SMU SOE Seminar (Dec 19, 2016): Industrialization and Evolution of Enforcement Institutions

    We analyze the evolution of economic institutions during the process of industrialization. In particular, we focus on the institution of contract enforcement. Empirically, we show that countries tend to shift their manufacturing production towards industries that require more relationship-specific investment during the process of industrialization. Theoretically, we build a dynamic model with incomplete contracts and evolving institutions to account for this pattern. In our model, the incompleteness of contracts leads to two types of misallocations that generate production inefficiency: unbalanced use of inputs and unbalanced production of different goods. In addition to this production inef- ficiency, the imperfect contract enforcement leads to distortions in factor supplies. These distortions have quantitatively significant effects on the aggregate outcome. The model can replicate the empirical patterns when we allow for the government to invest in enforcement institutions in order to improve the contractual environment. We also analyze how different types of governments, in terms of ability to control physical investment and ability to commit to future policies, choose different patterns of institutional investment over time. 

Keywords: Industrialization, Institution, Incomplete contract, Misallocation

JEL Classifications: E02, L14, L16, O14, O43

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