A 0.000
Covariance alfa
ln s, (-) ln n 0.091 0.550
ln s, (-) ln n 0.000 0.583
The alfa in the table is the elasticity of capital under the assumptions made when testing the
model. The outcome says that if the elasticity of capital is 0.550 the variance of the variables
(here the log of investment ratio and the log of population growth) can explain the variance in
the log of growth in per capita income.
As we can see the elasticity of capital in these cases are larger than the predicted 1/3 of the
textbook Solow model. Thus, taking the 1/3 the variance in the explanatory variables can’t
explain the variance in the productivity.
Critique on the model:

The first general critique we can give is that for calculating the elasticity of capital we use the
formula for the steady state in the Solow model implementing that all countries are in their
steady state, of course this isn’t the case.
Further critique can be given to the assumption that growth of technology and the
depreciation rate are given. A rather unorthodox but good way of looking at the influence of
those variables is taking a random sample of data. This can be done by taking random
numbers between 0.04 [g = 0.01, d = 0.03] and 0.125 [g = 0.025, d = 0.10] and add those
numbers to the data of MRW11. In the table 2 are the results for the adjusted data.
11
For convenience we assume that there is no correlation between the growth of technology and the depreciation
rate.
-8-
Table 2 Variance
ln s 0.260
X n+g+d
(-) ln X 0.407
ln Y/L 1.165
ln A 0.000
Covariance alfa
ln s, (-) ln X 0.055 0.550
ln s, (-) ln X 0.000 0.569
As we can see the elasticity in these cases is hardly influenced by the randomly chosen data. It
would be better to take real data to get the influence of these variables. However, this method
can say that even if technology and the depreciation rate are randomly distributed over the
world it could not explain the variance in productivity according to the Solow model.
This brings us to our last critique on the Solow model. As we have seen the model assumes
that the level technology is exogenous and the same for every country. When we look at the
empirical evidence Jones (1995) says that there is no evidence that there is any variance in the
level of technology. However McGrattan (1996) says there is a link between the level of
technology and the investment ratio. When we apply his thinking on the data of Jones12 we
get a variance of the level of technology of 0.154.
As we can see in table 3 the elasticity of capital is also hardly influenced by including this
measure of level of technology variance.
Table 3 Variance
ln s 0.260
(-) ln n 0.338
ln Y/L 1.165
ln g +d 0.000
ln A 0.154
Covariance alfa
ln s, (-) ln n 0,091 0,532
ln s, (-) ln n 0,000 0,565
However, we can say that if we include measures for variance in level of technology, growth
of technology and the depreciation rate the elasticity of capital shift to the predicted level of
1/3 in the Solow model.
Conclusion:
When we look at the textbook model of Solow and the assumptions that are made we can
conclude that the model fails to predict the variance in the productivity with the explanatory
variables chosen. Even with adding imperfect measures for variables we get results that
indicate that these additional variables can explain more of the variance of the productivity.
12
The investment ratio is taken with a lag of one time period on the growth rate per worker.
-9-
§2 Can R&D account for TFP growth?
by Ben van Gils
Nowadays output per hour worked is 10 times as valuable as output per hour worked 100 year
ago [Maddison 1982]. According to the economists in the 1950’s (Abramovitz 1956,
Kendrick 1956 and most important Solow 1956) almost all the change in output per hour
worked is attributed to technological change. But research and development plays an
important role in the process of technological change and the translation of new technologies
into new products and services [Ahn and Hemming 2000]. Therefore I want to investigate the
new or endogenous growth model. First I describe some important theoretical work on this
topic. Then I focus on the empirical work done by Cameron (1998). At the end of the paper I
try to answer the question “Can R&D account for TFP growth?”
A pioneer on the endogenous growth is Paul Romer. Romer (1990) states that R&D plays a
central role in the production of knowledge. He designed a model that is an extended version
of the Solow model (1956). Romer puts technological change into the Solow model. In
contrast with the Solow model the Romer model assumes endogenous rather than exogenous
technological change. An important characteristic of technology is that developing new and
better instructions is equivalent to incurring a fixed cost. Romer’s answer to the question is
yes because increases in the size of the market induce more research and faster growth. Larger
markets get a larger total stock of human capital that lead to faster growth. In his model
Romer uses an A for the stock of technology. Growth in this stock increases the productivity
of human capital in the research sector because the total stock of knowledge increases when a
new design is created. Romer assumes here that anyone engaged in research has free access to
the entire stock of knowledge. This finding suggests that free international trade can act to
speed up growth. Another suggestion of the model is that low levels of human capital may
help explain why growth is not observed in underdeveloped closed economies but observed in
underdeveloped open economies through economic integration with the rest of the world.
Another important observation made by Romer (1990) must be mentioned before I go through
with the analysis. Ideas are very different from most other economic goods. In contrast, ideas
are nonrivalrous. Once an idea has been created, anyone with knowledge of the idea can take
advantage of it. Most economic goods share the property that use of the good by someone
excludes your use of that same good. But ideas share a characteristic with most economic
goods. They are, at least partially excludable. To what extent the good is excludable depends
on the degree to which the owner of the good can charge a fee for its use. For this there exists
patent systems and copyright laws.
Two other important economists on the field of endogenous growth are Philippe Aghion and
Peter Howitt (1992). They concluded that growth results from technological progress and this
results from competition among research firms that generate innovations. The result of an
innovation is that you can produce more efficiently. In a growth process there is obsolescence;
the newly improved products replace the old ones. This progress creates losses too so
Schumpeter’s idea of creative destruction is born. Because monopoly gains are probably in
the future, present firms were encouraged to develop a new and better product so they (the
innovator) can access the market for the existing monopolist [Canton 2002]. So the economic
growth is determined through the level of innovations. Thus the theory of Aghion and Howitt
also explains how R&D contributes to growth. Only the economic growth can be too high or
too low according to them. On the one hand knowledge spillovers lead to lower R&D.
Because entrepreneurs only look at the revenues of innovation in their business cycle and
- 10 -
when a new innovation is present than the firm is driven out the market. On the other hand an
innovation leads to a better product and drive existing products out the market. This
phenomenon is known as business stealing.
The concept of how much R&D should be used is described by Jones and Williams (1998).
They investigate the over- or under investment in R&D. According to them the optimal R&D
spending as a share of GDP is more than two to four times larger than actual spending. In
their research they make a distinction between the private and social marginal product of
research. This distinction is because of three reasons. First there is a stepping on toes effect.
Doubling the number of researchers does not double the number of new ideas discovered. It
can happen that two or more of them came with the same idea. Another reason is the standing
on shoulders effect. An innovation is based on knowledge of the previous product. Because of
some flaws of the existing product the researchers can come up with a better product. The last
reason is creative destruction and is described above in the piece of Aghion and Howitt
(1992).
If you want to know if R&D can account for TFP growth you must also look at the returns of
R&D. According to the research done by Cameron (1998) there exists a strong and significant
link between R&D capital and output. In contrast to the above studies he found empirical
evidence for the yes answer. A one percent increase in the R&D capital leads to a rise in
output of between 0,05% and 0,1%. This conclusion is obtained by using two different ways
of estimating the effect of innovation. The first way is to use a measure of stock of R&D
capital (Dt) in a regression of the level of TFP. He uses the equation:
log TFPt = log A + β log Dt + µt
The second way is to use a measure of R&D intensity in a regression of the change in TFP,
shown in the following equation:
dlogTFP = ρ (Rt /Y)+ µ
The important difference between these two ways is that the first is based on a level estimate
and the second on a change estimate.
But there are a number of problems with these two approaches, both theoretical and empirical.
The various studies still have not proven that knowledge is separable in the production
function. Empirically there are the usual measurement problems. R&D data are a problem
because of problems of definition, inflation, depreciation and the treatment of time lags.
Cameron finds that it is also important to adjust for the cyclical nature of the TFP data. I think
this is a very good point because we are dealing with economics and therefore we must take
economic trends into account.
The results of the two approaches are summarized in table 2 for the first approach and in table
4 for the second approach (Appendix). Table 2 presents the estimate of the output elasticity of
R&D (β). Table 3 presents the estimate of the rate of return to R&D (ρ) in the USA and table
4 for other important countries. When these parameters are known you can determine the
effect of R&D on growth. But the outcomes of the studies are too different that this is almost
impossible. The output elasticity of R&D ranges from 0 to 0,5 and the rate of return to R&D
range from 0 to 1,43 (direct rate of return, because of too many empty spaces for the indirect
rate of return). The important point that you can make about the outcomes that they are all
positive and this means that there is a positive relationship between R&D and growth.
The conclusion of the paper is that R&D can account for TFP growth. Theoretically this is
explained by Romer (1990) and Aghion and Howitt (1992). Empirically this is explained by
Cameron (1998). He founds a positive relationship between R&D and growth.
- 11 -
§3 Conclusion
In this chapter we compared the Solow model with several new growth models. The reason
we did this was that these models give us the answer which proximate sources are important
for growth and which not. We have seen that the Solow model explains growth through
accumulation of capital. Where the level of growth is explained by the saving rate of a
country and the growth of its population. However the empirical evidence doesn’t supports
the traditional Solow model. Our own research with respect to the textbook Solow model
shows that the model fails to predict the variance in the productivity with the explanatory
variables chosen. Mankiw Romer and Weil have shown that the inclusion of human capital
can improve the empirical results and that there is strong evidence that human capital is a
source of growth. Economist like Benhabib and Spiegel however found contradicting
evidence on the role of human capital on growth. This means there is still no unanimous
consensus on the role of human capital.
Other economists have looked at R&D and innovation as sources of economic growth. In the
Romer model growth in R&D is endogenous. By investing in R&D the human capital stock of
a country broadens and growth follows. Aghion and Howitt have made another endogenous
technological growth model. In their model growth is been caused by innovations. Firms that
compete for a monopoly in the market generate these innovations. Cameron gives the
empirical evidence that R&D can account for TFP growth. He concludes that there is a strong
and significant link between R&D capital and output.
Our conclusion is that there are several proximate sources of growth. Traditional theory
predicts that the saving rate and population growth are important sources. Though we think
that these still account for economic growth we stress that there are more sources. In this
chapter we have looked at two other sources: human capital and R&D. We think that these
two sources are probably connected to each other and complementary. We think there is
evidence that they account for a significant part of growth. Besides these two sources there
may be other sources that are important in explaining growth. One that we didn’t discuss in
this paper is social capital. With social capital we mean stocks of social trust, norms and
networks that people can draw upon to solve common problems.13 Recent research suggests
that this source could also account for growth.
References
Aghion, P. and Howitt, P. (1992), A model of growth through creative destruction
Ahn, S. and Hemmings, P. (2000), Policy influences on economic growth in OECD countries:
An evaluation of the evidence
Barro, R.J. “Economic growth in a cross-section of countries”, Quarterly Journal of

economics (1991)
Benhabib J., M.M. Spiegel, The role of human capital in economic development. Evidence
from aggregate cross-country data. Journal of Monetary Economics (1994).
13
This explanation is based on the Civic Dictionary, http://www.cpn.org/tools/dictionary/capital.html
- 12 -
Cameron, G. (1998), Innovation and growth: A survey of the empirical evidence
Canton, E. (2002), Onderwijs, R&D en economische groei
Jones, Charles I. (1995). Time series tests of endogenous growth models. Quarterly Journal
of Economics 110 (MAY): 495-525
Jones, C. and Williams, J. (1998), Measuring the social return to R&D
Kroeger, Lindahl, Education in Sweden and the world. (1999)
Maddison, A. (1982), Phases of capitalist development
Mankiw, Gregory N.; Romer, David; Weil, David N.(1992) A contribution to the empirics of
economic growth. The Quarterly Journal of Economics 107 no: 2 407-437
McGRattan, Ellen R. (1996). A defense of AK growth models. Federal Reserve Bank of

Minneapolis Quaterly Review 22no: 4 13-27
Romer, P.(1990), Endogenous Technological Change
- 13 -
Appendix
- 14 -
- 15 -
- 16 -
I.4 (G17) Proximate sources
Zhou Beichun
Nanfei Pei
Jacob Glowacki (manager)
Ying Chen
STAGES OF ECONOMIC GROWTH
“It is not the strongest of the species that survive, nor the most intelligent, but
The one most responsive to change” [Charles Darwin].
Introduction
While there are numerous economic theories that devote time towards explaining how
growth can be achieved, how growth can be sustained and why some situations and
developments are detrimental to a sustained growth process, only relatively few
resources are devoted to the task of outlining the path a newly developing economy
will take throughout its growth process. While most theories allow to discern likely
developments and key moments from the underlying functions and resulting
phenomena, key development stages as one would could offer, for example in the
realm of biology or astrophysics, are usually not touched upon.
One reason for this avoiding behavior might be the scope the economist has to
consider: the development of an economy from undeveloped to an industrial economy
is a lengthy, complicated and not entirely clear-cut process, where substantial and
convoluted developments in various economic and social spheres have to be taken
into account, forcing the economist to look beyond purely economic data and analyze
trends and developments as regards demographic variables and social change.
It is a challenge to the economists to study the development and growth from
the point view of the population, technology and output. How can we explain the
evolution of human society from the agricultural economy to the industrial regime,
and now entering the modern growth stage? Why do some countries escape the
agricultural economy earlier than other countries?
Some studies on the relationship between the population, technology and
output cast light on those questions. The Malthusian model explains one thousand
years of the development of human history; the latest studies by Galor, Weil and
David try to explain how human society evolves from the Malthusian regime to the
Post Malthusian, and finally enters the Modern Growth era.
1. Malthusian growth theory

General overview
The earliest Malthusian model developed by Thomas R. Malthus in 1798 (Malthus
1798) can explain most of the history of mankind predating modern times.
The Malthusian model includes two key components (Galor and Weil 2000).
The first component is the existence of some factor of production such as land: this
factor is in fixed supply, implying a decreasing rate of return on all other factors.
The second key component is the positive relationship between the standard of
living and the growth rate of the population. The Malthusian model postulates that in
the absence of technological progress or the availability of land, the population is self-
equilibrating. The increasing standard of living will be the underlying cause of the
growth of the population. As a result, there is no big difference in the standard of
living across countries under the Malthusian regime.
Malthusian growth theory and human history

The prediction of the Malthusian model fits well with most of the documented human
history. The following study on population growth and output in the western counties
gives a nice picture of the Malthusian regime: from figure 1 below, we can see that
the population growth rate is about 0.1 percent during the years 500 A.D. to 1500
A.D.; according to Massimo Livi-Bacci (Livi-Bacci 1997), the average growth rate
through year 1 A.D. to 1750 A.D. is about 0.064 percent. The resulting growth rate of
output per capita is almost zero in the time interval from 500 A.D. to 1500 A.D..
Furthermore, the studies from Easterlin (Easterlin 1981), Pritchett (Pritchett
1997), and Lucas (Lucas 1999) show that the differences in the standard of living
among countries were quite small prior to the year 1800, yet there existed some
difference concerning the level of technology:
For instance, China’s sophisticated agricultural technology before the
nineteenth century did improve the output per acre, but failed to raise the standard of
living above the subsistence level. A similar situation occurred in Ireland where a new
productive technology in potato growing caused an increase in the total population but
no improvements in the standard of living.
Therefore, under the Malthusian regime, the development process in the
economy did not improve the living standard, but rather resulted in low yet steady
population growth. In other words, the advantage of any new and improved
production process was offset by a corresponding burst of growth in the population
under the Malthusian regime. As a consequence, the rate of technological change is
extremely low. Kremer (1993) argued that the change of the size of the population can
be seen as a direct result of changes in technology.
Society development-escaping the Malthusian trap

After a thousand years of development, the population in Western Europe maintained
a stable growth rate. Furthermore, the output per capita started to increase after 1500
A.D., with a significant jump at the beginning of the nineteenth century. See figure 1
and figure 2.
Figure 1: Output growth in Western Europe 500 – 1990 (Galor & Weil 2000)
Figure 2: Output per capita in western Europe from year 0 to 2000 (Galor and Moav 2002)
2. Evolution of the Human society
Galor and Weil Galor & Weil 2000) develop a unified model to describe the evolution
of the economy from the Malthusian regime to the Post-Malthusian regime, and
finally to the Modern Growth Era. The analysis focuses on two important issues from
a macroeconomic viewpoint: first, the behaviour of the income per capita; second, the
relationship between income per capita and the growth rate of the population.
As can be seen in figure 1, both the growth rates of the population and output
increased after 1820 A.D.. Indeed, the growth rate of the population began to fall after
it reached its peak in the nineteenth century whereas the output per capita kept
increasing.
Population growth accounts for about 40 percent of the output growth during 1820
A.D. to 1870 A.D., but for only 20 percent during 1925 to 1990, while now the
current forecast for the population growth in Europe predicts a negative growth rate.
The unified endogenous-growth model tries to account for the stated facts and show
that the developments in population growth, technology and output growth can be
described and explained consistently. The core point in this model is the interaction
between human capital and technological progress: technological progress raises the
rate of return of human capital while in turn human capital influences the rate of
technological progress, changes in attitude towards one variable will allow for
dynamics to arise.
In the following pages, we will explain what effects the technological progress
had on the evolution of the human society; of particular focus will be the role of
mortality. We also give an overview of the latest research from other points of view.
Effects of Technological progress

The model by Galor and Weil produces a Malthusian pseudo steady state that remains
stable for a long period but disappears in the long run. In this Malthusian regime,
output per capita is quite low and technology progresses slowly. Because of the
modest technology progress, the return to human capital limited.
As described earlier, any economic development induced by technological
progress was offset by corresponding growth in the population. In other words, the
growth of the population can be regarded as the indicator of the technology
development. As a result of the limited return to human capital and the corresponding
features of the economy, parents would focus more on the quantity of children rather
than quality in a Malthusian regime.
The pseudo steady state vanishes because of a steady accumulation of
technology development and population growth. At a sufficiently high population
level, the technology progress is high enough to provide parents with an incentive to
invest in some human capital, i.e. in their children. Subsequently, the increasing level
of human capital induces an acceleration of the technological progress, which in turn
raises the value of human capital.
In fact, the technological progress has two effects on the growth of the
population: on one hand, a higher level of technology awards families higher income.
As a direct result, the families become able to raise more children. This is what
happened in the post Malthusian regime, when the population experienced a growth
spur. On the other hand, higher income and return to human capital induces parents to
allocate more resources to the quality of child instead of quantity. Eventually, rapid
technology development resulting from the increase in the return of human capital
triggers the demographic transition: wages and the return to the quality of children
increase, but the population growth rate decreases. This phenomenon can be observed
the Western European countries.
The role of mortality

As the development dynamics in the unified model of endogenous growth hinge on
the accumulation of human capital, changes in mortality may play a pivotal role in
describing the transition from a Malthusian regime to a Modern Growth Regime:
Galor and Weil draw an example where an exogenous shock to health technology
causes a change in mortality that is not immediately observable. Consequently, as
fertility is not adjusted immediately, population growth will increase. However, this
rise in population growth will combine with the lower mortality to generate higher
returns to human capital, in turn spurning the rate of technological change that in turn
will lower mortality.
Advanced Malthusian models

A later study from Galor and Moav (Galor and Moav 2002) furthered the
development of a unified model to capture the interactions between the evolution of
the human society and the economic development by illustrating the relationship
between population, technology and output. Their study endeavours to depict the
interaction between four key elements:
The first contains the main ingredients of the Malthusian world - the economy
is characterized by land as the fixed factor of production, and a subsistence
consumption constraint below which survival becomes impossible.
The second element incorporates a number of Darwin’s attributes of evolution
such as variety, natural selection, and an overlapping process of evolution, into a
Malthusian economic environment. The Malthusian pressure imposed is an important
influence to the evolution of human species. Galor and Moav propose that although
the individual does not operate consciously in order to assure an evolutionary
advantage, the existence of a variety of types enable the selection process to select
those who fit the economic environment.
The third element links the evolution of the human species to the economic
growth process - based on the hypothesis that the development of human capital has a
positive effect on the technology progress, and ultimately results in economic growth.
The fourth element links the rate of the technological progress to the
demographic transition and to sustained economic growth.
The final argument is consistent with that of Galor and Weil (Galor and Weil
2000): The increase in technological progress increases the return to human capital, in
turn inducing parents to substitute for quantity by quality as children are concerned.
Hence, the growth of the rate of the technological progress increases the average
quality of the population, and in turn accelerates the rate of technological progress
even further. Ultimately, technological progress reaches a sufficient level in order to
induce a reduction of the fertility rate, generate a demographic transition and
sustained economic growth.
3. Rostow’s theory
Next to the theory based on the Malthusian regime, other approaches also are
proposed: Rostow (Rostow 1960) originally proposed stages of growth model of
rather descriptive nature. Within his framework, he identifies five categories of
development stages: the traditional society, the preconditions for take-off, take-off
phase, the drive to maturity and finally the age of high mass-consumption.
a) The traditional society: this state is characterized by a society with pre-

Newtonian science level and attitudes. The economy features only limited
production functions; innovation is possible but usually does only increase
total output while output per capita remains unchanged. The productivity of
capital is low; labour is used primarily in agriculture. This stage corresponds
roughly to the Malthusian steady state.
b) The preconditions for take-off: this is a transition period during which the
conditions for take-off are developed: science features prominently and begins
to induce technological progress. At the same time, capital mobilization
becomes commonplace, allowing for investment and private ventures. The
society and economy do not change during this transition period and
traditional structures and production methods prevail.
c) Take-off: the society receives a decisive stimulus of usually technical nature.
Capital per worker increases due to higher savings rates and thus higher
capital mobilization. Agriculture becomes increasingly industrialized,
necessitating less labour per unit of output and allowing for a greater
population to be sustained. The structure of society changes: entrepreneurs
enter the scene, while farmers with small farmsteads are reduced in number.
d) The drive to maturity: this is a period of prolonged growth and technological
progress. The economy benefits from a high investment rate and international
trade dynamics with other developed societies. Industry structures are being
established, leading to a well-defined modern economy.
e) The stage of high mass-consumption: the growth in income per capita
experienced in the last stages allows for universal consumption patterns
beyond necessities, skilled workers are prominent in the workforce. The
economy performs a switch towards durable consumption goods and services,
economic growth is technology driven.
While Rostow’s framework serves descriptive purposes primarily, the expressions

are used more or less universally throughout the literature. Some researchers try to
move closely along the stages within their theoretical concepts. One such model is
proposed by Zilibotti (1993).
In this model, Zilibotti tries to implement the known stages by Rostow into a
theoretical model of economic growth. He does this by matching the stages proposed
by Rostow to growth models and subsequently develops transition mechanisms. Thus,
a Solow-type model featuring a steady state is employed to model the corresponding
steady-state stage while a Romer-type model is employed with the beginning of the
take-off stage to model the following sustainable rate of economic growth generated
by technological change. The model thus builds on a number of ‘engines’ to provide a
fitting description to the respective development stage.
Bibliography
Darwin, Charles R. “On the Origin of Species by Means of Natural Selection: Or the
Preservation of Favoured Races in the Struggle for Life”, London: John
Murray 1859
Easterlin, Richard “Why Isn’t the Whole World Developed”, Journal of Economic
History, XLI (1981), 1-19
Galor, Oded & Weil, David N. “From Malthusian Stagnation to Modern Growth”,
The American Economic Review Vol. 89 (1999), No. , 150-154
Galor, Oded & Weil, David N. “Population, Technology, and Growth: From
Malthusian Stagnation to the Demographic Transition and beyond”, The
American Economic Review Vol. 90 (2000), No. 4, 806-828
Galor, Oded & Moav, Omer “Natural Selection and the Origin of Economic Growth”,
The quarterly journal of economics Vol. 117 (2002), No.4, 1133-1191
Kremer, Michael “Population growth and technological change: one million B.C. to
1990”, Quarterly Journal of Economics CVII (1993), 681-716
Livi-Bacci, Massimo “A Concise History of World Population”, Oxford: Claredon
Press 1997
Lucas, Robert “The Industrial Evolution: Past and Future”, University of Chicago
1999
Malthus, Thomas R. “An Essay on the Principle of Population”, London: J. Johnson
1798
Pritchett, Lant “Divergence, Big Time”, Journal of Economic Perspectives 11(3)
(1997), 3-17
Rostow, Walt W. “The Stages of Economic Growth: A Non-Communist Manifesto”
London: Cambridge University Press 1960
Zilibotti, Fabrizio “A Rostovian model of endogenous growth and underdevelopment
traps”, European Economic Review Vol. 39 (1995), 1569-1602
I. 5 (G14) Ultimate sources
Sjoerd Kitzen
Jeroen Broersma Statistician
Rianne Heijboer
Robert Gielissen
GEOGRAPHY
VERSUS
INSTITUTIONS AND POLICY
1. The Influence of Geography and Institutions on Economic Growth

By: Jeroen Broersma1 and Rianne Heijboer2
Economic growth is fuelled by the accumulation of production factors or improvements in

productivity, through technological change and efficiency improvements. More fundamental
forces, or “ultimate sources”, in turn drive these proximate sources of growth. Examples of
ultimate sources are institutions, market imperfections, policies or geography, which affect
economic growth in an indirect way through affecting accumulation and productivity.
In this chapter we discuss the influence of institutions and geography on economic
growth. Does either of these two factors affect economic growth? Is there any connection
between those two? First we address the role of geography. We investigate whether
institutions affect economic growth. Having considered these two sources separately, we
discuss how the two are connected. Is there causality between these sources? Are they direct
or indirect sources of economic growth?
Geography and economic growth

It is widely argued that geography affects economic growth and development in the context of
understanding cross-country differences and economic performance. Acemoglu et al. (2004)
approach focuses on differences in geography, climate and ecology. These factors determine
both the preferences and the opportunities of each individual agent in different economic
societies. They refer to this broad approach as the geography hypothesis. We will briefly look
at the three variations of his hypothesis, which each emphasize a different aspect.
Firstly, climate is one of the important determinants of work effort, incentives or
productivity. This idea has been around for a long time. The heat of climate can be so
1
Statistician
1
excessive to the human body, that it drains the strength and causes unproductiveness. As
Acemoglu et al. put it: “the inhabitants of warm countries are, like old men, timorous; as
opposed to the people in cold countries, who are like young men, brave.” (2004:13)
Second, geography can determine the technology available to society, especially in
agriculture. (Acemoglu, 2004:13) We should always take in to account the climate and its
impact on soil, vegetation, animals, humans and physical assets, in other words we should
take into account living conditions in economic development. Sachs is another proponent of
the view that geography is important in agricultural activity. He states: “By the start of the era
of modern economic growth, if not much earlier, temperate-zone technologies are more
productive than tropical-zone technologies....” (2001:2). Sachs also argues that geography
exerts an independent effect on the public health environment and on transport costs.
The third variant of geography hypothesis links poverty in many areas of the world to
their ‘disease burden’. Sachs emphasizes: “The burden of infectious disease is similarly
higher in the tropics than in the temperate zones” (2000:32) Furthermore in an earlier paper
he claims that prevalence of malaria reduces the annual growth rate of Sub-Saharan African
economies by more than 1.3 percent a year. This is a very large effect considering if malaria
had been eradicated in 1950 income per capita would be double of what it is today.
Olsson and Hibbs (2004) formalize a slightly different argument. They focus on
biogeography as being the fundamental impact on economic development all the way back to
prehistoric times. Countries with favourable bio geographic conditions, such as the prevalence
of plants and animals suitable for domestication were much faster in the transition from
hunter-gatherer to sedentary agriculture society. This would ultimately lead to the rise of
civilization, which conferred a development head start of thousands of years over the less
well-endowed areas. They claim three contributions: firstly, their paper is one of the first
attempts to explain the Neolithic transition from hunting gathering to agriculture. Secondly,
they formalize a study in the spirit of Diamond (1997) of the causal links between bio
geographic endowment, technological progress, and current levels of prosperity. The last
claimed contribution is that their study confronts the theory with biogeographically data. This
means that their empirical results demonstrate a relationship between initial biogeography and
income levels that does not run through institutions which contrasts to the work of other
scholars, who argue that geography only affects current prosperity indirectly via institutions.
All of the different geography hypothesis variations mentioned above show us that
there is a link between endowments and economic growth and development. We will analyze
the empirical aspect of the geography hypothesis further down after discussing the effects of
institutions on economic performance.
2
Analyst
2
Institutions and economic growth
North (1990: 3) defines institutions as follows: “Institutions are the rules of the game in a
society or, more formally, are the humanly devised constraints that shape human interaction.”
Economic institutions are considered one of the most profound causes of economic growth
and cross-country differences. They ensure a good structure of property rights and give equal
opportunities to everyone as well as ensuring the presence and perfection of markets. There
must be enforcement of property rights for a broad section of the society so that everyone has
an incentive to invest, innovate and take part in economic activity. A certain degree of
equality of opportunity is also necessary so that those with good investment opportunities can
take advantage of them. Acemoglu et al. believe that the structure of markets is endogenous,
and therefore partly determined by property rights. Equality of opportunity and secure
individuals’ property rights together create private incentives to maximize social welfare.
Differences in market performance thus must be an outcome of differing systems of property
rights and political institutions (Acemoglu, 2004:13).
Acemoglu et al. find that institutions are among the most important causes of long run
growth. They set up a framework in which today’s economic institutions influence future
economic performance and distribution of resources; this in turn together with future political
institutions affects political power, which is the determinant of both economic and political
institutions. (2004:6)
Empirical evidence on determinants of economic growth

Through out this section we will discuss the empirical evidence on the determinants of
economic growth found by different studies. We will also look at the association between
geography and institutions. Are they direct or indirect sources of economic growth?
Many different studies have focused on the role geography and institutions play in
determining economic growth. Acemoglu et al. (2004), Easterly/Levine (2003) all of these
find empirical evidence that is in favour of the institutional hypothesis.
Acemoglu et al. (2004) find in their paper that institutions are the main determinant of
economic growth. They argue that there is convincing empirical support for the hypothesis
that differences in economic institutions are the cause of differences in incomes per capita.
They outline this by using a scatter plot showing the cross-country bi-variate relationship
between the log of GDP per capita in 1995 and a broad measure of property rights. The
outcome is imperfect as a measure of economic institutions but the findings are robust to
using other available measures of economic institutions. The outcome of the plot shows us
that countries with more secure property rights have higher average incomes. Nevertheless
other aspects should be taken in account as well. We cannot automatically assume that there
3
is a casual link between secure property rights and prosperity. There can be a problem of
reverse causation or of omitted variable bias.
To avoid these problems of inference we should use natural experiments. They use
the Korean and the colonial experiment. The clearest one goes over the subdivided Korean
peninsula. After the division two independent countries came about. They organised in
different ways and adopted different sets of institutions. The South attempted to use markets
and private incentives in order to develop the economy. In the North however the economic
decisions were made by the communist state rather than mediated by markets. South Korea
maintained the system of private property of land and capital as in North Korea they were
abolished. Both countries had the same history and cultural roots. They showed remarkable
resemblance on ethnic, linguistic geographic and economic factors. So any difference in
economic growth should be attributed to differences in institutions. Consistent with the
institutional hypothesis the Koreans have experience dramatically diverging paths of
economic growth. South Korea has developed in one of the Asian Tigers and has been a
member of the OECD since 2000, while North Korea has a level of per-capita income about
the same as a typical sub-Saharan African country. The only plausible explanation for this
difference in economic development is the different institutions, which the country used.
(Acemoglu, 2004:18-21)
The Korean case is not as helpful as it is perhaps too extreme, the difference between
a market-orientated economy and a communist one provide insufficient evidence of the
importance of economic institutions. The colonial experiment shows that colonies, which
have inherited good institutions from their colonizers, are performing well. The countries,
which were sparsely inhabited, had low mortality rates or had less extreme climates when the
colonial period started, have developed good institutions and therefore good economic
performance. (Acemoglu, 2004:20 and 2001)
Easterly and Levine (2003) focus their analyses of the determinants of economic
growth, they evaluate four main questions regarding endowments and institutions using a
sample of 72 former colonies. For tests 1 and 2 the authors used simple OLS regression,
whereas for the 3rd and 4th tests two stage least squares model were used.
• First, do institutions explain development? From appendix A3 it is clear that the
institutions index has a positive association with both economic development and
better endowments.
• Second, do endowments explain cross-country variations in economic development?
The results we refer to can be found in appendix B.4 There is clear indication that
endowments explain economic development. Each of the four endowment indicators
3
Figure 3 and Table 1 in Easterly and Levine (2003).
4
Table 2 in Easterly and Levine (2003).
4
which are used (settler morality, latitude, landlocked and the crops/minerals
indicator) significantly explain cross-country variation in the logarithm of GDP per
capita
• Thirdly, do endowments explain cross-country variations in institutional
development? The result of the regression (appendix C5) indicates that endowments
help explain variation in institutional development. Each of the indicators is
significantly related to the aggregate institutions index.
• Finally, do endowments explain cross-country variations in economic development
beyond their ability to explain cross-country variations in institutions? This is the
most important test of their paper. In the second stage of the regression the authors
find that the dependent variable for geography does not differ from zero. The results
(referring to appendix C3) provide strong support for the institutional hypothesis but
no evidence for the geography hypothesis. Geography in this model is an indirect
source of economic growth.
Olsson and Hibbs (2003) have a rather different view than previously discussed; they
set up a theoretical framework over three major stages in history; the hunter-gatherer stage,
the agricultural stage, and the industrial stage. Their main aim was to provide a formal
representation of the link between initial bio geographic conditions and the present level of
economic well-being. The essence of their model implies that the earlier the transition from
hunter-gatherer to agricultural production, the longer the period of endogenous growth of
knowledge, and as a result, the earlier the transition to industrial production, and the higher
the level of economic development will be. The empirical analyses of the study focuses
mainly on contemporary levels of economic development, the regressions accounted that up
to half of the 1997 international variation in log output per person could be explained by their
exogenous measures. Olsson and Hibbs interpret this evidence as strong support of their
central prediction, which is that current variation in economic prosperity, is significantly
affected by prehistoric productive potentials of various environments. They also claim that the
geographic and biogeographic signals that were detected in the current levels of income per
person were robust to the controls for political and institutional variables that are known to
exert powerful, proximate statistical influence on international variations in economic
prosperity. (Olsson and Hibbs, 2003:28)
In Olsson and Hibbs (2003) the framework set out makes the principle prediction of
initial bio geographic endowments being positively related to contemporary levels of
economic growth. They set out using measurements of some key geographic and bio
5
3
5
geographic variables: the size of a continent, major axis of continent, climate and the number
of animals and plants that are suitable for domestication. The relationship is shown in figure 1
(in appendix D)
When the regression is set out the exogenous geographic conditions are measured by
four variables: Climate, latitude, axis and size. Biogeographic endowment is measured
separately with two variables, plants and animals. There are also variables for political
environment and social infrastructure. From the results they gather that there is much
evidence in line with Acemoglu et al. (2001) and Hall and Jones (1999): they conclude that
political and institutional measures have a clear proximate and statistical effect on economic
performance.
Olsson and Hibbs (2004) retain the common view that institutional arrangements
have much influence on the wealth or poverty of nations. However, ‘good institutions’ cannot
themselves be regarded as a fully independent variable, unaffected by geography,
biogeography and the level of economic development. Although some studies such as
Acemoglu et al. have claimed that the effects of geography are mediated entirely through
institutions, the results in Olsson and Hibbs (2004) show that biogeography as well as
geography retain statistical significance and remain important even if a measure for
institutional quality is included in the multiple regression. They conclude by emphasizing that
geography and biogeography (as the prime mobiles leading to current prosperity) have an
undisputed prior causal status over both institutions and current per capita incomes.
Conclusion
Acemoglu et al. (2004) state that geography influences economic growth. Geographic aspects
influence the type of institutions a country develops. In particular, economic institutions that
protect property rights and give equal opportunities to everyone boost growth. Acemoglu et
al. present evidence for the hypothesis that geographical elements affect growth indirectly
through institutions, whereas institutions directly affect economic growth. Economic
institutions determine incentives and constraints, and thus shape economic outcomes. Their
analysis relies on historical examples, political economy models, and econometric testing.
Easterly and Levine (2003) show that geographical variables significantly correlate
with growth in a simple OLS regression. However, the direct link between geography and
growth vanishes when a two-stage least squares method is applied. In the first stage,
institutions are significantly explained by geographical variables. In the second stage, the
authors find an insignificant coefficient for institutions, which are instrumented by
geographical variables. The authors conclude that geographic indicators, tropics, crops and
germs, shape institutions, which in turn explain economic growth. Thus geographical
6
elements play an indirect role on growth only, which is similar to the conclusion by
Acemoglu et al (2004).
Olsson and Hibbs (2004) reach different conclusions. Although they support that
institutions are a main source of economic growth, they find evidence that geography and
biogeography also directly affect growth, besides affecting growth through institutions.
The view elaborated by Acemoglu et al and Easterly and Levine can be graphically
summarized by the following scheme:
Geography Institutions Economic Growth/Development
While Olsson and Hibbs’s view can be summarized by:
Geography Institutions Economic Growth/Development
Summarize, we conclude that Acemoglu et al. and Easterly/ Levine find empirical evidence in
favour of institutions as the ultimate explanation of income differences, while Olsson/Hibbs
find evidence in favour of biogeographical determinants. What explains the differences in
results by these two groups of researchers?
• Acemoglu et al. and Easterly/ Levine only use data on former colonies; Hibbs and
Olsson use a sample of 112 countries. In particular, they do not take the ‘neo-
European’ countries (Australia, New Zealand and North America) in account,
because the food and technology package have not developed indigenously in these
countries but have been transferred by the European colonizers. In Acemoglu et al., in
contrast, these countries play a crucial role in their argument, providing examples of
colonization processes that brought good institutions that translated in high growth.
• Acemoglu et al. start their analysis at the onset of colonization 1500 AD, but Hibbs
and Olsson use the period of the Neolithic revolution, 11.000 BC as starting point for
their analysis. “In historical time, geography and biogeography are the primes
mobiles of current prosperity.” (Hibbs and Olsson, 2003) Hibbs and Olsson
distinguish three stages of growth: the hunter-gatherer economy, the agricultural
economy, and the industrial economy. Acemoglu et al., in contrast, confine the
analysis to the period after the colonization.
• Hibbs and Olsson give a causal link between biogeographical determinants and the
present level of income and development today. “Regions with a well-endowed
natural environment, which consequently made the transitions to agriculture and
7
industry comparatively early, should other things equal have higher income per capita
today than more poorly endowed regions where the transitions came later.” (Hibbs
and Olsson, 2003:19)
Bibliography
• Acemoglu, D., S. Johnson and J.A. Robinson (2001). “The Colonial Origins of
Comparative Development: An Empirical Investigation”, American Economic Review,
December, 91, 5, 1369-1401.
• Acemoglu, D., S. Johnson, and J.A. Robinson (2004). “Institutions as the Fundamental
Cause of Long-Run Growth”, NBER working paper #10481. .
• Easterly, W. and R. Levine (2003). “Tropics, germs and crops: How endowments
influence economic development”, Journal of Monetary Economics 50, 3-40.
• Hall, R. and Jones, C. (1999). “Why Do Some Countries Produce so Much More Output
per Worker than Others ", the Quarterly Journal of Economics, Vol. 114, 83-116.
• North, D.C. (1990), Institutions, institutional change and economic performance, New
York, Cambridge University Press.
• Olsson, O. and Hibbs, D. (2003). “Biography and long-run economic development”,
Elsevier econbase, European Economic Review.
• Olsson, O. and Hibbs, D. (2004). “Geography, biography, and why some countries are
rich and others are poor”, Proceedings of the National Academy of Sciences (US), vol.
101, no. 10: 3715-3720.
• Sachs, J. D. (2000). “Notes on a New Sociology of Economic Development” in L.E.
Harrison and S. P. Huntington eds. Culture Matters: How Values Shape Human Progress,
Basic Books, New York.
• Sachs, J.D. (2001). “Tropical Underdevelopment,” NBER Working Paper #8119.
8
Appendix A
Table 1: Correlations and summary statistics: selected variables
9
Appendix B
10
Appendix C
11
Appendix D
Figure 1: Biography and long-run economic development (Olsson and Hibbs 2003:20)
12
2. The influence of policies and institutions on economic growth
In the studies discussed in the previous section, institutions were found to have a strong direct
effect on economic growth. Institutions are the result of a long historic and cultural process.
For policy relevant questions, one would like to turn to ultimate factors behind growth that
can be changed over a shorter time period. We capture these factors by the term “policy”.
In this section we investigate the relationship between policies, institutions and
economic growth. First we will define what we mean by policies and institutions. Then we
discuss two opposing views: the one that policies affect economic growth and the view that
policies have no effect on growth. Eventually, we will conclude this section with our view.
Definition
By “policies” we mean the set of decisions made by the government. For example, the
decision of the government to keep inflation low (monetary policy) is an example of a good
policy. Other examples are the decisions on how high the tax-rate in a country will be and the
degree of openness to international trade. There are many characteristics of the economy that
a government can influence, so the term ‘policies’ is a rather broad term. The policy-view, as
this view is called in the literature, is therefore a view with many possible explanations.
The term ‘institutions’ has been defined in the previous section, but the distinction
between policies and institutions is sometimes blurred. By institutions we mean the way a
society is organised, which can only change slowly over time. Contrary, policies can be
changed very quickly, for example a government setting the tax-rate a bit higher.
The view that policies do affect economic growth

As mentioned in the previous sector, Acemoglu (2004) concludes that institutions are the
fundamental cause of long-run growth. Economic institutions influence economic
performance and the distribution of resources. This will, together with political institutions,
influence the distribution of political power. And finally, the distribution of political power
will influence economic and political institutions. Acemoglu describes in his paper that
institutions, formed hundred of years ago, determine whether policies are “good” or “bad”. So
in this view, policies do affect economic growth, but these policies are determined by the
institutions formed long ago.
Bassanini et al (2001) discuss different ways in which policies can influence

economic growth. They claim that policies have a direct influence on growth. The research in
this paper is based on growth-regression studies of OECD countries.
13
First, they claim that monetary policy to control inflation is important. The evidence
found in this article suggests that high inflation is negatively associated with the accumulation
of physical capital in the private sector and, through this channel, has a negative bearing on
output.
Average growth and median inflation in equal-sized samples of

annual data for OECD countries
Moreover, a high variability of inflation affects growth, possibly because it leads to a shift in
the composition of investment towards lower return projects. The authors present a regression
for 21 OECD countries over the 1971-1988 period. In this regression it indeed becomes clear
that a high variability of inflation has a negative effect on economic growth, as the coefficient
is significant and negative.
Second, the empirical evidence also confirms the importance of financial markets for
growth, both by helping to channel resources towards the most rewarding activities and in
encouraging investments.
The authors of this paper don’t make a distinction between policies and institutions;
they see these terms as being essentially the same.
Also Ahn and Hemmings (2000) conclude that policies affect growth. Their paper is a
literature review of many theoretical and empirical papers, which is far too broad to fully
describe here. Their main-conclusions on macro-economic policy are that low and stable
inflation affects economic growth positively. According to the authors there are several
reasons why high variability of inflation affects economic growth. Besides the uncertainty-
effect described earlier, there is the relative price distortion. Tommasi (1993) for example
14
finds that price distortions increase with inflation, which will have a negative impact on
growth.
Another policy they examine is the policy on international trade. Theoretically, they
state that more international trade will lead to exploitation of comparative advantages,
economies of scale and more competition. This will eventually lead to more economic
growth. The empirical evidence on these theories is mixed. There are studies that find a
positive link between openness and growth (for example Barro, 1991), but there are also a lot
of studies that find a negative link (Levine and Renelt, 1992).
Summarizing, we can conclude this part by saying that there are theories that state that
economic policies (like aiming at a stable inflation) affect economic growth. These theories
are confirmed by empirical evidence en regressions.
The slowdown in growth

However, there is some empirically evidence against the view explained above. The most
cited fact is that in developing countries the growth rates in the past two decades was much
lower than in the 1960s and 1970s.
Although the Washington Consensus which aimed to introduce neo-liberalistic policies in

developing countries, median per capita growth in these countries was around zero (as
compared to 2,5% in the sixties and seventies). If we assume that governments learn what
policies are best for their countries, we would expect higher growth-rates in the last decades,
instead of lower rates. Easterly (2001) has made a study on this topic. He states that if one
uses a standard growth model, with ‘the usual’ variables such as financial depth and real
15
overvaluation, initial conditions like health, education, fertility and infrastructure, these
models would predict economic growth for developing countries in the eighties and nineties.
He shows that the real deposit rates improved in the 80s, the overvaluation of the real
exchange rate diminished in the 80s and 90s and that life-expectancy increased. Overall, this
means that the economic policies indeed improved in time, what can be expected. But, these
improved policies contrasts with the slowdown in growth. This evidence would give rise to
the idea that policies do not affect economic growth.
Easterly then tests whether he disappointing growth-rates are caused by some
economic shocks, like an interest shock or a shock in the term of trade. These shocks don’t
seem significant in explaining the slowdown. The only explanation of the slowdown is the
slowdown in growth in OECD-countries, because they have a huge impact on the growth of
developing countries. This can be seen in the regression:
Per capita growth in developing countries regressed on policies, initial conditions, and
trading
partner growth rates
16
According to Easterly, this result means that policies are less important for growth than stated
in the previous view. The paradox of improved policies in combination with lower growth is
one of the reasons that another view has been given attention in the literature, namely the
view that policies don’t affect economic growth.
The view that policies do not affect economic growth

We will now describe some papers that state this view. We will begin with Mukand and
Rodrik (2002). They also point out, as Easterly, that economic policies in developing
countries have been improved. As an example, they give some figures on Latin America. The
17
index on structural reform created by Morley et al. rises in Latin America from 0,47 in the 70s
to 0,82 in 1995 (with 1 as maximum). But, in contrast to this figures, there are but a few
countries that have a higher growth in the 90s. Only Chile really does it better.
Another example that policies don’t seem to have much influence is the rise of India and
China. The authors state that these countries, whose growth-rates have been remarkable, have
introduced policies that have been regarded as unorthodox (like limited deregulation, absence
of clear property-rights, partial liberlization). India was after these reforms still the one of the
worlds most protected countries. In contrast, countries that introduced the so called ‘good’-
policies, like Latin America, didn’t experience higher growth-rates.
Mukand and Rodrik then present a model that will explain these differences. They
state that it policies are specific for a region. What will be a good policy in one region, can be
disastrous in another region. Furthermore, they state that countries will follow a country that
has introduced a good policy, either by implementing the same policy or by experimenting
their own policy. If one country experience high growth-rate due to a good policy,
neighbouring countries will adopt this policy. How further away, how less well the policy will
work. So countries at intermediate distance will at average have fewer gains than direct
neighbouring countries.
Countries far away see the success of the leading country. But because they are far
away, they know that the policy isn’t suitable for them. In reaction, they experiment with an
adapted policy. This will result in another remarkable gain, or in a disastrous fall, because the
effect of the experiment isn’t known. So this theory explains that countries in the
neighbourhood of a leading county have a bigger chance on success, and more importantly,
that countries far away can have either great successes or big failures. The authors test their
model with 32 formerly socialist countries and they conclude that the success of some Asian
republics is indeed explained by this model
So these authors don’t say that policies don’t affect economic growth, but they state
that there are some constraints on the implementation of policies. So the same policies don’t
have to work for different countries.
Easterly (2003) further elaborates the arguments. He gives some examples why
policies could have a smaller impact on growth than is stated by authors of the previous view.
Although theory predicts that taxes on capital should reduce investment on hence growth, in
practice many types of capital (e.g. human capital and capital in the informal sector) are not
taxed. Hence increases in taxes on conventional capital can be avoided by substituting to non-
taxed capital goods, thus reducing the effect of taxation on growth.
In the literature the author finds evidence that policies don’t affect growth. First he
describes the paradox explained above. Second, he claims that the literature has failed to find
a link between the most obvious policy that would influence economic growth, tax-rates, and
18
economic growth. Third, data on policies start in the 60s, and a lot of important data from
before the 60s is then not incorporated.
Eventually, Easterly conducts some empirical research. He regresses six policy-
variables for the years 1960 – 2000 on economic growth. It seems that they have a positive
and significant effect on growth.
Efffect of one standard deviation improvement in each policy variable on economic growth
However, if the extreme cases are left out, it turns out that none of the variables is significant
anymore. So, Easterly concludes that if extremes are left out, policies don’t affect economic
growth. Only in extreme cases policy’s matter, and he explains this by stating that it’s quite
logical that very bad policies affect growth negatively. But that doesn’t mean that good
policies will affect growth positively. This can be seen as “it is a lot easier to cut down a tree
than to grow one” (Easterly, 2003).
So we can conclude this part by saying that there are authors who say no connection between
policies and growth, or at least a connection with some conditions.
The interaction between policies and institutions

We now come to our last part, the interaction between policies and institutions. As is already
said, Acemoglu’s view is that institutions determine the policies of today. Easterly also has
conducted a research on this topic, by regressing policies and institutions on growth. He finds
that de macro-economic policies are never significant if institutions are being regressed too
(Easterly 2003). This would suggest that policies are indeed determined by institutions.
19
Another research, by Rodrik (2004), examines the question whether economic reforms (which
can be seen as improved policies that had a lot of impact on the economy) caused economic
growth. This study identified 80 periods since 1950 where a country had a growth of 2% or
more per year for a period of at least 7 years. The majority of these cases were unrelated to
major economic reforms (as liberalization and opening up trade).
This is a quite pessimistic view, because countries with bad institutions will not
improve. We find it logical that it is possible that good policies can improve institutions. For
example, if the institutions are of low quality, but a shock takes place (a revolution, or an very
good president), then it would be possible that good policies undertaken by this president
could improve the institutional quality. For example, the economic and political changes by
Gorbatsjov in the Soviet Union improved the institutions. Also the more gradually changes in
China moved the economy to a more capitalistic system. Notice that it are new policies that
influences the institutions, although it happens rather slowly (Li, 1998). Nowadays China
grows at a remarkable speed. This discussion is rather difficult, however, because the
distinction between policies and institutions becomes narrower. Furthermore, it is more
reliable to trust cross-country studies then to look at some examples, because we don’t know
which other factors are responsible for the changes in Russia and China.
Conclusion
Based on our review of the recent literature, we have to conclude that it is not clear if good
policies affect economic growth positively. There is evidence that there is a positive link, but
there is also a view that states that there isn’t. The idea that bad policies are bad for growth, is
wider accepted. The idea that policies are determined by institutions is confirmed by other
authors, although there isn’t either any consensus here. And we think furthermore that there
can exist a positive effect from policies on institutions. Graphicaly, this can be depicted as:
Institutions
Economic
growth/development
Policies
20
Literature:
Acemoglu (2004): Institutions as the fundamental cause of long-run growth
Bassanini (2001): Economic growth: the role of policies and institutions
Tommasi (1993): Inflation and relative prices: evidence from Argentina.
Barro (1991): Economic growth in a cross section of countries.
Levine and Renelt (1992): A sensitivity analyses of cross-country growth

resgressions.
William Easterly (2001): The lost decades: Developing countries' stagnation in spite of policy
reform 1980-1990, World bank, February 2001
William Easterly (2003): National Policies and economic growth: a reappraisal, New York
University, March 2003
D. Li, (1998), The dynamics of Institutional Change in China: The role of the bureaucracy.
(Geciteerd uit: http://ieas.berkeley.edu/shorenstein/1998.03.html)
Rodrik (2003), Getting institutions right.
Mukand and Rodrik (2003), In search of the holy grail: policy convergence, experimentation
and economic performance.
21
I. 6 (G13) Ultimate sources
Joris Ament
Willem Kerstholt (manager)
Renske Kok
Peter van Moorsel
POLITICAL ECONOMY
AND
ENDOGENOUS INSTITUTIONS
MODELS
Introduction
Political Economy - Endogenous Institutions Models
I - Introduction
Modern political economy models study the consequences of differences in institutions on
economic growth. [At the time of Adam Smith, the term political economy had a different
meaning: it comprised the study of national income and distribution in general]. In particular,
a stream of economics literature called the “New Institutional Economics” devotes special
attention to the role of institutions and the endogenous nature of institutions.
II - Major Approaches in Political Economics

There are various ways of approaching political economics. The major approaches are: State,
Justice, Economic, and Power-centered approaches. Below these different kind of views will
be discussed:
State centered approaches

The classical theory in political economy presumes that the state only fulfils a responsive role.
The state only responds to the economic processes. State-centered approaches shift the
balance between market and state. The role of politics in the economy does not start with the
identification of the market failures. The politics have their own goals they wish to achieve,
and they accomplish that by implementing policies that influence economic processes and
institutions. So state centered approaches refer to the imposition of political agendas to the
economy (Caparosa and Levine, 1993).
Justice centered approaches

The justice centered approaches do not cope with the subject of market’s success or failure,
but with the rights that come forward of the market. A market is, ultimately, a system of
property rights (Caparosa and Levine, 1993). The political process can define and alter these
rights.
These rights often concern the distribution and the equality of the recourses. The question is,
of course, what is fair? What is a fair distribution? There are two kinds of justices: substantive
justice and procedural justice (Craren, 2004). Substantive justice concerns the outcome of the
process. It concerns with the amount of recourses everybody has at the end of the process. In
contrary procedural justice is not about the outcome, but about the process itself. For example
in general is in Western countries procedural equality high and substantial equality low. For
communistic countries it is reversed. In general the procedural equality is low and the
substantial equality is high for that countries. This approach is subjective and dependent on
the ideology of a person.
Economic centered approaches

At this approach economic theories are applied to policy. It makes individual maximizing
behavior and rational choice the theme of political process and political decisions. This
method is inspired by the neo-classical theory, but that theory doesn’t imply a great role on
the government. In this approach that is just the case, there is a great role for the government.
Yet the role for the government doesn’t come down to the public responsibility for economic
affairs, or by trying to prevent market failure. The government should interpreted politics as
one focus to applied economic logic.
Power centered approaches

This approach identifies politics with the use of power and, by finding power in the economy,
claims to have established that the economy is political. There are two main problems, which
make this approach complicated. The first problem lies in the way power and politics are
related. Those who use power within the economy do so in the pursuit of their private
interests. This does not (directly) need to involve a political struggle over the instruments and
institutions of power (in other words; the government). If it is not involved with that struggle,
then power-centered approaches to political economy have to do with politics only in a very
limited sense of the word. The second problem, which occurs at this approach, is the
consideration whether the use of power is positive or negative. Examples like the power to
improve technology are of course positive. Naturally enough examples of negative power
exist. A good distribution of power makes an economy more efficient.
So unlike the other approaches to political economy, power-centered approaches do not focus
on the relation between private interests and public decision-making, but focuses more on the
allocation of efficiency in the society (Caparosa and Levine, 1993).
III - Endogenous institutions approaches

A group of approaches links the performance of economies to the incentives the institutional
setting provides to the participants in the economy. North (1990) defines institutions as: “[…]
humanly devised constraints that shape human interaction.”
Institutions thus are the rules of the game to which each economic actor should obey. In many
countries the rules of the game are the outcome of a political process, hence the institutional
approach is a part of political economics. It borrows from several of the previously treated
approaches. Political actors have influence on the decision process in so far as that they have
the power to change the rules.
Neoclassical, non-political, economics treats institutions as exogenously given, usually not of
any influence on the results of the market or on the behavior of the atomized actor. The
institutional approach (also known as New Institutional Economics) on the other hand sees the
actor as embedded in social relationships. Institutions govern the behavior between human
beings, and gradually change over time. This last point is an important point because it is the
step between institutions and the development of economies, and thus the link between
politics and economics (Yeager, 1999).
Different groups in societies have different interests. In an ideal democracy each groups can
promote the benefit of the own group only by gaining enough support for the idea to let it be
implemented by politicians of the own choosing. In this sense, the institutional setting will
reflect, or gradually change to come to reflect, the interests of vested powers. When social
settings change, and certain groups rise in power and other fall, the institutional setting may
reflect archaic social stratification. The old holders of power, still in charge of the politicians
in case of a democracy, or for example in charge of the army in less free societies, will refrain
from changing the institutional setting towards the interests of the new holders of power. The
new holders of power will nevertheless gradually be able to alter the situation. In certain cases
this can lead to civil wars, but in democratic situations the changes can occur peacefully.
The key proposition is that the relation between different categories in a civilization may, via
political processes, change the relative price structure, which might, depending on the
direction of the changes, better or worsen the economic position of a country (North, 1990).
In the remainder of this chapter the endogenous institutions model will be applied to the last
two thousand years of European history. In this history several examples of clashing groups in
society will be apparent, with differing results for the local economies.
IV - A Practical Application – Europe, From Rome to Mercantilism

After the decline of the Roman Empire, Europe underwent several drastic changes to both its
political and its economic structure. Former Roman holdings became lands governed under
the feudal system, during which agriculture played a crucial role in daily life. Increased
demand for a wider variety of goods, as well as new discoveries abroad delved Europe into
several centuries of mercantilism, where each nation-state involved attempted to maintain a
trade-surplus in order to fund successful military campaigns to protect both their colonial
holdings and their trade routes. This increased level of nationalism also involved the
colonization of Asia, Africa and the New World, as well as the strengthening of national
borders within Europe. The face of Europe was altered again when, first in England and later
the rest of Europe, the Industrial Revolution moved many former agricultural workers into
urban areas to work in factories. These drastic changes also affected the class system in
Europe. There always was a rich minority, just as there has always been a poor majority.
However, as the political and economic climates of Europe changed, so did the relationships
between the upper, middle and lower classes.
From Rome to Feudalism

The roots of European feudalism lie in the political and economic structure of the Roman
Empire. Rome’s economy was based on agriculture, and the poor peasant farmers who
worked the land were required to pay a land tax, irrespective to frequent bad harvests or their
inability to work the land while engaged in military service. Those farmers who defaulted on
their debts could be sold into slavery, at the same time losing their land. The virtually
powerless peasants, in the face of frequent raids from northern European Barbarian groups, as
well as the demands of the Roman tax collector, turned to powerful figures for protection.
Often, the peasants gave up ownership of their land in return for protection (Jupp, 2000). It is
this practice that caused the European feudal system to develop after Rome’s decline.
Like the Roman Empire, the feudal system in Europe depended massively on agriculture. The
peasants, under the protection of their king and his army, farmed their individual tracts of
land. The peasant’s entire family would help, as this was the family’s occupation. In return for
his protection, the ruler/owner of the land would require a tribute from his peasants, whether it
be in the form of agricultural product, money or military service (Jupp, 2000). Everything the
peasants required was either produced on the farm, received from their ruler, or obtained
through barter with local artisans such as blacksmiths or weavers. The king, in turn, received
his revenue from his subjects. The political and economic institutions in this case are very
easy to understand, as a solely agricultural economy requires little trade, so no revenue can
come from this source. Therefore, the governing party, the rich landowners, sold protection in
return for tribute. There existed a very small, extremely wealthy ruling class as well as a very
poor class of peasants and artisans. Also better off than the peasants were the ruler’s fighting
men, and these enforced the class system. A change in either political or economic institutions
was unlikely at this point because the king, using his feudal knights, could easily put down
any peasant revolt. There was also little incentive for the king’s knights to attempt to seize
power, because they were richer and more powerful than all but the king himself. The only
group that would possibly want to challenge the king, the peasants, lacked the power to do so.
A considerable increase in the level of trade eventually caused the decline of the feudal
system. This increase in trade introduced wider variety of available goods. Merchants set up
their shops in towns, and almost all trade was conducted there. The economic institutions that
were in place at the time were ill designed to profit from an increase in the level of trade.
Landowners only taxed their peasants, and the farmlands they worked, and therefore did not
collect any rent on the business conducted inside towns (Jupp, 2000). Farmland declined in
value relative to towns, causing wealthy landowners to lose revenue, and with that, power.
Merchants, in turn, only gained wealth and influence. The ruling classes, who became
determined to reap the benefits of this new economic institution, did not ignore the increase in
importance of trade.
To Mercantilism
Mercantilism became Western Europe’s major form of economic and political institution in
the seventeenth century. (Irwin, 1991) Trade’s rise to importance during the decline of
feudalism elicited in many nation-states the desire to out-perform other nations. Countries, or
rather the ruling classes of these countries wanted not only to reap the benefits of trade, but
also that other nations performed worse as a result. During this time, the smaller feudal
powers consolidated into larger and more competitive nation-states (LaHaye, 2004). Herein
lies the idea of mercantilism; a nation through its trade policies, as well as its military actions,
would attempt to outperform its rivals. The fierce competition caused this time period to be
characterized by nearly constant warfare between the major participating nations. The forces
of each nation were charged to both protect its own mercantile interests, as well as disable that
of other nations. To finance these constant military campaigns, trade-surpluses were required,
specifically the in-flow of gold and silver resulting from the trade abroad (Cameron, 1989).
There were opposing views on whether mercantilism was beneficial or detrimental to an
economy. Smith’s Wealth of Nations portrayed mercantilism in a bad light, pointing out that
through protectionist policies, a nation forwent the potential gains from trade. Several German
historians and economists, particularly Gustav von Schmoller, opposed Smith’s views.
Schmoller believed that the mercantile system was “above all a policy of state-making carried
out by wise and benevolent rulers,” which at the same time helped in strengthening national
economies. (Cameron, 1989) The political, and therefore also the economical institutions in
the major mercantile nations differed significantly, and these differences, in turn, led to
varying levels of success. In the absolute-monarchies of France, Spain and Portugal, the
royalty used its absolute power to reap the profits of its merchant fleet. The royalty spent all
of the profit from trade on their own lavish lifestyles and frequent military campaigns. The
great majority of the populations of these nations lived in extreme poverty. Because the
royalty, and not better informed trade experts were making all of the decisions, these absolute
monarchies did not develop as successful a trade empire as did the Netherlands and England.
The success of these two nations relative to the absolute-monarchies arises from the increased
competency of the decision-makers. The monarchs of England and the Netherlands did not
have absolute power. Instead, the power was in the hands of a wider, albeit still small, range
of the population. These people, such as the ‘stadhouders’ in the Netherlands, had closer ties
to trade than did the monarchs themselves, and were therefore better equipped to develop
more efficient economic institutions. These merchants convinced their rulers to grant them
outright monopolies on the national trade, and were also given protection by the nation’s
military. Thus, the much more efficient system of trading abroad, paired with the exploitation
of their colonial holdings allowed the wealth of these nations to flourish. (Irwin, 1991)
Because not only the aristocracy of these countries was profiting from the mercantile
ventures, this greater wealth was also spread over a larger fraction of the population. In the
cases of the Netherlands and England, the specialized and highly skilled merchant class used
its seafaring expertise and its influence to allow its power rose drastically in relation to
royalty. In both England and the Netherlands, the political institutions, constitutional
monarchies, resulted in greater wealth, and also allowed for the lower merchant class to
achieve even more political power. The royalty of these two nations was willing to concede
this political power, because they too were earning massive sums of money thanks to the
expertise of the merchants.
Advances in seafaring led to the rise of mercantilism in the seventeenth and eighteenth
centuries, and it would be another type of advance that would help to rearrange the political,
economic and class systems in the eighteenth and nineteenth centuries. This time
technological advances in England greatly increased the productivity of capital, in a period
that came to be called the industrial revolution. With the numerous advances in technology,
production of goods, such as textiles, that was once time-consuming and expensive, could
now be done quickly and at lower costs in factories. The industrial advances centralized
production in factories and thereby necessitated the move of a large fraction of the population
into urban environments. This centralization, though miraculous for the factory-owners and
other rich industrialists, also “gave rise to an industrial proletariat,” the poorly paid, massively
overworked employees of the new factories. (Habakkuk, 1965) These people were the former
farmers and artisans whose work were displaced by the more efficient machines of the
industrial age, and had little influence and few rights. The pay was incredibly low, and the
work was difficult and often dangerous. The use of child labor was abundant in this period,
and workers had very few political and economic rights. There loomed the threat that this
incredibly poor working class would cause social unrest, which was the cause for several
“strategic concessions, which were made in England to adult men over an 86 year period.”
(Acemoglu, Johnson and Robinson, 2004) Starting in 1832, these concessions were made by
the ruling class, knowing that they were giving up political power. However, the concessions
were deemed worth the loss because they served to appease the working class thereby
avoiding potentially disastrous revolts. Thus the initial stages of the industrial revolution
served to drive England’s population into the factories and into population. However, by
organizing, the poor masses were able to force concessions of more and more poiltical and
economic powers and freedoms, because they possessed de facto power in their ability to
revolt. Towards the beginning of the 20th century, however, there remained a small group of
wealthy rulers in each country, extracting the majority of the rents from their business
interests. There also remained nations, the majority of whose population was now an
unskilled, extremely poor factory worker. Though the proletariat did earn gradual increases in
both compensation and rights, they still did not achieve the political power to be able to earn
any significant income.
V - Conclusion
Political economy, the interrelationship between the political and the economic affairs of the
state, is a very complex and broad subject. Over the years different theories have been made
about this subject. The subject also can be viewed out of different perspectives, out of which
different approaches originate. It should be clear that it is an area that keeps on developing.
Endogenous institutions models give a synthesis between economic reasoning and more
sociological discourse. It gives an explanation of differences in the attained income and how
these result from distribution of power and the way changes in this distribution are handled. If
there is anything to be learned from these 1500 years of class struggle in the face of changing
political and economic institutions it is that the real rents to be collected from any successful
economic venture fall into the hands of those with political power. In cases where a small
group possesses the political power, such as in the absolute monarchies of France and Spain
in the 17th and 18th centuries, any wealth gained due to economic prosperity will fall into this
ruling minority. In many ways, this is still the same, despite the fact that political power today
is not concentrated among nearly as few people as in the past. The use of protectionist
methods, such as tariffs and voluntary price floors protects from international competition
those groups who have the political influence to acquire this type of protection.
Politicians, in an effort to maintain their political power, attempt to appease these influential
groups in exchange for their support. Thus, it is important to realize which parts are played by
whom when analyzing a change in political or economic institutions. The course of the last
1500 years also makes it evident that for a lower class to rise in status, this class must acquire
either economic or political power. Unrivaled expertise in shipping and trade were what
propelled the merchant class into prominent roles, and the seizure of de facto power in the
form of threatening social unrest forced rulers to concede more political representation to the
industrial-age English proletariat. Despite many major institutional changes, the distribution
of power has long determined, and still determines the distribution of wealth. This must be
kept in mind when assessing present-day and future changes in government or international
strategy, on both domestic and international levels.
Bibliography
1. Acemoglu, Johnson, Robinson. “Institutions as the Fundamental Cause of Long-Run
Growth” NBER Working Paper Series. Working Paper No. 10481 (May, 2004).
2. Basgen, Brian and Andy Blunden. “Encyclopedia of Marxism”, 1999,
http://www.marxists.org/glossary
3. Cameron, Ronaldo. “A Concise Economic History of the World.” Oxford: Oxford
University Press, 1989.
4. Caporaso, J.A. and D.P. Levine, “Theories of Political Economy”, Cambridge
University Uress, 1993
5. Craren, S. 2004. “Justice based Political economy”, University of Texas, Dallas
6. Gabriel, S. 2004. “Introduction to Political Economy, Course Outline”
http://www.mtholyoke.edu/courses/sgabriel/political_economy_main.htm
7. Gamble, A. and A. Payne. 1996. “Editorial policy statement from: New Political
Economy” Vol. 1, No. 1
8. Habakkuk, H.J. and M. Postan, Eds. “Cambridge Economic History of Europe VI part
I.” Cambridge: Cambridge University press, 1965.
9. Hartwig, J. 2004. “Introduction to Political Economy, Course Outline” (now offline)
http://darkwing.uoregon.edu/~jhartwig/classes/ps321
10. Irwin, Douglas A. “Mercantilism as Strategic Trade Policy: The Anglo-Dutch Rivalry
for the East India Trade.” The Journal of Political Economy, 99.6 (1991): 1296.
11. Jupp, Kenneth. “European Feudalism from its Emergence through its Decline” The
American Journal of Economics and Sociology, (Dec, 2000).
12. LaHaye, Laura. “Mercantilism.” Library of Economics and Liberty. 20 September
http://www.econlib.org/library/enc/Mercantilism.html
13. North, Douglas C. 1990. “Institutions, Institutional Change and Economic
Performance.” Cambridge University Press.
14. O’Brien, Patrick. “Mercantilism and Imperialism in the Rise and Decline of the Dutch
and British Economies 1585-1815.” De Economist 148.4 (2000): 469-501.
15. Steele, G.R. “The money economy: mercantilism, classical economics and Keynes'
general theory.” The American Journal of Economics and Sociology, Oct, 1998.
16. Sidwick , Henry. 1887. “The Principles of Political Economy”. MacMillan and
Company, 2nd edition (taken of the internet).
17. Yeager, Timothy J. 1999. “Institutions, Transition Economies, and Economic
Development”. Boulder: Westview Press.
I. 7 (G12) Endogenous Institutions
Pieter van Erp
Dirk Hendrix
Marcel Jonker (manager)
Luc Verschuren
EXPLANING ECONOMIC AND POLITICAL

INSTITUTIONS IN FOUR COUNTRIES
1. France vs. Great Britain

Introduction
In this paper a comparison is made between the development of the institutions in Britain and
in France. Britain and France are both West-European countries and have a population of 60
million people. Britain and France were two rivaling countries, which have fought several
wars. Both countries are now rich and powerful, but got in this position trough different paths.
France
1.1 Historical development of institutions before the Revolution
Until the beginning of the sixteenth century France was not a stable country. The Romans,
Germans, Muslims and the Britain’s invaded France. In France a lot of civil wars were fought,
but in the early 16th century the France Crown was strengthen and Francois I became the king
of the Frankish monarchy. In this period the first political institutions became clear. In the
beginning the France Crown had the de jure and de facto power. In this period property rights
were introduced but the nobility still ruled strongly. The economic institutions could not be
taken too serious. At the end of the 16th century the de facto power began to change. The
number of Protestants began to grow and tried to take over the power. This led to the Wars of
Religion. Henry IV ended this Wars of Religion and became the first Bourbon King. Henry
IV introduced the Edict of Nantes, which guaranteed religious property rights for Catholics
and Protestants and political rights. (Source: Website Landenweb)
In the 17th century King Louis XIII and Cardinal Richelieu made France from a feudal
monarchy to an absolute monarchy. The Feudal parliament and the nobility were almost never
summoned for political decisions. They started a rebellion. When this rebellion was
suppressed the power of the French Monarchy was at his highest. This absolute monarchy
caused a lot of different political and later economic institutions King Louis XIV, the Sun
King, took over and allocated power to Versailles where al the princes and lords lived. France
then became a very centralized ruled country. France becomes the most powerful country in
Europe. Louis XIV promoted industries, trading and colonization oversees. The influence of
France in the colonized countries was relatively small because France brought mainly slaves
to this countries and only little of their own inhabitants. Many institutions for the higher
culture were established like police protection. (Source: Engerman, Sokoloff)
Louis XIV decentralized France and divided his government into almost forty smaller
governments. This way France had a more incentive full tax system. The bureaucratization of
Louis the XIV started out well through stimulation of the France market and subsidizing the
1
transport cost of French merchants. The overseas trade was directly controlled because of the
strong monarchy. The absolutist monarchy could also increase their revenues by granting
trade monopolies. However the reign of Louis XIV failed in several areas. For example, Louis
XIV revoked the Edict of Nantes and got France in financial troubles. When he died, Louis
XV took over. Louis XV was not able to rule as strongly as Louis XIV did. The de facto
power of the Bourgeoisie was rising and England became the largest colonial power. The
economic institutions could not be maintained. The Bourgeoisie, feeded by the Enlightment,
made the commoners question the principles of the old regime and absolution. The
commoners wanted equal rights and the abolition of the class system. In 1789, the crisis came
to a head and the Bourgeoisie wanted more rights. The French revolution had begun. (Source:
Website Landenweb, Website UNCG). In Figure 1.1 the changes within the French system
are showed by theory of Acemoglu. (Source: Acemoglu 2004)
Figure 1.1
The initial political situation of an absolute monarchy was charactarized by certain de facto
and de jure power. These powers, on their turn, affected the economic and political
institutions in France. These institutions and the influence of the de jure and de facto political
power realized new institutions and a new distribution of resources. This is shown in the last
two boxes.
1.2 Historical development: The Revolution until the present
This revolution has been very important for the institutions France has today. The
revolutionaries issued the Declaration of the Rights of Man. This declaration was meant to
end the class system and embodied freedom, equality and brotherhood. The Declaration of the
Rights of Man consisted a lot of things that are important today like liberty, property rights for
the people in the Bourgeoisie and security. During the revolution, people gained property
rights, because the Bourgeoisie was now able to own their own firms and did not have to hand
over their profits to the nobility.
The Revolution ended when Napoleon entered Paris and became First Consul. In 1804 he
crowned himself emperor. He thereby challenged and diminished the power of the church.
Napoleon reformed the education system and justice system and started a powerful central
administration and expanded his empire with many military campaigns. A new period of
different political institutions had started. In this period France got some very important new
economic institutions, like more secure property rights and the Patent Law promulgated in the
Code Civil.(Source: Acemoglu). The military campaigns got France in North-Africa where
France became a colonial power in North-Africa. In Europe he conquered a large empire. For
example, Napoleon conquered Italia, Germany and Poland. His plans of war got him
increasingly bigger problems. Russia defeated Napoleon and England pointed out to be to
2
strong at sea. Napoleon was defeated in Waterloo in 1815. (Source: Website Landenweb,
Website UNCG)
The French Crown was restored. The centralized administration of the Republic was
conserved but the nobility and the church took over power. This reminded people too much
of the old regime and this system got not be maintained. In 1848 Louis Napoleon, the nephew
of Napoleon Bonaparte was elected the first president of the Second Republic. After having
an argument with the legislative power Louis Napoleon made himself emperor of France.
Louis Napoleon started to reshape the French economy. He realized for example a free trade
pact with England Under his power the trade and industry flourished. This started the
industrial revolution in France.
Louis Napoleon got into a war with Germany, Italia and Russia and was defeated. The empire
ended in 1871 when the war with Germany ended and Louis Napoleon was defeated. (Source:
Website Landenweb, Website UNCG)
In this period France became a democracy. The industrial expansion continued during this
time and the French economy grew fast. This growth was mainly fed by several Pacts made
with other European countries. This growth had slowed down in the 20th century when France
got into the First World War. One of the pacts was the Triple Entente with Russia and
England. When one of these countries, Russia, got involved in the First World War France
had to participate. Until 1917 France wasn’t very successful in their war against Germany. In
1917 the defense of France was structurally reorganized and France defeated Germany.
(Source: Website Landenweb, Website UNCG)
After the war the relation between France and a lot of European countries worsened, because
France wanted too much reparations. The economic situation in France worsened, because of
the postwar problems and the unstable government. A new cabinet was chosen and this
cabinet tried to strengthen the alliances to stop the pressure of Hitler’s Germany.
But when Germany violated the Pact of Munich, France started the Second World War
against Germany. The Germany troops pulverized the France army. Until September 1944,
the Germans suppressed France. The invasion in Normandy made sure that France was a free
country again. (Source: Website Landenweb, Website UNCG)
The postwar years where characterized by economic growth, consumerism, technological

advancement and political instability. At fast speed the France cabinets succeeded each other.
In 1958 De Gaulle became the new president of France. He changed a lot of political
institutions. He issued a new fundamental law, which centralized the power of the
government. The period of De Gaulle is characterized by restoring the position of France
between the influencing countries in the world. De Gaulle ruled till 1969 when he resigned
but his policy was maintained. France grew to become one of powerful countries of the
European Union and the world. In the coming decades France stayed an influencing and
strong economic country. The power of the president decreased a little in the 20th century but
France stayed a centralized ruled country. (Source: Website Landenweb, Website UNCG)
1.3 Conclusions
Over time a lot of different thing happed in France and France was ruled by a lot of different
nations and people. In the 17th century the power of nobility started to grow and in the 18th
century, France became an absolute monarchy. A lot of new institutions were created but
almost all of them favored the nobility. However, the power of the Bourgeoisie was growing.
3
This lead to a Revolution, which caused power to shift in the direction of the Bourgeoisie. In
this period, France was ruled by Napoleon. Napoleon established a lot of important economic
and political institutions, which are still very important nowadays. When Napoleon was
defeated at Waterloo a lot of things changed. After a short period of changes in leadership,
France became a relatively stable democracy. Over time France grew to become the country
as it is today. When we look at the institutions and the theory of Acemoglu, the period
between 1789 and 1815 had been important for France. In Figure 1, it is shown how the
institutions and distribution of resources have changed over time. During this period of
changes, the Bourgeoisie got securer property right and the Code Civil was issued. After this
period of changes, the Industrial Revolution caused France to grow and become a rich and
powerful country as it is today.
Great Britain
Historical development of institutions
The history of Britain is exciting and far from stable. Over a long period of time, the Romans,
the Anglo Saxon and the Vikings entered Britain and conquered parts of the country. After the
Norman invasion in 1066, England became a unified country for the first time since the
Romans left 600 years earlier. The Norman kings consolidated their hold on England, and
then took control of Wales and Ireland. Britain became a monarchy. In the beginning the
kings had the de jure and de facto power. (Source: UK information guide, British History)
After Henry II, England started running into problems. People and pretenders to the throne
tried to gain political rights. Upcoming parliaments where developed and from that moment
on, kings failed to maintain an absolutist monarchy. This started when King John (1215) was
defeated by the barons and only kept the throne by signing the Magna Carta, which stated that
the king was not above the law, that he only ruled by the will of the people, and that if he
broke his part of the contract, then the people had the right to overthrow the king. This did
limit the king’s powers of taxation and require trials before punishment. It was the first time
that an English monarch came under the control of the law. This reduced power of the king
(monarchy) and the increased power of the people can be notified as a change in de facto
power. (Source:Acemoglu 2004)
Non-stable monarchies followed during the Middle Ages. There have been several fierce
contests for the Crown and several (continental) wars continued to cost England more money
than it could afford. England soon lost all its French territories, apart from Bordeaux. The
Battle of Bosworth (1485) with the victory of Henry VII resulted in a new royal house, the
Tudors and England was to enter a new period of history. The rule of the Tudors, including
Henry VIII, Mary and particularly Elizabeth brought in one of the most glorious eras of
British history; exploration, colonization, Atlantic trade, victory in war, and growing world
importance. Britain discovered and collected several overseas colonies in taking part in the
conquest of the New World. (Source: UK information guide, British History).
However the Tudor monarchs, followed by the first Stuart kings failed to build an absolutist
monarchy, mostly because of the Parliament, which blocked attempts to concentrate power. In
England the crown was not strong enough to control overseas trade (by for example creating
monopolies) so individuals and small partnerships carried on most trade. There was not a high
entry barrier into the merchant class and the interests of the merchants were now directly
opposed to those of the kings. Namely, changing to more efficient economic institutions
4
would decrease their political power (losing also de jure power to the merchant class)
(Source: Acemoglu 2004). This rule would have a central role in the political changes that
would follow later on. Also the fact that the Stuart kings believed that they had a divine right
to govern caused increasing resentment in the changing world. This brought him into a bigger
conflict with the English Parliament. The struggle for supremacy between Parliament and the
King (monarchy) led to Civil War in 1641. The parliament won and the king, Charles I was
executed in 1649. Oliver Cromwell became head of state, which was the start of England's
only period of dictatorship. Cromwell was unable to find anything to replace the monarchy
and when he died, his son, Richard, became head of state. He was not a man to rule Britain
and was not a popular choice. Parliament invited the son of the dead king to re-take the throne
his father had died for. So Britain resumed a monarchy under Charles II in 1660. (Source: UK
information guide, British History)
The Civil War did have an influence on the great expansion of the British colonization and the
trading merchant groups in the Atlantic. The so-called constitutional outcome in England that
was settled because of the Civil War and later on the Glorious Revolution (1688) had
enormous consequences. The de facto power was successfully used to reform political
institutions so that de jure political power was acquired. This new form of government led to
secure property rights, a favorable investment climate and rapid multiplied effects on other
economic institutions, particularly financial markets. The change in balance of (de jure and de
facto) political power in Britain led to a set of economic institutions favoring the interests of
merchants. The merchants were able to control the powers of the monarchy in order to protect
their property and trade opportunities. These changes in political power, political institutions
and thus economic institutions seemed to be efficient, and resulted in an industrial advantage.
Because of this, England moved ahead economically compared to the countries that moved
further towards greater absolutism. (Source: Acemoglu 2004)
Further changes in institutions after 1688 resulting in a Parliament that was in control of the
fiscal policy. The English monarchy was now able to borrow huge amounts of money because
the Parliament guaranteed that it would not default, which was crucial to the success of the
English war machine. There also was a huge expansion of financial institutions and markets
because of the greater security of property rights. Because of the huge successes of the
changes in economic institutions, the Parliament became more and more successful which
made its power permanent. (Source: Acemoglu 2004)
Britain was fast becoming the crucible of the Industrial Revolution as steam power, steam
trains, coalmines and waterpower began to transform the means of transport and production.
The industrial revolution brought about a more urban society. New territories in Canada and
India expanded the Empire, but there was also the loss of the American Colonies with the
declaration of independence (1776). (Source: UK information guide, British History)
Later on, the situation in Britain cannot be described as stable. For a period of 22 years, from
1793 to 1815 Britain waged war with France. In spite of the great power of the Britain
Empire, the French troops controlled Europe. The grandiose ambitions self-crowned Emperor,
Napoleon was finally defeated by the British sea power, under command of Wellington’s
Peninsular army in 1814. (Source: UK information guide, British History)
Britain, the dominant industrial and maritime power of the 19th century, played a leading role
in developing parliamentary democracy. As the century and Industrial Revolution progressed,
small elites were taking over the power in the parliamentary monarchy. The franchise was
restricted to males with relatively large amounts of assets, income or wealth. The existing
economic institutions, particular in the labor market, disadvantaged the poor and the
organization of trade unions by workers was illegal. The poor, disenfranchised workers had
5
little de jure power and also limited de facto power. In later periods, this all caused collective
actions by (disenfranchised) workers. These masses were relatively well organized and
therefore difficult to repress by military actions or by making concessions to buy off
opposition. Elites now faced a trade-off between losing political power and the prospect of,
possibly radical, redistribution versus the risks of destroying assets and health and the threat
of revolution. The de facto power of the disenfranchised had increased and because of the
threats democracy was, in many ways, forced on the elites. This resulted in political and
institutional changes. This was the first step to the future allocation of de jure power. The rise
of democracy had begun. (Source: Acemoglu 2004)
The First Reform act of 1832 removed some of the worst inequalities under the old electoral
system. However the Reform act did not create mass democracy and is was rather designed by
the elites as a strategic concession. The elites where still in electoral advantage and there was
also evidence of continued corruption.
The Second Reform Act (1867) and Third Reform Act (1884) increased the electorate and
working class voters became the majority in all urban constituencies. The Redistribution Act
of 1885 removed many remaining inequalities in the distribution of seats. From now on
economic institutions also began to change. (Source: Acemoglu 2004)
Civil services where opened to public examination. The introduction of a huge amount of
labor market legislations favored workers position in relation with the industry. During 1906-
1914, the Liberal Party introduced the modern redistribute state into Britain. The introduction
of health and unemployment insurance, government financed pensions, minimum wages, and
a commitment to distributive taxation resulted in more equal Britain after the 1870’s. Also the
education system was extended and opened up for all classes. The People Act of 1918 gave
the vote to all adult males and later on to all women (1928). These changes in economic
institutions had a great, positive, influence on the British economy. (Source: Acemoglu 2004)
The twentieth century also has seen Britain fight two world wars at considerable human and
crippling economic cost. The first half of the 20th century saw a serious depletion of strength
of Britain. The second half witnessed the dismantling of the Empire but Britain rebuild itself
into a world leading, modern and prosperous European nation. (Source: UK information
guide, British History)
Conclusions
Overall, it can be concluded that there has been a clear shift in power that stared in 1832. In
the beginning Britain was governed by the relatively rich. The de jure and de facto power was
in hands of the rural aristocracies. However, under pressure by the threat of revolution, elites
where forced to introduce economic and social changes, which changed the de facto power of
the disenfranchised. Workers now also demanded political rights, which would allocate future
political power to them. Changes in political institutions influenced the economic situation,
which had led to a different distribution of resources. Changes in the labor market, in
government policy, in the educational system reduced inequality over time. Mass
democratization, which reallocates the durable de jure power away from the elites to the
masses, was a fact. From now on also the poorer segments of society could vote to implement
economic institutions and policies consistent with their own interests. A general result of the
democratization is that the economic institutions changed radically in favor of those newly
endowed with the de jure political power, mostly the relatively poor. (Souce: Acemoglu 2004)
6
Comparison
Over a long period, Britain and France were ruled and invaded by several nations. In the
Middle Ages several kings took over power.
In the 17th century Louis XIII ruled France and Cardinal Richelieu made France from a feudal
monarchy to an absolute monarchy. The power of the monarchy was now at his strongest
level. This absolute monarchy remained under the reign of Louis XIV. Louis XIV changed a
lot of economic institutions to stimulate and control trade, industries and colonization. The
bureaucratization of Louis XIV started out well through stimulation of the France market and
subsidizing the transport cost of French merchants. But the reign of Louis XIV also failed in
several areas. When he died, the de facto power of the Bourgeoisie was rising. The
commoners wanted equal rights and an abolition of the class system. In 1789 the crisis was at
his highest and the lead to the French revolution.
In Britain, the Tudor monarch was not able to create an absolute monarchy as in France.
Mainly because the Parliament blocked attempts to concentrate power. The Crown wasn’t
strong enough to control overseas colonies so individuals and small enterprises developed.
Britain needed these enterprises, because it had a lot of inhabitants living oversees, while
France had mainly slaves living in the oversees colonies. (Source: Engerman, Sokoloff) There
were not high entry barriers to the merchant class, so the group of merchants grew rapidly.
The Kings thought that they could keep power, despite of the growing power of the
merchants. This led to a Civil War between parliament and the kings. After this war, Britain
grew even faster because of the reform of the political and economic institutions, forced by
the parliament. In France, in this period the absolute monarchy was still at its strongest. The
French merchants had less rights then the merchants in Britain and so the France economy
was not growing as fast as in Britain. While France was struggling and waiting for the
revolution, Britain was changing enormously. This happened, because of the change of the
distribution of de facto power. In Britain, the property rights became more secure through the
huge expansion of financial institutions and the Industrial Revolution.
Despite the great power of the Britain Empire, the French troops controlled Europe. The
Revolution of 1789 in France ended when Napoleon entered Paris. Napoleon reformed France
by changing the justice, educational, military systems. In France, during this period, 160 years
later as in Britain, the economic institutions changed and the inhabitants got more secure
property rights. But Britain remained economically stronger than France; despite of Napoleon
started invading Europe and Northern Africa. These military campaigns cost France a lot of
money. Napoleon conquered a large Empire, but got himself in trouble by fighting in Russia
and later against England.
In Britain, small elites were taking over power in the parliamentary monarchy when the
Industrial Revolution progressed. The industrialization in combination with the presence of
bad economic institutions for the poor, especially in the labor market, played a huge role in
the change towards democracy. Upcoming, relatively well-organized, disenfranchised masses
were gaining de facto power from the parliamentary monarchy that was mostly in the hands of
a small number of elites. Reform acts led to a more equal distribution of seats, which caused a
shift in political power (de facto and later on de jure) and changing economic institutions.
This led to the democracy as there still is today. In France, after the Revolution, the Crown
was restored but this could not be maintained, because of the pressure of the merchants and
entrepreneurs, so a Republic was created. In 1848, France started growing towards a
democracy. This democratization leads to a catch up with Britain. Trade and industry began to
flourish. Despite of a war with Germany, the French economy grew fast and France became a
democracy.
7
In the beginning of the 20th century, Britain and France started the Triple alliance with Russia.
When Russia got involved in a war with Germany, France and Britain started the First World
War. Until the end of the Second World War the growth was slowed down. The slowdown
was the largest in France, because France was captured and Britain could trade with the
United States. After the wars, both countries were characterized by economic growth,
consumerism and technological advancement. De Gaulle centralized the power of the
government in France even more. This gave the president a lot of power. In Britain, the
government remained decentralized. Britain and France grew to become powerful countries
within the European Union and in the world.
Although the history of institutions is very different between France and Britain, they are
almost equally rich nowadays. Different institutions caused similar incentives and similar
growth. This does not mean that institutions are not important. Important for the growth in
France and Britain was the Industrial Revolution. The important changes in institutions in
France and Britain had been introduced before and in the beginning of the Industrial
Revolution. At the beginning of the Revolution, Britain was a stable monarchy and the
institutions helped the industry to develop. The Industrial Revolution in France started later
on. It started at the time when France became a stable democracy. Thus, it is important for a
country to have stable institutions. These institutions are important apparatus to help a country
to develop.
Overall, can we concluded that Britain moved ahead economically after the middle ages. In
Britain, the presence of the Parliament and its increasing political influence resulted in a
favorable trade climate and good economic institutions. France was still an absolute
monarchy, while Britain starts to industrialize and democratize. It took until after the French
Revolution and the Napoleon era for France to catch up. In this period France became a
Republic. In France, from this period on, the good economic institutions also had been
introduced. In the period of the two world wars, the growth in Britain and France had slowed
down. After the Second World War, both countries grew rapidly. Britain remained a relatively
decentralized ruled country, while France, under the influence of the Gaulle, had become
more centralized. Nowadays, France and Britain are rich countries with respectively a GDP
per capita of $27,600 and $ 27,700.
8
References
Acemoglu, D., Johnson, S. and Robinson, J. "Institutions as the Fundamental Cause of Long-
Run Growth." NBER working paper 10481 (2004)-LVIII – nr. 1
Engerman, Stanley L. and Kenneth L. Sokoloff. “Factor Endowments, Institutions, and

Differential Growth Paths among New World Economies” (1997)
Great Britain - UK information guide, British History

<http://www.great-britain.co.uk/history/history.htm>
Britannia, British History by Hampton R. and Fox S.

<http://www.britannia.com/>
Frankrijk Bronnen: Bailey, R. 2000, Lonely Planet, 2001. Van Reemst. 1999.
<http://www.landenweb.com/l.cfm?LandID=149&FRANKRIJK>
French History Timeline

<http://www.uncg.edu/rom/courses/dafein/civ/timeline.htm>
9
2. Argentina vs. United States of America
Introduction
In the 16th century the Aztecs and Incas in the America’s were among the richest civilizations
in the world, yet the nation states that now coincide within the boundaries of these empires are
among the poorer societies of today. At the same time, the countries occupying the territories
of the less-developed civilizations in (North) America are now among the very richest
countries in the world. Acemoglu, Johnson, and Robinson (2004, p.21) claim that this
“reversal of fortune” can be explained by the impact of European colonialism on the
economic institutions in these countries. This paper will perform two case studies in order to
verify whether this analysis is correct. Firstly it will examine the impact of colonization on
Argentina, secondly on the United States of America, and finally it will come to the main
conclusion that the fundamental cause of the differences in institutional developments
between the Argentina and the United States is the historically used type of colonization. The
initially established political institutions by the colonizers have been very important
determinants for the following institutional developments in both Argentina and the United
States.
Argentina
1. Introduction
During the end of the 19th century and the beginning of the 20th century, Argentina had been
an economically emerging country with exceptional comparative advantages. It was one of
the largest and best- endowed countries in Latin America, with economic, social, political and
institutional developments comparable to those of developed countries. Although, in the 16th
century, the Spanish colonizers had not established very elaborate and favourable institutions
in the country.
Even though many countries experienced strong economic growth in the years after the
second World War, Argentina has lagged far behind in the second half of the 20th century.
(Source: Véganzonèz & Winegrad) In this case political and institutional developments in
Argentina are discussed, which are, for a large part, responsible for these, rather exceptional,
economic developments in Argentina.
2. Historical development of institutions
A milestone in the history of Argentina was the colonization of the country by the Spanish.
After the Inca’s, the powerful Spanish came to the county of Argentina in search of silver and
gold. They established a set of institutions aimed at extracting resources rather than respecting
the property rights of the majority. After the colonization by the Spanish and until the
independence of Argentina by the first constitution in 1816, the political institutions were
primarily consequences of shifts in de facto political power of internal or external authorities.
These shifts were dependent on the changes in distribution of resources. Thus, because of the
extractive form of colonization by the Spanish, there were no incentives for them to establish
elaborate political and economic institutions. Nonetheless, the Spanish placed Buenos Aires
on the map as an important mercantile town of the world. (Source : Van Reemst, van der
Doef, Frank, Hotwijk & Thielen, 2001/2002)
10
At the time of the independence of Argentina there was a struggle for power between
centralists and federalists. This initiated between the so-called ´Unitario´s´, supporters of
central political authority, and the leaders of the provinces and landowners, ´gaucho´s, who
did not want to submit to the central authority in Buenos Aires. Internal physical struggle
between federalists and centralist ultimately leaded to the victory of Urquiza, a supporter of
central power, over the federalists. The party with most de facto power thus saw the
opportunity of altering the political institutions in her favor and thereby gained more de jure
political power; in 1853 a new constitution and a federal presidential system were founded
and Urquiza became the first president of Argentina. The president gained an enormous
amount of power, because he became the political leader of the country and he gained the
right to veto. Under the new political institutions, economic institutions were improved during
the 19th century and the beginning of the 20th century; the educational system was improved,
there was state-induced industrialization and the economy was modernized. During this
period of economic prosperity, Argentina was pretty much commercially integrated with
Europe. This was an important reason why, at that time, the country was experiencing rapid
economic growth, like in western countries. Paradoxically, the big landowners, financial elites
and most important exporters actually had most of the power during these times of economic
prosperity. Although formally now there was a democratic system with elections, the reality
was that the power remained in the hands of the elite who largely ran the country in the
interests of the landowners.
11
External shocks like wars and economic crises had leaded to new ideas and ideologies and
thereby to collective insubordination among the middle class, which lead to transformations in
the distribution of de facto political power. Moreover, The Industrial Revolution formed the
ground root to the emergence of political movements. This had also caused gradual changes in
de jure political power, in the form of movements towards a formally social democracy by
Juan Péron. Péron, an absolutist dictator, had gained a lot of support among the people during
World War ΙΙ. Even though he was arrested in 1945, the protesting Argentinean people
managed to get him back in power. This way he became president and regained de jure
political power. With this power he managed to restructure the economic institutions in
Argentina; he improved the social structure of the economy, encouraged investments and
nationalized all big companies and actually the entire economy. Economic welfare increased
and there was increasing support for Péron. Nonetheless, Péron was a very authoritarian
leader, who was not afraid to use violence. The established unions also didn’t have much
power at that time, because of the direct guardianship of the government. When the economy
had to suffer decay in the fifties, Péron decided to resign under the political pressure of the
army, the church and the elite.
The years between 1955 en 1973 can be characterized by political chaos, with many coups
d´état and takeovers. Though a new president had prohibited all political parties with the idea
to create political rest, the support from the Argentinean population to Péron had been very
extensive. So extensive that the new president was forced to recognize his party again. Thus,
because of the massive support of Péron, his implicit de facto political power, the newly
created political institutions were not strong enough to prevent Péron from having political
influence and regaining a certain amount of de jure political power. However, his come back
had not been much of a success, due to the problems of political chaos.
Between 1976 and 1983 a military authority under the leadership of general Videla took
control. His leadership was one of military suppression. This type of extorting bad political
institutions, like bureaucratic politics, lead to an at least equally bad economic situation. This
severe economic situation was also for a large part caused by the restructuring of economic
institutions under the Videla administrations towards more liberalization, which caused a
huge increase in public debt and in inflation.
Due to miserable economic circumstances, bad political institutions and military pressure
from remainders of the Videla era, promising president Raúl Alfonsín could not improve the
situation during his leadership.
Carlos Menem, winner of the following elections improved economic institutions; he limited
inflation, reallocated public savings and stimulated free (international) trade, partly through
approaches to the IMF and the World Bank for help. His economic liberalization was actually
more successful. However, he gained de facto political power by favoring the powerful elites
and abused this power by appointing friends for political positions and by reforming the
political institutions in his favor by introducing the possibility of obtaining a second term of
office. Using the theory of Acemoglu (Source : Acemoglu 2004): although he improved
certain economic institutions, Menem abused his political power to obtain more power and to
be able to reform the political institutions of Argentina in his favor. A combination of formal
political democracy and stagnating social democracy caused existing institutions of political
democracy to lose credibility. (Source : Buve 2004) Although the intentions of Menem might
not always had been the right ones, he managed to successfully reform economic institutions
after many years of economic decay.
After other presidents have had a difficult time under economic decay, Nestor Kircher has
become the current president of Argentina. In 2002, Argentina faced an enormous financial
crisis; to high a public debt and an unsustainable one-to-one exchange rate of the peso with
the American dollar, resulting in an overvaluation of the peso.
12
These problems lead to very serious credibility problems in the Argentinean economy.
(Source : Van Reemst, van der Doef, Frank, Hotwijk & Thielen, 2001/2002) Partly because of
a serious political crisis, in 2002, the Argentinean government has finally dropped the so-
called currency board, an important cause of these current economic problems. The reason
why Argentina had not already dropped this currency board has something to do with political
and institutional impediments. A fundamental cause is again a struggle of power between the
central and decentralized governments, already referred to in the first part of this chapter. Two
main problems have arisen in Argentina. In the first place the system of a combination of
taxation by the central government and spending of the provincial governments is inefficient,
because the system causes free rider and moral hazard behavior of the provincial governments
due to weak budget constraints. This has created such a large public debt. Secondly both
central and provincial governments do not want to lose their formal de jure political power
and that is why a complex and unclear system of regulation is implemented; there are no
incentives for both central and provincial governments to create an institution to supervise
their implementation of established agreements. This is why the system lacks decisiveness to
make certain important decisions, like the decision to drop the currency board.
3. Conclusions
The colonization of the country of Argentina by the Spanish was one of extraction of natural
resources and without the establishment of clear political institutions. This is why the initial
political institutions (at the time of the colonization) were not very elaborate and didn’t secure
property rights very well.
These initial institutions caused much of political instability and shifts and de facto and
instability between de jure and de facto political power. De facto political power has generally
been in the hands of elite groups like landowners, while de jure political power was executed
by different, mostly authoritarian, political leaders. This asymmetry of powers has led to
multiple coups d’états and other takeovers of de jure political power.
Authoritarian political leaders have, several times, changed political institutions in their favor.
They just did not want to loose power. They have also influenced economic institutions, like
Some leaders, like Urquiza, Péron and Menem have succeeded in improving the institutions.
They managed to secure property rights, to modernize the economy and to improve labour
marktet conditions. Others like Vidéla have only worsened them. Hid librtation policy has
lead to increasing public debt and inflation.
The Industrial Revolution caused the need of social economic and social political
developments in the western countries, like the emergence of unions and free elections.
However, the, often self-enriching, political regimes in Argentina have never really succeeded
in encouraging these developments.
A severe lack of social democracy and political struggles between central governments and
powerful elites, have led to a serious lack of decisiveness within the Argentinean government.
This lack of decisiveness has led to many economic difficulties during the second half of the
20th century. The conclusions are summarised in Figure 2.1, derived from the model of
Acemoglu. (Acemoglu, 2004)
13
Figure 2.1
United States of America
1. History
In 1492 Columbus, sponsored by the Spanish King to find a direct western all-sea route to
Asia, accidentally discovered the America’s. Shortly after this all major European powers
(France, England, the Netherlands, but most notably Portugal and Spain) founded settlements
in the New World.
At the end of the 16th century, with its overwhelming military and maritime power, Spain had
conquered most of South and Central America and large parts of North America (Mexico).
These countries contained an enormous wealth in natural resources and were rather densely
populated. In its conquest for gold and silver the Spanish rulers established a set of
institutions aimed at extracting resources rather than respecting the property rights of the
majority.
During the first half of the 16th century the other European powers had only played a role in
the margin. England and the Netherlands, however, were rapidly gaining economic and
military strength and began to challenge the Spanish supremacy. Especially England began to
claim territory in the New World and in response to this, but also to punish England from
wandering from the Catholic path, did Philip II send forth his naval “Armada” in the year of
1588.
As noted by William Elson (1904, Ch.5) few events in history have been more far reaching
than the destruction of the Spanish Armada. It marked the end of the Spanish dominion of the
sea, and, where Spain had conquered Mexico and most of South and Central America, the
British became the colonizers of the present-day United States of America.
2. Early Institutions
Because the native population of North America was small in number, relatively low-
developed, and not endowed with large quantities of silver and gold the British had little to
gain from a set of institutions aimed at extracting resources and plundering the natives.
Instead the British founded (in total 13) self-supporting colonies along the Atlantic Coast and,
other than the operation of the Navigation Acts to regulate trade, allowed the colonies to go
their own way. These colonies were:
14
Massachusetts
New Hampshire
THE NEW ENGLAND COLONIES
Connecticut
Rhode Island
New York,
Pennsylvania
New Jersey THE MIDDLE COLONIES
Delaware
Maryland
Virginia
North Carolina
THE SOUTHERN COLONIES
South Carolina
Georgia
Source: Bloy (2004)
In these colonies only partial British rule applied. “Each of the thirteen separate colonies had
a Governor appointed by the Crown. He was responsible only for trade and defense. The daily
administration -by-laws, internal taxation and so on - was in the hands of local, very
democratically elected colonial assemblies. Each of these had two Houses: the Assembly (the
colonial equivalent to the House of Commons) and Council (the equivalent to the House of
Lords). The Council was made up of important persons in each colony.” (Source: Bloy, 2004)
A direct consequence of the political institutions as set forward by the British was that a broad
cross-section of colonists (with significant investment opportunities) was in charge of
establishing the economic institutions in the colonies. The resulting economic institutions, as
a consequence, ensured broad-based property rights with rather effective enforcement,
relatively good access to economic resources, and strong entrepreneurial incentives. Basically,
the foundation of the economic success of the British colonies was already present in its
earliest political and economic institutions.
3. War of Independence
In 1763 England had won the Seven Year’s War against France and gained full control over
Canada. Suddenly the size of British territory in North America had doubled which put a
severe strain on the Royal treasury. To increase revenues Britain started to tighten its control
over the 13 colonies and impose various regulations and taxes. During the 17th and 18th
century, however, the 13 British colonies had grown vastly in economic strength and become
highly independent from Britain. Not only did the colonists denounce the heavy taxation, they
passionately resisted any reduction in self-governance.
“The conflict escalated and King George III issued a proclamation on August 23, 1775,
declaring the colonies to be in a state of rebellion. On July 4, 1776, the Continental Congress
adopted a Declaration of Independence. Armed conflict between America and England lasted
until 1783. Known as the Treaty of Paris, the peace settlement acknowledged the
independence, freedom and sovereignty of the 13 former colonies, now states, to which Great
Britain granted the territory west to the Mississippi River, north to Canada and south to
Florida, which was returned to Spain.
The 13 colonies were now "free and united independent states" - but not yet one united nation.
The success of the Revolution gave Americans the opportunity to give legal form to their
ideals as expressed in the Declaration of Independence, and to remedy some of their
grievances through state constitutions. As early as May 10, 1776, Congress had passed a
15
resolution advising the colonies to form new governments. On a national level, the "Articles
of Confederation and Perpetual Union" produced by John Dickinson in 1776, were adopted by
the Continental Congress in November 1777, and they went into effect in 1781. The
governmental framework established by the Articles had many weaknesses, for example the
national government lacked the authority to set up tariffs, to regulate commerce and to levy
taxes. It lacked sole control of international relations: a number of states had begun their own
negotiations with foreign countries. Nine states had organized their own armies, and several
had their own navies.
In May 1787, a convention met in Philadelphia to draft a new Constitution which established
a stronger federal government empowered to collect taxes, conduct diplomacy, maintain
armed forces and regulate foreign trade and commerce among the states. The Constitution
divides the government into three branches, each separate and distinct from one another.
The powers given to each are delicately balanced by the powers of the other two; and each
branch serves as a check on potential excesses of the others.” (Source : History of the United
States, 2004)
So, without the interference of Britain, the economic framework of the United States became
a little bit more favorable towards long-term economic growth. But as the colonies already
had quite “good” economic institutions, and the involvement of Britain in its North American
colonies had never been large, the main improvements were indeed in the political sphere.
The new political system placed strong checks on the legislative, executive, and judicial
branch of government1, preventing those in power from creating a set of economic institutions
that are beneficial for themselves yet detrimental for the rest of society. This not only ensured
the future survival of the “good” economic institutions but also led to a stable and trustworthy
government, both of course in favor of economic growth.
Figure 3.1 captures the events of the War of Independence in the framework as proposed by
Acemoglu, Johnson, and Robinson (2004) The political institutions before the War of
Independence had been introduced by the British and divided de jure political power between
the governor (trade and defense) and the colonists themselves (responsible for everything
else). The distribution of resources, and consequently the de facto political power in the
colonies, was absolutely in favor of the colonies. Yet the British had one very important
trump: they provided the much needed protection against the French. In return for this
protection the colonies paid taxes to the Crown and there was a balance in the system.
As mentioned before, this delicate balance was disturbed when the British defeated the French
and the colonies became substantially less dependent on the U.K. for their military protection.
At the same time, the U.K. started to use its de jure political power to a) further increase its de
jure political power at the expense of the power of the colonies and b) substantially raise the
tax burden on the colonies. These “external shocks,” as Acemoglu, Johnson, and Robinson
(2004, p.6) would refer to them, modified the balance of power -and gave rise to such a
discontent with the British among the colonists- that they eventually resulted in the War of
Independence.
1
Noteworthy is that even today the political system of the United States is still essentially the same as it was set
forth in the constitution of 1787!
16
Figure 3.1
After the War of Independence, as can be seen in figure 3.1, the distribution of resources was
of course not entirely the same as before the war. The important changes in de facto political
power however were mostly the result of the diminution of British military power in the
former colonies. With the British gone the confederate colonies were able to introduce a
completely new set of political institutions which, as mentioned earlier, placed strong checks
on the legislative, executive, and judicial branch of government. This resulted in a stable and
trustworthy government and, as was also mentioned before, in an economic framework that
became even more favorable towards long-term economic growth.
4. Civil War
When slavery was introduced in North America in the 17th century it soon died in the New
England and Middle colonies where it did not work for a society based on small farms and
shops. But it flourished in the Southern colonies where the climate facilitated large plantations
which required large amounts of workers. Before (and during) the American War of
Independence this imposed no problem, as the differences between the North and South were
of minor importance compared to their common interest in opposing Britain. After the War of
Independence, differences between the North and South were worked out through
compromises. During the course of the 19th century, however, when the industrial revolution
caught momentum in the North and the balance of economic and political power began to
shift, slavery eventually led to the largest conflict in the history of the United States of
America.
Of major importance was that the southern states remained predominantly agricultural with an
economic and social system highly dependent on plantations and slavery. While slavery for
them had become an economic institution distanced from theoretical and ideological issues,
public opinion in the North began to turn against the concept of human slavery. “But even as
the need to protect [the institution of slavery] grew, the ability, or at least the perceived ability
of the South to do so was waning. Southern leaders grew progressively more sensitive to this
condition. In 1800 half of the population of the United States had lived in the South. But by
1850 only a third lived there and the disparity continued to widen. While northern industrial
opportunity attracted scores of immigrants from Europe in search of freedom the South's
population stagnated. Even as slave states were added to the Union to balance the number of
free ones, the South found that its representatives in the House had been overwhelmed by the
17
North’s explosive growth. More and more emphasis was now placed on maintaining parity in
the Senate. Failing this, the paranoid theory went, the South would find itself at the mercy of a
government in which it no longer had an effective voice.” (Source : Harrison, 2004)
Clearly the North had a distinct advantage in its ability to produce soldiers and supplies and
thus to win the war, yet the South’s fear to lose their way of life was big enough to secede
from the Union and form their own confederacy and risk going to war. As President Lincoln
was determined to keep the Union together and did not allow the Confederate States to
secede, the conflict eventually led to the American Civil War of 1861-1865.
Figure 4.1 again captures the events leading to the U.S. Civil war in the framework as
proposed by Acemoglu, Johnson, and Robinson (2004). The basic shock that can be identified
is the industrial revolution, which -over time- shifted the balance of both de facto and de jure
political power towards the Northern states. At the same time public opinion in the North
starts to turn against the single most important economic institution of the Southern states:
human slavery. The South feels more and more threatened by the North, culminating in the
seceding of eleven southern states from the union. As mentioned before, President Lincoln did
not allow them to form an independent nation which is why proceedings eventually
culminated in the U.S. Civil War.
Figure 4.1
In retrospect it is clear that the war was won by the North and that the political situation
returned to the pre-war situation. The Southern states re-joined the U.S.A. and were forced to
abolish the (economic) institution of slavery. Although a major event in America history with
important social implications, the Civil War only led to minor changes in the economic
institutions. In conclusion, the Civil War is a good example to demonstrate the relevance of
the framework of Acemoglu, Johnson, and Robinson (2004) but the event itself did not
significantly affect the long-term economic growth perspectives of the U.S.A.
18
3. Conclusions
The colonization of the America was not one of extraction and plundering natives, because
the country did not have many natural resources of interest. Instead the English settled in the
country and decided to create economic institutions that ensured broad-based property rights
with rather effective enforcement, relatively good access to economic resources, and strong
entrepreneurial incentives.
Because of fairly democratic political institutions, de facto political power was, very soon, in
the hands of the population of the thirteen separate colonies. The de jure power was for a
small part in the hands of Governors appointed by the Crown. However, most de jure power
was given to the very democratically elected colonial assemblies.
The established political and economic institutions had lead to economic welfare and strong
autonomy, especially in the northern states.
These favorable economic developments in the northern states, facilitated by the Industrial
Revolution, caused a large immigration flow into the northern states. This immigration inflow
leaded to a shift property rights in favor of the northern states. The de jure power of these
states in the House increased and these states finally overpowered the southern states.
As already mentioned, the Civil War is a good example to show the relevance of the
framework of Acemoglu, Johnson, and Robinson (2004) but in itself, the event did not
significantly affect the long-term economic growth perspectives of the U.S.A
Comparison
Argentina had been developing very well during the second part of the nineteenth century, but
it has been by far outpaced by the United States since World War II.
A fundamental cause for this development is the difference in colonization between the two
countries. Generally, in Argentina natural resources were extracted and not much attention
was paid by the colonists to establishing stable economic and political institutions. In
contrary, in the United States, the English decided to found good institutions, because they
intended to establish themselves in this country.
The main consequence for the United States was real and stable democracy. Instead, in
Argentina there was formal but no real democracy. Instead there have been authoritarian
regimes and very powerful self-enriching elites. Moreover there has been instability in
political and economic institutions and in de jure political power.
Before World War II, Argentina had been able to develop pretty well, because of large
resources of natural resources and intensive relationships with other western countries.
However, after World War II, developments in Argentina completely turned around and years
of political chaos followed. Mainly because of the lack of good institutions, Argentina faced
troubles with the arrival of the Industrial Revolution and the trend of liberalization. On
contrary, in the United States, especially the northern states, prospered very well. The de facto
and de jure increase of power of the northern states created the possibility for them to further
improve institutions. For example, slavery was completely abolished.
Nowadays, Argentina still faces the problem of vague political institutions and the fear of
political leaders to loose political power. The distribution of power between central and
decentralized governments is unclear and this causes a serious lack of decisiveness. On
contrary, the United States have only gradually improved their stable political and economic
institutions. Moreover, nowadays, the political system of the United States is still essentially
the same as it was set forth in the constitution of 1787.
19
References
Acemoglu, D., Johson, S. and Robinson, J. "Institutions as the Fundamental Cause of Long-
Run Growth." NBER working paper 10481 (2004)
Arda, Atilla. and Edwin Lambrechts. “Institutionele problemen achter de crisis in Argentinië”,
Tijdschrift voor Politieke Ekonomie 2003 derde jaargang 24(4) 3-15
Buve, Raymond. “Democratie in Latijns- Amerika: voor vrienden de regering, voor vijanden
de wet”. Internationale Spectator januari 2004
Jonker, Marcel. The economic crisis of Argentina; needed: a government and a plan, final
paper
Véganzonèz, Marie-Ange and Carlos Winograd. Argentina in the 20th century: an account of
long-awaited growth. OECD, 1997
Argentinië. Bronnen: Van Reemst, 2001, Doef, P. van der 2001, Frank, N. 2002, Holtwijk, I.
2001, Thielen, J. 2002
<http://www.landenweb.com/geschiedenis.cfm?LandID=164&ARGENTINIË>
The Origins of the American War of Independence. Bloy, M. Oct. 4th 2004
<http://dspace.dial.pipex.com/town/terrace/adw03/c-eight/america/amorigin.htm>
History of the United States - Revolutionary Period and New Nation. American Information
Resource Center (AIRC), U.S. Embassy in Warsaw & U.S. Consulate General in Krakow,
Poland. Oct. 4th 2004
<http://www.usinfo.pl/aboutusa/history/revolutionary.htm>
The American Civil War – The Causes. Harrison, T. Oct. 4th 2004
<http://www.swcivilwar.com/cw_causes.html>
20
II. 1 (G62) Investment policies
Jeffrey Oudeman (analyst)
Marcel Mulken (statistician)
Jasper van Hekken (manager)
Paul Gille (analyst)
EDUCATION POLICIES
Human capital is generally seen as a key factor that contributes to high levels of income and economic
growth. Human capital is the result of education and on-the-job training, but also results from
experience and learning externalities. The OECD provides the following definition of human capital:
The knowledge, skills, competencies and attributes embodied in individuals that facilitate the creation
of personal, social and economic well-being (OECD,2001).
This paper is about what should be done by policy-makers to make sure education is arranged in the
best way. So how can education contribute best to economic growth? First we are going to see why
people chose to go to school and we will check whether they go to school enough; are individual
returns to education high enough to make sure people take enough education or should people be
stimulated to go to school more because positive externalities exist?
In the second part of this paper we will compare the USA and Europe. In the US education is more
general and concept-based, while in most European countries (Germany) education is more skill-
specific. The question is: What is better for economic growth? Should we invest in general education
or skill-specific training?
1. Education and its effect on economic growth
The European Union (E.U.) wants to be by 2010 the most competitive and dynamic knowledge-based
economy in the world, capable of sustainable economic growth with more and better jobs and greater
social cohesion (European Council, Lisbon 2000). Also in the Netherlands politicians are talking a lot
about our knowledge-based economy and about how to be more innovative and increase our human
capital (which encompasses characteristics like education, work experience and health) etc. One of the
political parties, which is now one of the political parties in office, D66, even made education their
main topic during the election campaign last year. At the presidential election in the US last year,
education policies played a very important role.
1.1 Growth – education links

Education has many direct and indirect effects (& externalities) both on micro and macro level. The
figure below gives an overview of these effects.
Source: Dahlin, B.G. , “The Impact of Education on Economic Growth,” Duke University
We like to focus on the macro level and the effect of two kinds of education on economic growth.
Based on the above diagram (of course with underlying assumptions and the scientific proof for the
effects as presented) we can say that education causes higher economic growth in four ways:
1. Increased earnings (higher productivity)
2. Increased earnings of neighbours (learning through observation)
3. Higher participation in the labour force which results in a increased labour force
4. Lower population growth and better health of population (and labour force)
The first one of the above list is the most important, so education causing higher productivity and thus
higher economic growth, that’s what we will review and discuss.
While it might seem obvious that there is a link between education or human capital on the
one hand and a nation’s growth rate of GDP on the other hand, it is quite difficult to find statistical
evidence for such a link; some empirical studies even find the link to be insignificant. Imperfect
techniques to measure the education of individuals and the aggregate human capital of an economy
might be among the reasons why this link turns out to be insignificant in some empirical studies.
Disagreement in the results of those empirical studies sometimes does arise because of different
measures of education and different definitions of human capital. For example the number of years
spent on school, the quality of the schooling, the nature of the curriculum and the student’s effort are
all components, which should be included in an ideal measure of an individual’s education. Still we
think economic literature as well as empirical studies generally supports the view in which education
and human capital are positively related to the growth rate of GDP.
1.2 Education and its returns

The idea of positive educational externalities is that the benefits of individually acquired education
may not be restricted to the individual but might spill over to others as well - that is, to other
individuals in the same industry, city, region or economy. Indeed if social returns at the macro level
exceed the private returns on the micro level, increased public support for education is justified. There
is compelling evidence that human capital increases productivity, suggesting that education really is
productivity-enhancing rather than just a device that individuals use to signal their level of ability to
the employer.1 Whether there is insufficient investment in human capital, however, is subject to
debate.
We can distinguish between the return of education for individuals and for the society as a
whole. When we look at individuals we mostly look at the earnings. People prefer a high wage and
therefore are willing to invest in their skills and capabilities. The question is how much they benefit
from more schooling and at what cost. It is also the case that education stimulates not only individuals
but also shift outward to the public, so education also has a positive effect on others.
It is obvious that when we stimulate education, people get more “human capital” and therefore
become more skilled. When people become more skilled they can stimulate a countries economy and
also earn more individually. But when we look at the earnings only, 40% of the variation is explained
by measures such as educational qualifications, literacy and work experience.
When we look at how human capital can affect earnings we find that earnings depend on:
• years of education
• skills that do not always come from more education, but from the other sources (like
background), and
• factors that are not quantified (like race)
The standard approach to explain the variations in wages, where the explanatory variables include
years of schooling, either age or a simple proxy for experience, and other characteristics, is based on
the work of Mincer. The formula is:
Ln w = α + β0S+ β1E+ β2E2
This equation gives a relation between the logarithm of wages (w) to the years of schooling (S) and
labour experience (E). It has to be said that the evidence that earnings are positively associated with
schooling is robust and uncontroversial. A problem is that, because of a lack of suitable data,
important data that probably are correlated with both schooling and earnings has to be included. It also
seems probable that the costs and benefits of education vary across individuals. But when we look at
the figure below we can see that there is a relation between schooling and wage.
1
“The returns to education: A review of the empirical macro-economic literature”
Sianesi and van Reenen
We can say that not all earnings variation is due to human capital. People vary in the extent to
which they trade of earnings against other job factors, like job-satisfaction and working hours. It’s also
that in real life we haven’t got a perfectly working market, so individual earnings is not determined
entirely by each person’s productive capacity and the level of individual investment. Factors like
discrimination on grounds of race and gender or shocks in technology are mostly beyond control of the
individual wage earner.
1.3 Government intervention

We can ask ourselves if education should be stimulated and, if so, in what way? What are for example
the roles of schools, family and social environment? What kind of intervention could help to improve
education and thereby the competitiveness of a country.
Parent have an important influence on education. In many well-development countries, young
people whose parents have completed some tertiary education, are about twice as likely to participate
in tertiary education as those of parents that haven’t got such a high schooling level. Well-educated
parents can stimulate their children in different ways. They have skills which can be thought to them
and also have a better ability to pay for their children compared to less educated (wealthy) people. It
has to be said that this connection between parental education and skills is a modest one. ‘Rich
children’ can have better opportunities but this won’t say that therefore they become more skilled.
Another aspect worth noting when we look at intervention is the social environment. Not only
parents play a role in decisions but also other family members, colleagues and friends. Beside that you
have people who are trusted and well informed about career and educational opportunities and there
are organizations who provided trainings to make people more skilled. Access to these ‘instruments’
will depend on individual skills as well as the existence of networks. The benefits of guidance can be
seen individually through better learning strategies, career decisions and greater satisfaction. The
collective benefits could include better-targeted human capital investment and better job and skill
matching which can lead to a higher output.
Hence, for children with uneducated parents or those in an education-adverse social
environment, the private return to schooling is probably lower than the social return. Intervention is
justified, for example in the form of enhancing access to schools targeted at special groups.
2. Two types of education and expenditures on it in US and EU

Skill-specific or general education: which should we favour?
We distinguish two types of education, namely a specialized, skill-specific, vocational education and a
concept-based, general education. Europe (we will focus on the EU) has a focus on specialized, skill-
specific, vocational education and fostering it at the upper-secondary (secondary schooling from the
age of 14) and tertiary level. While the opposite is true for the United States, as we can see in Table 1.
Table 1: Education Indicators

Country % Upper % Upper University Non- University Non- University
Secondary Secondary Net Entry University Tertiary University Tertiary
in General in Vocational Rate Tertiary Attainment Tertiary Return
Education Education Attainment Return
France 47 53 33 8 11 18 14
Germany 23 77 27 10 13 17 11
Italy 28 72 8 10
Netherlands 30 70 34 22 11
EU 42.4 57.6
US 52 8 25 9 13
Source: Krueger, D. , “US-Europe Growth Differences: The Role of Education,” University of
Pennsylvania, CEPR and NBER
The educational system in Europe is known as rigid and inflexible relative to the system in the United
States. Another difference is that the channelling of students into either vocational or general
education starts earlier in Europe. While in the United States there isn’t even a separate stream for
vocational education at the upper secondary level, in the EU 57.6% of the students were enrolled in the
vocational stream.
General education is primarily imparted at the universities and at that level we see the United
States have the highest net entry rate and the highest tertiary attainment from the countries included in
table 1. Of course this is reflected in the differences we see in education expenditures, as described in
table 2, between the U.S. and EU-member states. The percentage of GDP spend on primary and
secondary education (in 1998) are comparable in the U.S. and the European countries. But we see
(relative) expenditures on university tertiary education are much higher in the United States, for
example 2.3% of their GDP goes to university tertiary education, while in Germany this is only 1%.
On the other hand (relative) expenditures on vocational tertiary education are larger in Europe. Per
student figures reflect this as well, for example in PPP dollars, in the US $19,802 was spend per
student on the university tertiary education, while in Germany it was only $10,139 in 1997. Thus we
may say education expenditures in the US and in Europe do explain the differences as described in
table 1.
Table 2: Education Expenditures

Country Expend. Expend. Expend. Expend. Expend. Expend.Expend.
/GDP /GDP /GDP per per per per
Primary+ Vocational University student student studentstudent
Secondary Tertiary Tertiary Vocational as % of University
as % of
Tertiary per capita Tertiary
per capita
GDP GDP
Vocational University
Tertiary Tertiary
France 4.4 0.3 0.9 7,636 36 7,113 34
Germany 3.7 0.4 1 10,924 48 10,139 44
Italy 3.5 0.1 0.8 6,283 36 6,295 28
Netherlands 3.1 1.2 7,592 31 10,796 44
US 3.7 2.3 19,802 61
2.1 Growth differences between the US and the EU

We have just seen the differences in education between the US and the EU. Our choice is to see
whether we can determine if those differences in education are one of the reasons for the growth
differences between the US and the EU. Table 3 gives us information about the growth rates of Real
GDP per capita.
Table 3: Growth Rates of Real GDP per Capita

Country 1970-1980 1980-1990 1990-1998 1999
US 2.1% 2.3% 2.0% 3.2%
Germany 2.6% 2.0% 1.0% 1.4%
Italy 3.1% 2.2% 1.2% 1.3%
France 2.7% 1.8% 0.9% 2.5%
UK 1.8% 2.5% 1.7% 1.7%
We see that during the 1970s many European countries grew at a faster rate then the United States.
But the general picture shows us the growth in European countries slowed down, resulting in quite a
growth gap between the United States and the European countries during the 1990s and for sure during
the ICT-revolution (Information and Communication Technology). We know that even in 2004 there
is a huge growth gap between the US and EU, even after the bursting of the ‘ICT-bubble’ during
2000/2001. Of course it’s clear that this growth gap has many reasons and causes, but the differences
in education could indeed be one of them. While European focus on vocational education was
appropriate during the technologically tranquil times of the 1950s an 1960s, this focus may have also
resulted in European technology adoption and economic growth being impeded from the 1980s
onwards.
To see if the above view is correct we take a closer look at the growth rates in the
manufacturing sector. The key hypothesis we want to investigate is the following:
Vocational education enables workers to very productively operate established technologies,

while general education enables workers to adapt more easily to new technologies.
So technology adoption is faster in a country with more generally educated workers, which should
result in higher productivity (and growth rates). When we review growth rates in output per hour
(productivity) we expect the US to have higher growth rates compared to the European countries. The
manufacturing sector is most likely the sector where we could see best if our expectations are right.
Table 4: Growth Rates in Output per Hour, Manufacturing

Country 1978-1984 1985-1991 1992-2002
US 2.9% 2.4% 4.3%
Germany 2.4% 2.2% 2.7%
Italy 3.8% 1.7% 1.6%
France 4.8% 3.6% 4.2%
UK 3.5% 4.6% 2.9%
Table 4 shows us that the growth rates in the US are indeed (much) higher during the 1990s (except
for France), while in the early 1980s the EU still has higher growth rates. So we see a shift during
those two decades from lower growth rates in the manufacturing sector in the US, to much higher
growth rates compared to the ones of the EU. A gap occurs from the 1980s on and it seems to get
bigger over the years. When we take into account that the gap between the US and the EU is even
larger when we examine technology-driven industries (8.3% average annual productivity increase in
the 1990s in the US compared to 3.5% in the same industries in the EU), we have a strong indication
that our assumption and theory is right. Pharmaceuticals, office machinery and computers, motor
vehicles, aircraft and spacecraft are a few of the industries classified as technology-driven industries.
Generally we can say about these industries that (new) technology and (product) innovation play a
very important, crucial role. Firms in these industries are very much dependent on technology and
innovation and they can’t afford it to lack (too much) behind of competing firms. A good example is
the manufacturing industry of computers, with several very big companies (like IBM, Dell, Packard
Bell and Compaq), who every day need to improve their computers to keep being competitive.
Because indeed during the last 25 years we have been experiencing an increased growth rate of
technological progress with several new technologies. Which according to our assumptions and theory
should result in higher growth rates (of productivity) for countries like the US, who have relatively
more general educated workers compared to countries like Germany, who relatively have less general
educated workers. Several economists say Europe has suffered from a “technology deficit” relative to
the US. And there is lots of direct evidence that this is indeed the case. Just one example where Europe
lags behind the US in the usage of new technology is the ICT capital. Table 5 shows us the ICT
contribution to output growth.
Table 5: ICT Contribution to Output Growth (%Points)

Country 1980-1985 1985-1990 1990-1996
US 0.28 0.34 0.42
Germany 0.12 0.17 0.19
Italy 0.13 0.18 0.21
The US, Germany as well as Italy have been experiencing an increasing contribution of ICT to output
growth, but we see that in the US the ICT contribution rose much faster. So again we see the gap
between US and the European countries is only increasing.
Once more we of course have to realize and emphasize that the different types of education is
not the only explanation for the growth differences between EU and the U.S. over the years. It is also
not our aim to review those other (possible) explanations, like the introduction of the computer, the oil
crisis and the economic policy from the governments (the current big deficits from the U.S. and tax
cuts from the recent years for example).
But we do want to briefly mention some more of the evidence and theoretical and quantitative
findings found by for example D. Krueger about our subject. In economic literature and economic
scientific research is found much evidence to state that education indeed helps to cope with technical
change, one of the main and important assumptions when we review the role of the two different types
of education. The same we can say about the evidence for increase in growth rate of embodied
technological change. This is important because D. Krueger argues that ‘the emergence of a gap
between the US and Europe since the 1980s is related to the almost concurrent increase in the rate of
technological change’. He constructed a model to test the effect of the different types of education and
education policies between the US and EU. His model suggests that ‘while European education
policies that favor specialized, vocational education may have worked well during the 1960s and
1970s when technologies were more stable, they may have contributed to slow growth and increased
the European growth gap relative to the US during the information age of the 1080s and 1990s when
new technologies emerged at a more rapid pace.’ And his quantitative analysis with a calibrated
version of his model shows that the role of education may be significant. One of the examples shows
0.6 percentage point of the 1 percentage point growth gap between the US and EU in the 1990s is
explained (in his model of course) by differences in education policy, far more than the product and
labor market regulations do explain this growth gap.
2.3 Economic theory, scientific research and evidence

Of course over the years there is a lot of scientific research been done on education from an economic
point of view. Education (human capital) has a prominent place in economic theories. Many models
have been developed within the last decades, also especially about education and its effects on
economic growth. Examples are the “macro-Mincer”, and new growth theory. There are two main
approaches in how human capital with or without externalities is introduced in new growth theory:
• The incorporation of human capital as a factor input, for example by adapting the Solow
model.
• Explaining the process of knowledge accumulation by relating it directly to human capital
accumulation, or indirectly via research and development (R&D) activity.
It’s beyond our goal to discuss those kinds of models into detail, but it is interested to see if the
conclusions they draw are similar with what we found out so far. Dirk Krueger indeed argues that ‘the
recent growth gap between the US and Europe may be partially explained by Europe’s stronger focus
on vocational education, compared to the US.’ And he says ‘If our hypothesis is valid, education
reform towards more general education in Europe may have beneficial consequences for technology
adoption and economic growth. There are signs that such reforms are underway’. More generally
Brian G. Dahlin says: ‘Although the empirical evidence is difficult to interpret, macroeconomists in
the last decade have stressed the importance of human capital’s contribution to growth: The main
engine of growth is the accumulation of human capital – or knowledge- and the main source of
differences in living standards among nations is a difference in human capital.’ One thing is sure
education is a topic of ongoing research.
3. Conclusion
We have seen that education has direct and indirect effects (externalities) on both micro and macro
level. We focussed on higher productivity on macro level and the effect caused by two different types
of education, namely specialized, skill-specific, vocational education and a concept-based, general
education. Education indicators showed us that Europe has a far more vocational trained labour force,
while the US labour force is more generally educated. Education expenditures (government policy) do
reflect this picture and of course are mainly causing it as well.
Since the end of the 1980s the United States had higher economic growth compared to key
member states of the EU, like Germany. The growth gap increased during the 1990s and we see a
quite similar picture when we look at the growth rates in output per hour in the manufacturing sector.
This leads us to the conclusion that one of the causes of these growth gaps between the US and the EU
is indeed the differences in education. The technological adoption in the US is (much) higher than in
the EU, so during the past two and a half decade with an increased growth rate of technological
progress with several new technologies. Economists talk about the “technology deficit” from the EU
relative to the US, which we endorsed by giving the example of ICT contribution to output growth.
Also with respect to ICT contribution we see the gap between the US and Europe has been increasing.
So education reform to more general education in Europe may have beneficial consequences for
technology adoption and economic growth. Theoretical and quantitative findings from D. Krueger do
support the above.
Despite disagreement about definitions and measurements of education (and human capital)
and imperfect techniques to measure it, economists have done a lot of research on education and
developed several theories. Empirical evidence is quite hard to obtain and interpret and some empirical
studies even find the link between education & human capital and a nation’s growth rate of GDP to be
insignificant, still everybody seems to agree on the importance of human capital and thus education.
References
• Krueger, D. , “US-Europe Growth Differences: The Role of Education,” University of

• Dahlin, B.G. , “The Impact of Education on Economic Growth,” Duke University
• Krueger, D. and Kumar, K.B. (2003), “Skill-specific rather than General Education: A
Reason for US-Europe Growth Differences?,”
• ‘education policy analysis 2002’ OECD
• Mamuneas, Savvides and Stengos, april 2002, ‘economic development and the return to
human capital: A smooth coefficient semiparametric approach’
• Johannes Hers CPB rapport 1998,‘Human capital and economic growth: a survey of the
literature’
• Jonathan Temple, ‘Growth effects of education and social capital in the OECD countries’
• Barbara Sianesi and John Van Reenen, march 2002‘The returns to education: a review of the
empirical macroeconomic literature’
• http://www.house.gov/jec/educ.htm
• http://www.oecd.org
II. 3 (G21) Structural Policies
Ben van Gils
Marc Rooijackers
Peter van Oudheusden
Bart van de Gevel
DOES LIBERALIZING TRADE

LEAD TO
FASTER GROWTH?
Introduction
Leading economic institutions like the OECD, World Bank and IMF have been strongly
advising countries to open up to the world economy. Increased openness could lead to higher
growth and could cause convergence of less developed countries to developed countries.
Countries with liberalizing trade policies can therefore get easier access to loans. More and
more developed countries even tie their development aid policies of developing counties to
those, who have open trade policies.
In the last decennium empirical evidence has been presented that these policies do
actually improve economic performance in growth. However a recent paper of Rodriguez and
Rodrik (2000) criticize the used methods of these researches and doubt some of its results.
Winters (2004) comes to following conclusion in his overview paper on the role of trade on
growth:1
“While there are serious methodological challenges and disagreements about the
strength of the evidence, the most plausible conclusion is that liberalization generally
induces a temporary increase in growth”
In this paragraph we will give an overview on some of the more influential studies
that conclude that openness of a country does lead to more growth. First we will look at the
much-cited study by Dollar (1992). Secondly we will discuss the study done by Warner and
Sachs (1995) and by Frankel and Romer (1999). Also we discuss the critics made by
Rodriguez and Rodrik (2000) on these three studies. We will end with a short conclusion.
Dollar
The first study that we discuss is the study by Dollar (1992). This was one of the first
empirical studies that dealt with the empirical relationship between growth and trade. Dollar
argues that the reason for this is that outward orientation is hard to measure across countries.
According to him it combines two factors. The first factor is the level of protection and the
second the amount of variability in the exchange rate. Because the latter doesn’t reflect a
country’s long run trade policy Dollar focuses on the first factor. But how can we measure
this factor? For this he introduces an index of country i’s relative price level (RPL). This
index can be calculated by the following formula:
RPLi = 100 × ePi / PUS ,
where e is the exchange rate in dollars per unit domestic currency and Pi is the consumption
price for a country i. This formula implies that if al goods are tradable and there are no trade
barriers then RPL would be 100 for every country. But the problem with the formula is that
there are also non-tradables and that these will cause the value not be 100 for each country
even with open trade. Dollar argues that differences in factor endowments between countries
are the cause of different prices in non-tradables. He solves this problem by regressing the
1
Pp F4
1
price levels on factor endowments.2 He uses this relationship to calculate the measure by
which a countries real exchange rate is distorted away from the free trade level. Dollar sorts
the countries on the measure of distortion. On average he finds that countries in Africa are
most distorted followed by countries in Latin America. Asia is less distorted than those two
regions but more distorted than Europe and the Middle East. Besides this expected result he
also finds some anomalies. Peru has a very low price level and Japan, Korea and Taiwan a
surprisingly high level. To eliminate the anomalies he includes a measure of variability of the
real exchange rate.
The outward orientation index is being created by a weighted average of the two
variables above.
Dollar regresses his measure for outward orientation on growth. Important is that he
adds the investment rate in his regression equation. This because both should produce more
rapid growth and exclusion of the investment rate could cause a too great effect of outward
orientation on growth. The regression shows there is a positive relationship between growth
and outward orientation. But this result should be dealt with caution because outward
orientation could also pick up effect of other relevant omitted variables and there could be
backward causation. Dollar also includes a dummy variable for Africa in the regression
equation. Even with this dummy included there is still a significant positive relationship. He
divides his dataset in four quartiles bases on outward orientation and then estimates the
growth for each of the quartiles. For the highest quartile he estimates a per capita growth rate
of 2.9%, for the second quartile a growth of 0.9%, the third quartile -0.2% and the closest
quartile a growth of -1.3%.3 Dollar comes on basis of this to the following conclusion:4
“The results strongly imply that trade liberalization, devaluation of the real exchange
rate, maintenance of the real exchange rate could dramatically improve growth
performance in many poor countries.”
Sachs and Warner

A second influential paper is titled “Economic convergence and economic policies” by Sachs
and Warner (1995). In this paper they ask the question why poor countries do not grow
rapidly to close the gap with rich counties. They think policy failures are the main cause why
they can’t narrow the gap. This in contrast with other views which give human capital or
technology the central role. In their paper they use two subsets of appropriate policies. The
first set is related to property rights and the second is related to integration of the economy in
international trade. For this paper we will look particularly at the second subset. This subset
contains four criteria:5
(1) a very high proportion of imports covered by quota restrictions;

(2) for Sub-Saharan Africa, high proportions of exports are covered by state export
monopolies and state-set prices;
(3) a socialist economic structure;
(4) a black-market premium over the official exchange rate of 20 percent or more.
Failure on one of these criteria does indicate that a country is not qualifying for the openness
subset. When a country passes the criteria above it qualifies for the subset related to
integration in the world economy.6 The subset related to property rights is constructed in a
2
Dollar explains the intuition behind this method as follows: “ The residuals of this regression
indicates whether prices are high or low, given its factor endowments, and from these residuals can be
constructed a cross-country index of real exchange rate distortion.” (Pp 526)
3
We include the sensitivity analyses of these estimates in table 1 in the appendix.
4
Pp 540
5
These descriptions are based on the ones by Sachs and Warner page 10 and 11. For how the find data
for the criteria I refer to there article.
6
In their study they use a dummy 0 for qualifying and 1 for disqualified.
2
similar way. They now use regression analysis to confirm their hypothesis that qualifying
countries display a strong tendency to convergence. In the appendix table 3 we include the
results of there most important regression. In the second column of the table the regression
contains only the two the subset variables: the political variable (PNQ) and the openness
variable (ONQ). They come to the conclusion that both of these variables are important for
growth and convergence. This result still applies when other variables are included to
regression analysis like human capital and technology. This means that qualifying countries
do better then non-qualifying countries. Important for our discussion is that they indicate that
the influence of open trade policies is even larger and more significant than politics.
Frankel and Romer

The third study, which claims a positive relationship of trade liberalization and the last that
we’ll discuss here, is the study of Frankel and Romer (1999). In there study they begin by
pointing on the problems concerning previous studies on the topic. The biggest problem is
that the effects of trade on growth, which previous studies show, could be caused by
backward causation. It could be that a country changes its trade policies to more outward
oriented when it grows. This implies that the trade is not the cause but the result of growth.
To sort out which of these explanations is the most plausible Frankel and Romer use
geographical variables as instrumental variables for international trade. The reason for this is,
they argue, that knowing how far a country is from other countries provides considerable
information on the amounts it trades. They base this claim on literature on the gravity model
of trade.7 They even argue that geography does not influence income other than through
trade. The size of a country is the second variable that could influence the within-country
trade. By using these instruments they could determine the real influence of trade on growth.
This influence is independent on a countries income.
In the appendix we have enclosed table 4 with the basic results of the paper. In the
first column we see that an increase of the share of trade with 1 percent point increases
income per person 0.9 percent. The standard error estimate of 0.25 shows that the relationship
is significant. Also there is positive relationship between size and income per person. But this
relationship is only marginal significant. Frankel and Romer argue that the OLS estimates
understate the influence of trade on income. Besides the OLS estimates also include
instrument variables estimates (IV). This is because there are reasons why there should be a
positive correlation between trade and the error term in OLS.8 There is now even a larger
positive relation between trade and growth. A one percentage point increase in trade, in these
estimates, will increase income per person with 2 percent. However, the relationship is not as
significant as estimated by OLS. Lastly they test the results for robustness. They do this by
removing outliers, correcting for differences in continents, taking oil producing countries into
consideration9 and testing the instrument variables on endogenous components. None of these
changes has a major effect on the results. Their conclusion is in summary that trade does raise
income.
The critics by Rodriguez and Rodrik

The above studies conclude that trade does indeed foster growth. In their paper Rodriguez and
Rodrik (2000) give some skeptics on the cross-national evidence. They don’t argue that there
7
See for evidence Linneman 1966, Frankel et al.1995 and Frankel 1997.
8
They give in the paper the following four reasons why the IV estimates are larger than the OLS
estimates: 1 Countries that adopt free trade policies are likely to adopt other policies that raise income.
2 Countries that are wealthy for reasons other than trade are likely to have better infrastructure and
transportation. 3 Countries that with low trade may have to rely on tariffs to finance government
spending. 4 Increases in income of sources other than trade may increase the variety of goods that
households demand away and shift the composition of their demand away from basic commodities
toward more processed lighter weight goods. Pp 391 t/m 392
9
In the 98-country sample which the table in the appendix contains these countries where already
excluded. The relationship between trade and growth stays however significant and even increases
somehow.
3
is no such relationship but that the evidence should be taken with some caution. We will look
at the criticism they raise about the studies we have discussed earlier in our paper.10
They begin by criticizing the paper of Dollar (1992). First they argue that the
distortion variable constructed by Dollar has some serious conceptual flaws.11 The problem
with this concept is that economies that combine import barriers with export taxes will be less
protected according to relative price level (RPL). Also countries, which will soften import
restrictions by export subsidies, will look more protected than those that do not. They
conclude that the measure of Dollar is sensitive to the form of trade restrictions. A second
point of critique on the study is that the RPL method works best if the law of one price (LOP)
holds. But as already noted above Dollar himself knew that there were problems with this
law. According to Rodriguez and Rodrik the problems are more serious. First a significant
part of the distortions are caused by monetary and trade policies. This is a problem because
for example an appreciation of the exchange rate would raise the relative price of import-
competing and export-competing goods. This would cause a high distortion rate without trade
policy having anything to do with it. Dollar’s measure of distortion fails also when transport
costs or geographical factors influence the variable. The third point of critique is the index
variability chosen by Dollar. This index has nothing to do with trade restrictions but measures
instability at large. Dollar included this variable to eliminate anomalies in his dataset. The last
point of skepticism that is being raised is that the results aren’t robust with respect to the
distortion variable. Rodriguez en Rodrik show that with improved data and included variables
like continental dummy’s, initial income and initial schooling the distortion index is not
robust.12 This was the most important index used by Dollar. The variability index remains
robust but this index doesn’t represents outward orientation.
Rodriguez and Rodrik also criticize Sachs and Warner’s study, mainly with respect to
the criteria used for openness. They argue that the individual components, which are mainly
responsible for the strength of Sachs-Warner dummy, are not indicators for openness. The
two dummies that are main distributors to its statistical power are the black market premium
(BMP) and the state monopoly of exports (MON). To show this they construct a new dummy
only consisting the above two variables BMP and MON. When this new dummy is used in a
regression together with other variables, the latter have little predictive power. But what do
the variables BMP and MON represent? Rodriguez and Rodrik argue that the BMP is in fact a
dummy for Sub-Saharan Africa and the only information we can extract from it is that
African economies have grown more slowly. This is because non-African countries, with
restrictive policies towards export, escape disqualifying for this dummy and Africa countries
with restrictive export policies but reformations in the late eighties are also overlooked. The
second dummy BMP, which in theory could give inside on trade barriers shows also
something different according to Rodriguez and Rodrik. They argue that the premium rather
reflects a wide range of policy failures not only concerning trade barriers. Because Sachs and
Warner only disqualify a country with a BMP of more than 20% they say the dummy
measures the effect of widespread macroeconomic and political crises. They conclude that the
Sachs and Warner measure is correlated with alternative explanatory variables. Therefore, it
is too risky to draw any conclusions of it.
The third pro-trade evidence on growth was the paper by Frankel and Romer (1999).
Also this paper gets its share of criticism by Rodriguez and Rodrik. First they claim that the
paper concerns the volume of trade instead of trade policies. Secondly they argue that the
geographical instrument variable used in the paper is not a valid instrument. The reason for
this is that geography influences growth in more ways than only trade. They give as an
example the quality of institutions through colonialism, wars and migration. Also geography
could influence the quantity and quality of natural endowments. Because of this they re-run
10
They also discuss papers of Edwards(1998), Ben-David(1993) and in short three others (Lee 1993,
Harrison 1996 and Wacziarg 1998).
11
For the proof we refer to pages 15,16 and 17 of the paper of Rodriguez and Rodrik (2000)
12
They used a more recent version of the Summer-Heston database (Mark 5.6 instead of Mark 4.0)
4
the Frankel and Romer regression with additional geography variables and come to the
conclusion that trade becomes insignificant.
Conclusion
We have seen three studies, which claim to have found empirical evidence that liberalizing
trade policies could improve growth. Important is that most of the studies only predict a
moderate effect of trade policies on growth. These three studies are only a couple of
numerous studies of the last decade, which have made the same claims. Although these
results have caused a wide support on free trade policies by eminent economic institutions
there is also criticism. Rodriguez and Rodrik have shown that the studies have some major
shortcomings. They have the concern that trade policies crowded out other institutional
reforms with potentially greater payoffs.
We join Winters (2004) in his conclusion that the empirical work shows that it is most
plausible that trade induces a temporally moderate positive effect on growth. But we also
agree with Rodriguez and Rodrik that institutional reforms are probably a better bet for
developing countries, to pursue growth.
References
Dollar, D. (1992), Outwarted-oriented Developing Economies Really Do Grow More

Rapidly: Evidence from 95 LCD’s, 1976-1985, Economic development and Cultural Change,
Vol. 40, pp523-544
Edwards, S.(1998), Openness, Productivity and Growth: What do We Really Know?, The
Economic Journal, Vol. 108, No. 447 pp 383-398
Frankel, J.A., and Romer D.(1999), Does Trade Cause Growth?, The American Economic
Review, Vol. 89, No. 3, pp 379-399
Rodriguez, F and Rodrik, D. (2001), Trade policy and economic growth: a skeptic’s guide to
the cross-national evidence, Macroeconomics Annual 2000, pp 261-324
Romer, P. (1994). New goods, old theory and the welfare cost of trade restrictions. NBER
working paper series nr. 4452
Sachs, J.D. and Warner, A.M.,(1995), Economic convergence and economic policies, NBER
working paper series, Working Paper No. 5039
Winters, A.L. (2004), Trade Liberalization and economic performance: An overview, The
Economic Journal, 114 February, F4-F21
5
Appendix
Table 1 Sensitivity Analysis
Regression Real Exchange Rate

Number Constant Distortion Variability Investment Dummy R2
N = 95 DC
1 1,84 -0,033 -0,8 0,18 0,4
[3,55] [2,9] [5,24]
2 2,87 -0,045 -0,07 0,16 4,66 0,49
[4,91] [2,71] [5,2] [4,01]
N = 48 PC
3 1,23 -0,029 0,02 0,2 0,38
[4,02] [0,64] [3,53]
4 2,17 -0,033 0,03 0,15 5,24 0,57
[5,45] [0,96] [3,05] [4,37]
N = 24 PC
5 1,86 -0,027 0,04 0,08 0,26
[2,6] [0,86] [0,96]
Source: Economic Development and Cultural Change (Dollar 1992)
Table 2 Outward orientation and other measures
GDP per capita Distortion Variability (% Of GDP) (% of GDP)

1 2606,13 88,22 0,09 2,86 20,67
2 1603,04 110,79 0,11 0,85 16,87
3 1883,83 140,54 0,15 -0,24 18,03
4 1003,96 174,00 0,28 -1,30 14,60
Deze tabel is een samenvatting van de appendix uit het desbetreffende artikel waarbij 1 = erg open, 2 = open, 3 = gesloten en 4 =
erg gesloten
Source: Economic Development and Cultural Change (Dollar 1992)
6
Table 3 Growth effects of the political and openness measures
1 2
Constant 9,912 8,282
(t-ratio) [5,344] [4,408]
SOC -1,267
[-1,820]
EDU -0,624
[-1,391]
RIGHT -0,670
[-1,227]
PNQ -0,764
[-1,852]
BMP -2,246
[-6,026]
OWQID -0,848
[-1,958]
EXM -1,885
[-3,584]
ONQ -2,770
[-5,851]
LGDP70 -0,839 -0,568
[-3,8] [-2,595]
R bar 2 0,446 0,311
Mean dv. 1,583 1,512
Standard Error 1,587 1,824
Sample Size 95 114
Source: Economic convergence and economic policies (Sachs and Warner 1995)
Table 4 Trade and Income
Estimation OLS IV OLS IV

Constant 7,4 4,96 6,95 1,62
[0,66] [2,20] [1,12] [3,85]
Trade Share 0,85 1,97 0,82 2,96
[0,25] [0,99] [0,32] [1,49]
Ln population 0,12 0,19 0,21 0,35
[0,06] [0,09] [0,1] [0,15]
Ln Area -0,01 0,09 -0,05 0,2
[0,06] [0,10] [0,08] [0,19]
Sample size 150 150 98 98
R2 0,09 0,09 0,11 0,09
SE of regression 1 1,06 1,04 1,27
First stage F on excluded instrument 13,13 8,45
Source: Does trade cause growth? (Frankel and Romer 1999)
7
II.2 (G22) Structural policies
Pieter van Erp
Dirk Hendrix
Marcel Jonker
Luc Verschuren
PRODUCT MARKET COMPETITION

AND
INNOVATION
The best of all monopoly profits is a quite life.
John Hicks (1935)
1. INTRODUCTION
In March 2000, leaders of European countries established an agenda to make the European
economy by 2010 the most competitive and dynamic in the world. They expressed the ambition
to become, within a decade, “the most competitive and dynamic knowledge based economy in the
world, capable of sustainable growth with more and better jobs and greater social cohesion” In
the ‘Lisbon strategy’ detailed policy recommendations were agreed upon, covering matters such
as research, education, training, internet access and on-line business. (Source: Towards a
knowledge based society)
A cornerstone of the Lisbon strategy is its focus on the completion of the internal European
market. This emphasis is derived from the notion that (further) reform of economic, social, and
administrative regulations can produce significant and long-lasting benefits by means of inducing
stronger product market competition within the European Union. Increased competition,
subsequently, is thought to result in lower prices, improved product quality, increased consumer
choice, and, most importantly, in increased innovation.
In assessing the link between competition and innovation an important distinction should be made
between static and dynamic efficiency. This distinction will be introduced in the first part of this
paper, which covers the theoretical background of the relation between competition and
innovation. The subsequent section then discusses the deregulation process and its results in the
European telecommunications sector. Chapter four, then, will provide a similar case study of the
European air transport sector. The fifth and final chapter of this paper will address the
conclusions based on the theoretical evidence, empirical evidence, and case studies as presented
in this paper.
2. THEORETICAL BACKGROUND
2.1 Competition and static efficiency
In (product) markets characterized by imperfect competition firms often seek to lower their
production in order to create scarcity rents. As a result resources are moved to less productive
sectors in the economy. Moreover, in product markets characterized by oligopolistic competition
companies also tend to invest heavily in competing for market shares and entry deterrence. (See
e.g. Scherer 1980 and Wilson 1990). Imperfect competition thus leads to inefficiencies resulting
from resource misallocation.
Besides from resource misallocation inefficiencies also result from opportunity for slack that is
introduced by monopoly power. Several reasons for so-called ‘X-inefficiencies’1 have been
introduced:
- Regarding managerial effort, it is often impossible -or at least costly- to directly observe input
and effort of managers. To overcome this principal-agent problem reward structures are often
based on relative performance. Yet, in the case of imperfect competition there is less opportunity
for comparison of performance. This creates opportunities for slack, and leads to inefficiencies.
(See Nalebuff and Stiglitz 1983)
- An alternative explanation of inefficiencies resulting from imperfect competition is based on

the observation that, in the presence of market power, profits are less sensitive to the actions of
managers. Consequently owners have less incentive to ensure that managerial effort is kept high;
again resulting in inefficiencies. (See Nickell 1996:727)
- Imperfect competition may also influence the effort of workers when monopoly rents are
shared with workers. This might occur because it makes the life of managers more comfortable
(see e.g. Smirlock and Marshall 1983) or because workers demand a fair wage/effort ratio
compared to managers (see e.g. Akerlof and Yellen 1988). If higher rents derived from monopoly
paper are indeed shared with workers,2 these rents are either captured in the form of higher wages
1
X-inefficiency is the term introduced by Liebenstein (1966) to capture inefficiencies generated from non-
competition, i.e. low effort of managers and workers to reduce costs, improve quality, introduce new ways
of doing things, etc.
2
Both Krueger and Summer (1986a,b) and Dickens and Katz (1986a,b) provide impressive evidence that
rent sharing is indeed quite common across different types of industries.
2
or reduced worker effort. Consequently there is a direct connection between higher rents derived
from monopoly power and 1) lower worker effort and 2) stronger incentives to engage in
unproductive activities to protect vested interests. Both lead to inefficiencies resulting from
imperfect competition.
In conclusion, increasing competition can lead to efficiency gains by reducing both allocative
inefficiencies and X-inefficiencies. These are so-called ‘one-off efficiency’ improvements, or
‘static efficiency’ improvements, because it improves efficiency at a specific moment in time
only. As will be addressed in chapters four and five, increased competition can markedly improve
static efficiency in markets that were previously characterized by imperfect competition, resulting
in higher quality products and most noticeably lower prices for consumers.
2.2 Competition and dynamic efficiency
While an efficient use and allocation of resources at any moment in time is obviously important,
in the medium and long run, it is dynamic efficiency that matters most for growth in living
standards. (OECD 2002:3) Here ‘dynamic efficiency’ or ‘ongoing efficiency’ improvements can
be broadly defined in terms of productivity growth through innovations. Several theoretical
channels through which competition leads to innovation and thus increases dynamic efficiency
have been proposed:
- “Darwinian effect: Intensified product market competition could force managers to speed up the
adoption of new technologies in order to avoid loss of control rights due to bankruptcy (Aghion et
al., 1999). More generally, firms should innovate to survive under competitive pressure (cf.
Porter, 1990).
- Neck-and-neck competition: In a simple model of “creative destruction”, the incumbent firms

unlike new entrants have no incentives to innovate. Under a more gradualist technological
progress assumption with incumbent firms engaged in step-by-step innovative activities,
competition could increase innovation. It is because more intensive product market competition
between firms with “neck-and-neck” technologies will increase each firm’s incentive to acquire
or increase its technological lead over its rivals.
- Mobility effect: In the learning-by-doing model of endogenous growth, the steady-state rate of
growth may be increased if skilled workers become more adaptable in switching to newer
production lines (namely, Lucas effect). In this case, more competition between new and old
production lines (parameterised by increased substitutability between them) will induce skilled
workers to switch from old to newer lines more rapidly (Aghion and Howitt, 1996).”
(Source: Ahn 2002:7)
2.3 The Possible Trade-off between Static and Dynamic Efficiency
3
In the line of reasoning of Schumpeter (1943) the organization of firms and markets most
conducive to solving the static problem of resource allocation (static efficiency) is not necessarily
most conducive to innovation and technological progress (dynamic efficiency). While there is
general consensus that increased competition may bring static efficiency gains, Schumpeter
argued that market power, and not competition, is the driving force behind innovation:
- “Firstly, some form of temporary ex post market power is required for firms to have the
incentive to invest in R& D.
- Secondly, the rents from ex ante market power provide firms with the internal financial
resources for innovative activities.
- Finally ex ante market power also helps reduce uncertainty associated with excessive rivalry
which tends to undermine the incentive to invest.” (Kim and Phillips 2003:2)
Note that if this trade-off between competition and static efficiency versus dynamic efficiency
indeed exists, the Lisbon strategy would be fallacious. Stimulating competition in European
markets would indeed bring allocative efficiency gains and result in better products and lower
prices; yet in the long run it would hurt innovation and economic growth instead of helping
Europe to become “the most competitive and dynamic knowledge based economy in the world.”
2.4 Is Competition conducive to innovation?
The basic Schumpeterian model indicates that innovation and growth are declining with
competition because the monopoly rents from innovation tend to dissipate more quickly when
there is stronger competition. However, as mentioned by Scarpetta and Tressel (2002:5),
extensions of this model yield a more complicated picture and often lead to opposite conclusions
(see e.g. Aghion and Howitt, 1998; Boone, 2000). Empirical evidence should resolve the matter,
but the amount of empirical evidence is unfortunately limited due to data availability.
Nevertheless the general conclusion of the available empirical literature is a positive relationship
between competition and innovative activity. (See e.g. Nickell (1996), Blundell et al. (1995) and
Bassanini and Ernst (2002), OECD 2002, etc.)
An example is for instance recent OECD research (2002) which used the extent of anti-
competitive product market regulation (PMR) as a proxy for the strength of product market
competition and R&D intensity as a proxy for innovative activity. Both proxies are of course not
perfect; R&D spending for example measures inputs rather than outputs from the innovative
process, and disregards several other important aspects of innovation; yet the cross-country
pattern of R&D intensity and the extent of product market deregulation does suggest a positive
relationship between product market competition and innovation:
Figure 2.4.1
R&D intensity& product market deregulation (1998)
4
(Source: OECD 2002)
Important empirical evidence as presented in Aghion et al. (2002), which is in support of an

inverted U relationship between competition and innovation, also indicates that competition has a
positive effect on innovation. Yet under fierce competition firms lack the capacity, (and in highly
concentrated industries a monopolist lacks the incentive), to invest in innovation. Therefore, if a
market moves from monopoly to perfect competition, innovative activity generally increases, but
comes to a halt when competition gets too intense. This would not only be a logical conclusion, it
also combines strong arguments for and against a positive relationship between competition and
innovation.
4. CASE STUDY: THE EUROPEAN TELECOM SECTOR
Historically, the European telecommunication sector was characterized by strong national

monopolies. This environment created a strong national orientation for the sector with the
consequent loss of the potential opportunities of a European-wide market. In 1999, for example, it
could happen that a short-distance call from two neighboring European states was more than 3
times as expensive as a call from the US to Europe. (Source: Ten years without frontiers 2002:29)
To improve efficiency, reduce costs, and stimulate innovation the telecommunications markets
have been fully liberalised in most of the EU as of 1 January 1998. The program to liberalize the
5
telecommunications market was part of the wider process of the economic integration of Europe.
The Treaty of Rome (March 25th 1957) initiated this process and it was accelerated through the
European Community's internal (single) market programme in the mid-eighties. For the
telecommunications sector especially the Maastricht Treaty (EU treaty, 1993) was very important
for the integration of the telecommunication sector and its internal network. A couple of common
policies were initiated from 1984 on to establish common development lines. The most important
aspect of this first phase policies were:
• Standards development to solve the problems of national fragmentation created by

different national specifications.
• Common research; shared programmes between the operators and industry at European
level (R&D framework programmes).
• Special development programmes for the least developed regions of the EU. Programmes
in the context of structural funds (adopted in 1986).
• Initial tentative steps towards a common European position in the international
telecommunication arena.
(Source: http://europa.eu.int/ISPO/infosoc/telecompolicy/en/tcstatus.htm#I.)
By 1987, the second phase of the community policy was initiated with the publication by the
“Commission of the Green Paper on de development of the common market for
telecommunication services and equipment”3. This Green Paper opened the debate on the
telecommunication regulatory environment in Europe. From this moment on great steps towards
the European single market were made, eventually resulting in full market liberalisation,
harmonisation of conditions for a common regulatory framework, and promotion of European
players in the telecommunications market.
All changes in policy and the effects this had on the markets of course brought some major
benefits for everybody living in these markets. Liberalisation in the telecommunication sector
resulted in benefits such as:
• Greatly increased choice for consumers. Over 95 % of the population in 12 Member

States can now choose between more than 5 operators for long distance and international
calls. A choice of more than 5 operators for local calls is also possible in 8 Member
States
• Competition between these operators is spurring innovation. There are now more
advanced services than ever before. The average level of internet penetration in EU
households, for example, was around 40 % in June 2002 – up from 18 % in March 2000.
Furthermore, high-speed internet access is progressively gaining ground, and in October
2002 there are 10.8 million retail broadband customers in the EU.
• Competition, combined with technological progress, is also bringing down prices. For
example, tariffs charged by the old national monopolies for national calls have been
3
Towards a dynamic European economy: Green Paper on the development of the common market for
telecommunications services and equipment, COM(87) 290 final, 30.07.19
6
reduced by around 50 % on average since liberalisation, and those for international calls
by around 40 %. New operators in many Member States offer even lower prices, even for
local calls: new entrant tariffs for national calls are up to 56 % lower and for international
calls up to 65 % lower in some countries.
• As a result, the cost of a basket of national calls - including fixed charges and
subscriptions - has fallen for both business and residential users since 1996. Business
users pay, on average, 30 % less for the same service, while residential users pay 16 %
less.
(Source: Ten years without frontiers 2002:29)
In conclusion, with the arrival of the full liberalization of telecommunication sector in the
majority of the Member States of the European Union on 1 January 1998, a 10-year process of
harmonization and liberalization was completed. Old-style monopolies have been broken up,
which led to increasing competition. Because of this process the transparency and predictability
of the market increased and economic performance, development, and innovations in the market
were stimulated.
5. CASE STUDY: AIR TRANSPORT
Similar results have been accomplished in air transport. Historically, the aviation sector was
characterized by tight regulation on the basis of bilateral agreements. Flying between two major
European cities usually implied, as recent as five years ago, that one had to choose between one
of the national airlines.
“Three successive packages of liberalizing measures – adopted during the 1990s – have
effectively turned all European-owned and controlled airlines, regardless of the Member State in
which they are legally established, into “Community carriers” with equal rights of access to all
the Community’s markets and equal responsibilities under the law. The result is that any EU
airline can now operate on any route within the Community. This has triggered a number of
developments in the industry:
• The number of promotional fares available has increased dramatically. This is due to the
presence of low-cost carriers in the market and the way in which established carriers
have responded to them (see box 10). According to a recent study prices of
promotional fares decreased by 41 % between 1992 and 2000. While some of the very
lowest prices may not prove sustainable, the importance of promotional fares in the
industry is unlikely to change.
7
• The number of “Community Carriers” offering scheduled passenger and freight services has
risen from 119 in 1992 to 133 today, having peaked at 140 in 2000. Since 1993 an average of
more than 20 new carriers per year have been set up in the EU. Over 40 carriers formed in 1993
have shut down or been taken over. All this points to
dynamism and lively competition in the sector.
• The number of routes linking Member States has risen by 46 % since 1992 – giving
passengers a wider choice of destinations and carriers. The number of routes where
more than two carriers are competing rose from 61 in 1992 to 100 in 2001. On such
routes, business, economy and promotional fares were around 10 %, 17 % and 24 %
lower.” (Source: Ten years without frontiers 2002:27)
Increased competition in the air transport sector thus led to more intra-EU routes, more
competition, and significantly lower prices. Moreover, especially the low-cost carriers
implemented a completely new and innovative business model to compete with the established
national airlines. Essential elements of this business model are a single type fleet of planes, fast
turn-rounds, use of cheap secondary airports; no frills or free drinks during the flight; and low-
cost booking almost entirely over the internet. In Europe, indeed 99% of cheap intra-EU flights
are now booked through the internet. (Source: The economist) Additionally, increased
competition in the air transport sector also forces established airlines to adopt the innovative
internet-selling and yield-management techniques of their low-cost rivals. In conclusion, the
liberalization of the EU air transport market is another example of increased competition leading
to lower prices, while simultaneously greatly stimulating innovative behavior across the sector.
6. CONCLUSION
Increasing competition by means of regulatory reform can lead to large static efficiency gains in
markets characterized by imperfect competition. Several channels have been discussed through
which increasing competition leads to a reduction in allocative inefficiencies and so-called X-
inefficiencies. There is general consensus in the literature, and also abundant empirical evidence,
that increasing competition in these markets leads to higher quality products and services,
increased consumer choice, and lower prices. Besides the two case-studies performed in this
paper, table 1 shows many more examples of increased competition leading to strong price
reductions in real terms:
8
(Source: OECD 1997:11)
While there is general consensus in the literature and empirical evidence that increasing
competition can lead to static efficiency gains, there is still some controversy about the
link between competition and dynamic efficiency gains. Our two case studies, in line
with the general conclusion of the empirical literature, indicated a positive relationship
between competition and innovation. However, following Schumpeter (1943) and
empirical evidence of Aghion et al. (2002), some degree of market power is needed to
provide firms with the internal financial resources for innovative activity and some
degree of market power also reduces uncertainty associated with excessive rivalry.
Therefore, in order for the Lisbon Agenda to succeed and Europe to become “the most
competitive and dynamic knowledge based economy in the world, capable of sustainable
growth with more and better jobs and greater social cohesion,” we conclude that product
market deregulation and the completion of the internal market has been sound economic
9
policy to increase static and dynamic efficiency in the European Union. Two caveats,
however, should be taken into account. Firstly, increasing competition on product
markets characterized by imperfect competition will indeed increase static efficiency, but
creating too much competition might actually hurt innovation and thereby economic
growth. Secondly, increasing competition by means of product market deregulation
should not become a one-size-fits-all approach based on past success. Each market is
different and programs to further deregulate and increase competition in for example the
electricity, gas, and financial markets have to take this into consideration. As long as the
European Union takes this into account we believe that similar results can be achieved as
those of the programs that deregulated the telecommunications and air transport sector.
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THE WEALTH OF NATIONS

A collection of papers on the theory, empirics and policy

With contributions from

I. Why are some countries so rich and some so poor?

Table I.1 Sources of growth and income differences - Classification

1. Proximate sources of growth and income differences

To study the proximate sources, economists perform growth or level accounting

Empirical studies: growth and level accounting.

Models of factor accumulation, productivity, and growth

GROWTH AND LEVEL ACCOUNTING:

• the total stock of capital available, K

The most used equation to measure growth of national income is as follows:

An increase in national income can be explained by an increase in the capital

Comparison of OECD with LDCDifferences in output per worker

Brazil 0,319 0,873 0,482 0,758

China 0,060 0,891 0,632 0,106

Central Africa R. 0,033 0,582 0,339 0,159

Y = AKα L 1-α in levels

Growth accounting in practice

Results of growth accounting in practice for the period 1960-2000

Table 2.1. Results of Europe

Table 2.3. Results of South America

Table 2.4. Results of Africa

Growth accounting in practice for the period 1980-1998

Table 3.1. Results of Europe

Table 3.3. Results of South America

Table 3.4. Results of Africa

University of Michigan: Global Change, 2001

Penn world Data: http:// www.bized.ac.uk/dataserv/penndata/pennhome.htm

GROWTH AND LEVEL ACCOUNTING:

Figure 1: The income gap with the US explained

Source: CPB, Four Futures of Europe.

So how do we close the income gap?

Source: Speech minister Hoogervorst, Europe: the challenges ahead.

Labour market institutions

Figure 4: Equality vs Participation

Some data on past R&D

Research and Development expenditure represented 1.99% of the European Union’s

R&D expenditure by sector

Source: Organisation for Economic Co-operation and Development,

The European Union:

De Mooij and Tang (2003), “Four Futures of Europe”, CPB

Ahn and Hemmings (2000), “Policy influences on economic growth in OECD

“Organisation for Economic Co-operation and Development”, EAS, ANBERD

Brandon Shackelford “U.S R&D projected to have grown marginally in 2003’’

Charles F. Larson “R&D and Innovation in Industry’’

Aswath Damodaran “Research and Development Expenses: Implications for

Simona Frank “R&D expenditure in the European regions’’

Simona Frank “R&D expenditure and personnel in the EU’’

II. The Solow Model

III. The MRW-Model

IV. The Solow model compared to the MRW-model

Sample Non-oil Intermediate OECD

Variable 5-Year growth 10-year growth 20-year growth

When we take the natural logarithm we get the following formula:

3. VAR(aX + bY ) = a 2VAR( X ) + b 2VAR(Y ) + 2abCOV ( X , Y )

Applying this to formula 2 we get the following:

We can rewrite this as:

6. VAR (ln(n + g + d ) = VAR (ln n)

Results data MRW:

Critique on the model:

Barro, R.J. “Economic growth in a cross-section of countries”, Quarterly Journal of

Canton, E. (2002), Onderwijs, R&D en economische groei

Jones, C. and Williams, J. (1998), Measuring the social return to R&D