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Institutions, Preconditions and Industrialization, Dohan Revised 5/7/14
by Michael R. Dohan, Associate Professor of Economics, Queens College of CUNY, 2013©
Concepts to consider for writing the final report for Eco 207
Use to study for answering the two exam essays
and
the Multiple-Choice/Identification of Concepts/True-False on Final.
Starting Growth and industrialization: the pre-conditions
A culture or social norms or (religious) beliefs that accepts and values economic activity and trade as a socially and
morally acceptable profession.
A relative good initial endowment of resources (arable land, coal, forests, water power, iron ore (in the case of England
and the USA), building material.
Individuals free to become small business persons and entrepreneurs to make the market produce and work
Relative absence of violence and crime
A stable political environment and the absence of war on the territory
Some sort of transportation infrastructure to ship products around (canals, roads, rivers, and eventually the railroad)
A large fairly accessible market (coast trade, monetization, system of weights and measures
A legal system that works and enforces contracts and property right, internally consistent over time, and not subject to
corruption.
Some good number of educated literate people.
An interest throughout society in the development and production of new “technology and science”
Agricultural production above the subsistence level of output to provide food and materials for cities and workers
A (potential) labor force for expansion of economy (unemployed, underemployed, low productivity in current work).
Levels of investment as a % of GDP and the preconditions necessary to raise it, such as reinvestments of profits (before
a modern financial system of financial intermediaries evolved to assemble savings and to lend them out).
Consumer sovereignty in the market determines output and affects prices
A Restatement of the page above
Qualitative Institutions and conditions
1. Widespread agreement in the population and acceptance of belief systems consistent with the efficient
operation of a market economy, e.g.
 Production and distribution according to market forces (prices, profits, interest), guided by self-centered
utility maximization a la Adam Smith
 Acceptance of the concept of profit, prices, interest, wages as principal methods of resource allocation
 Acceptance of the “economic man” is being important in society
 Acceptance or tolerance of change
2. Security: Absence of warfare, bandits and piracy and violence.
3. The existence of entrepreneurs, (usually motivated in part by profit) and “researchers” (some of whom are
motivated in part by non-economic goals) who were constantly looking for “ways to do thing better”.
4. A mobile labor force that is free to move and take jobs in response to wages and/or preferences.
 Men vs women vs children
 Upward mobility in society (meritocracy)
 Elimination of the social caste to prevents mobility.
5. Monetization of the economy.
6. A good size market demand for the goods (England and American relied primarily on internal markets but some
considerable foreign trade).
Michael D. Dohan, Ph.D. Associate Professors of Economics, Queens College, 2014
Institutions, Preconditions and Industrialization, Dohan Revised 5/7/14
7. A source of motive power stronger than humans or horses (water power initially, then the steam engine)
 Human power + sticks
 Horse Power and oxen power and wood ploughs
 Water power for new looms
 Steam engines
o New agricultural machines including steel ploughs, systhes< harvestor)
o Machine-powered agricultural machines (steam): combines threshers
 Gas-powered agricultural traction (tractors, soil preparation,
8. A simple stable financial system (Money, letters of credit, monetary banking/intermediaries)
 facilitating trade (medium of exchange)
 a stable monetary system (unit of account t, store of value)
 for collecting and allocating private savings (a desire to reinvest profits, the economic surplus)
 Today, we would expect to see a effective if simple banking system and other financial institutions)
9. A good infrastructure to support commerce and trade and production (initially very rudimentary in 1750)

Ports and airports

Roads and bridges.

Communication system.

Transportation system, independent of roads.

Sources of energy and a distribution network
10. Per capita output greater than the subsistence level
 to permit the collection of taxes
 voluntary savings and investment
 to provide resources for public and private capital and human capital for economic growth
11. Existence of a reasonable system and degree of taxation which effectively collect taxes.
12. A government which permits markets to operate freely (Laissez faire) albeit with
appropriate regulations where the markets fail and prevention of monopoly and restraint of trade.
13. An effective legal system to enforce contracts and intellectual property rights, no corruption
14. An education system based on empirical knowledge (knowledge versus belief)
15. Solid protection of property rights
16. The absence of extensive “arbitrary” corruption and other practices in government and business which raises the
transaction costs and information costs and reduces to efficiency of the market economy.
17. Stronger Limited Central Government
Later, the government will have to expand its role:
 to making allocative decisions and regulations in areas where the market system fails work well (e.g., in the
provision of public goods, managing external costs and benefits, principal-agent problems,
 To provide for the social welfare, working conditions and non-economic goods and services.
 England (unlike China) started to attack the problem of child labor and excessive working hours fairly early in
the its industrialization process.
Michael D. Dohan, Ph.D. Associate Professors of Economics, Queens College, 2014
Institutions, Preconditions and Industrialization, Dohan Revised 5/7/14
Sources of technology in growing economy
Incentive structure for peasants to grow and market grain
MPPl retained by the peasant after taxes and contract deliveries and its effect on the peasant
Internal price structure
Information system generates inaccurate information
Information system is decentralized through market interaction
Models of industrialization and development
Import-substitution model -> lesser role for foreign trade -> autarky
Export-led expansion
Internal market demand led expansion
Michael D. Dohan, Ph.D. Associate Professors of Economics, Queens College, 2014
Institutions, Preconditions and Industrialization, Dohan Revised 5/7/14
Sources of growth
The extensive growth model (adding more capital and labor) Q = Ā(L+∆L)α (K+∆K)β Cobb-Douglas Production function
∆L = adding more labor, ∆K= adding more capital, Ā (technology)= total factor productivity remains constant
As the capital/ labor ratio rises, the marginal productivity of additional capital investment falls because of the law of
diminishing marginal returns.
Russia reached this point in the 1970s. It was also misallocating more resources because of the bad price system and
fixed technical coefficients in the material balance approach.
China is probably reaching it now that it is running out of labor.
The intensive growth model (adding more capital and labor and promoting technology progress and efficiency so that)
Q = (A+∆ A)*(L+∆L)α (K+∆K)β
∆L = adding more labor ∆K= adding more capital ∆A= total factor productivity increases and is not subject to the law
of diminishing returns.
So, anything or policy the increase the total factor productivity, say at 3% will make output grow at 3% time whatever
growth comes from added capital. Total factor productivity can come from a variety of sources in addition to new
technology. For example, simple by improve the way the economy uses existing resources.
Incentive structure for peasants to grow and market grain
MPPl retained by the peasant after taxes and contract deliveries and its effect on the peasant
Internal price structure
Information system generates inaccurate information
Information system is decentralized through market interaction
Conditions for inducing workers to move to were needed )at less two conditions)
Labor conditions in rapidly industrializing countries from the Industrial Revolution on
Incentive (or disincentives) to adopt new technology
Sources of increasing total factor productivity and technology in growing economy
problems in creation of new technology
1. Cultural and method of educational training may teach wrong habits. For example, relying on rote
memorization instead of critical thinking, of taking risks to be wrong, etc.
2. Restricted access to labs and tech staff, working on the projects only of a senior professor (common in Europe at
one time, but better now).
3. Habit of borrowing, buying or stealing technology prevent their “scientific institutes” from really developing
their own. (Chinese high-speed RR was built largly with foreign technology.
Improving science and technology
1. Educate more engineers, scientists and provide good funding and salaries.
2. Build more research centers and national laboratories
3. Ability to patent new technology and profit from it.
4. How research labs are organized with state of the art equipment available to all researchers regardless of their
rank.
5. Impact of intellectual property laws on the transfer of technology
6. Protect technology from “pirates” who steal it (Won’t name names here).
Michael D. Dohan, Ph.D. Associate Professors of Economics, Queens College, 2014
Institutions, Preconditions and Industrialization, Dohan Revised 5/7/14
Advantages of a market system, profit maximization and utility maximization
Conditions for a market to work EFFICIENTLY: many buyers and sellers, homogeneous products, perfect information
(yea, right), profit maximizing producers and utility maximizing consumers (buyers)
Competition for consumer dollar
Prices reflect actual opportunity costs and benefits so that social marginal benefit of producing a product such as
bushel of wheat was equal to the social market cost of producing that bushel of wheat. SMB=SMC.
If SMB>SMC, produce more wheat, if SMB<SMC, produce less wheat.
Incentive structure for managers to produce the right mix and quantity of product at the minimized costs and sell at a
price where P = MC, so that throughout economy from your micro economics MCB /MCA = PB /PA = MUB /MUA
Incentive structure to minimize costs, e.g. so firm “a” MPPl ax /MPPkax = w/r, and that for firms “a”, “b”,…MPPlx = MPPl x
so that the marginal physical products for each input type were equal in all firms producing “X” so that resources can not
be shifts from one producer to another producer and increase total output of “x”.
Concept of Pareto efficiency: Remember the story of the sole peasant farming his own plot of land and knew only of
his own marginal utilities and the marginal product of his resources (land and labor) and the marginal (opportunity) cost
of producing one good A instead of another good B. He still had the challenge of allocating his labor and land the
maximize his utility, even though he did not refer to prices. He still had to produce where MCB /MCA = MUB /MUA
Don’t mess with a good equilibrium price system or you will get inefficiencies. EXCEPT IF THERE IS MARKET FAILURE
WITH EXTERNALITIES OR PUBLIC GOODS.
Problem with gas subsidy in Nigeria
Rice subsidies in China
Corruption the increases the extra transaction costs and drives a wedge between what the buyer pays and
what the seller receives - leads to a misallocation of resources.
What motivates managers in allocating resources
Manager’s motivation based on profit maximization in the market place
Manager’s motivation based on value of output
Manager’s motivation based on target fulfillment
Manager’s motivation based on non-monetary (non-material) rewards
Raising the domestic saving and investment rate
1. Make sure that macro-economic policy ALWAYS maintains full employment.
2. Use periods of unemployment (wasted resources which are actually savings) to build investment goods.l
3. Income distribution ( hi GINI coefficient) and its controversial role in economic growth,
More unequal income distribution could create saving from the rich (although they may not be
entrepreneurs) Makes real resources available for investment. Often, however, in third and second
world economies, the rich waste this on conspicuous consumption (Veblen) like the new Russians and
rich Chinese, or stash the money offshore.
4. Some cultures have naturally high savings rate.
5. Corporations who reinvest retained earnings and depreciation are large SAVERS and Investors in real plant and
equipment usually.
Michael D. Dohan, Ph.D. Associate Professors of Economics, Queens College, 2014
Institutions, Preconditions and Industrialization, Dohan Revised 5/7/14
6. Encourage households to save adequately for retirement (about 20% of income) from a young age in addition to
the modest pensions paid buy social security.
Investment in infrastructure (transportation, communication, education)
Investment in heavy industry (A industries in Soviet Russia)
Investment in agriculture
Investment in consumer goods (B industries in Soviet Russia)
Investment in housing (Often neglected or building the wrong type like in China)
Role of foreign investment and foreign debt. Don’t let corruption take a big chunk of the money, or you will get little.
Inflation and monetary policy and macro economic policy.
Hyper-inflation can destroy an economy.
Too little demand wastes resources.
Building the wrong thing or super-big low return show projects wastes resources.
Method of allocating investments:
a. Allocated by banks according to plan
b. Allocated by state politicians according to “national something” such as the show projects in China or Russia
or some of the oil states.
c. Allocated by planners to meet the demands of the Politburo – whether needs or noth
d. Allocated according to profit and the cost of capital and interest rates
Things affecting Total Factor Productivity
What firms in which economies adjust their labor force requirements for changes in output and technology.
Weak intellectual property laws.
Incentive to adopt new technology
Cultural and educational training and the creation of new technology
Impact of intellectual property laws on the transfer of technology
Corporate governance (the various forms): advantages and disadvantages
Corruptions as a major barrier to growth, sound infrastructure, income distribution, etc.)
Michael D. Dohan, Ph.D. Associate Professors of Economics, Queens College, 2014
Institutions, Preconditions and Industrialization, Dohan Revised 5/7/14
Chinese Economic Reforms and Growth 1980-2010
High household savings rates
General problems in China Today
Prices are influenced by the consideration of their political effect on the population
Social safety net for unemployed laborers
Soft budget constraints on SOE firm and its impact on efficiency
Loss of competitive advantage in the export led model because of rising labor costs and China’s solution
Small domestic market (purchasing power and taste for foreign goods) for domestic manufactured consumer goods
Diminishing marginal product of capital as K/L ratios rise.
Rising per unit labor costs relative to other nations
State-owned enterprises operating below capacity or losing money and operating on a soft budget constraint.
Weak private property laws, for example, in agricultural land.
Need to use middle consumer market to guide many production and consumption decisions
Initial problems in Soviet industrialization and in China in 1958
Problem of getting grain from peasants for export and/or for feeding urban and industrial workers
Inherent Problems in a Command Economy
Factory Directors and Gosnab (Supply Ministry) had the real information about market equilibrium and the length of
queues to buy goods and services. Asymmetric information distorted the planning and statistical system and the
material balances methodology required to develop a balanced plan which depended on this information.
Principal-agent problems interfered with collection of accurate information, instead of letting the market orders
determine what was needed. That was the cause of the great US recession when the mortgage brokers in the USA
often fed the banks the wrong information about a loan applicant, raising the cost of the loan to the borrower.
Technical coefficients in the material balance process froze technology coefficient ratios in place because factor
directors did not like changing technology because it disrupts production so there was no factor substitution.
(Capital for labor, less fuel for a better tractor,). Became less and less efficient.
Success indicator problem in centralized planning tends to cause many problems with efficiency because
Wrong assortment would often be produced because of the supply of the constraining input (leather, cloth,
copper for wire, etc) and the need to specify an “Indicator” by which you reward the director and workers
Little incentive to reduce cost
Hoard of labor and excess supplies, coal, etc.
Director of factories never revealed their true capacity or excess inventories
Raises prices were possible
Directors did not introduce new design or technology because it disrupts operations and reaching output targets.
No competition to introduce new products -> stagnation in product design and eventually overproduction
No incentive to curb pollution in planned economy because no bonus for manager.
Prices based on labor theory of value and not on scarcity
Hoarding of labor and unused inputs occurs in what economies and why (soft budget constraint and scarcity) Grow
mismatch between what consumers wanted and what they were offered.
Soviet households began to save leading to a large ruble overhead that threatened inflation.
Prices based on labor costs
Michael D. Dohan, Ph.D. Associate Professors of Economics, Queens College, 2014
Institutions, Preconditions and Industrialization, Dohan Revised 5/7/14
Prices, based on labor costs, become less and less tied to actual resources cost Including raw materials, repair rates and
spare parts from the supply side and scarcity (willingness of the buyer to pay (more) actual resources from buyer
side on the demand side (for a stronger engine, better steel, more accessories).
Flexibility in adjusting the labor force to the needs of the firm
No Incentive to minimize costs or design and introduce new products or technology because the factory got rewarded
for exceeding the planned targets (number of tractors of a certain type) for output by just a little bit, rather than
earning more profit.
Top-down planning (central planning)
Material Balances and their problems. and the plan was always late.
Command economy firms and the principal agent problem encountered by central planners
Asymmetry in information structures both in command economies and market economies
Incentive structure
Problems of market failure caused by
External costs and benefits
Inadequate provision of public-type goods
Unwillingness of consumers to make decisions solely on price for complex goods and services (e.g., medical)
Irrational decision making and bounded rationality (buyers not have raw ability or right “decision making model,
or having imperfect information, etc)
Assymetric information
Principal agent problem
Common property (no ownership)
Characteristics of Corporate governance
Shareholders type board or directors want to maximize long-term share price (though some owners have very
short time horizons) depending on the stock options they offer the offices
Stakeholders type management where the board of directors (share-holders, banks (lenders) workers, consumers,
government, suppliers all have a say in policy.. Very difficult to lay off workers and raise prices. Try to please all
participants.
Slower to hire new full-time workers. Like in US, more part-time workers.
SOE in China: State-owned enterprise board of directors: meet targets
Private firms maximize profits
Ownership of companies: advantages and disadvantages
Publicly owned to raise capital: legal person, limited liability, supposed to maximized the present discounted
value of the shares, board of directors (can be useful) to represent interests of shareholders
Spin-offs, buy-back, mergers, problem of principal-agent, board captured by executives in terms of
compensation, golden-parachute, difficulty of keeping track of different divisions and personel. Diseconomies of
scale.
Privately owned : problem of firm continuity
Family owned: trust only family, often less competent, not always honest, limited amount of capital, not
transparent, found frequently in Asia
Worker owned: the true collective
State-owned: interference from state to achieve certain targets or produce certain products, difficult to lay-off
workers, soft budget constraint financed by banks (which turned into non-performing loans), did not profit
maximize
Bank-owned in part
Michael D. Dohan, Ph.D. Associate Professors of Economics, Queens College, 2014
Institutions, Preconditions and Industrialization, Dohan Revised 5/7/14
NON-PROFIT ORGANIZATIONS WITH A SEMI-AUTONOMOUS BOARD OF DIRECTORS WHO GUIDE THE
ORGANIZATION TO FULFIL ITS GOALS.
Problem of interlocking directorates and which can make companies less competitive when they give preference to
related companies.
Major questions:
Who should own what to provide goods and services and why.
1. What sectors should be state-owned or government-owned and why?
2. What sectors should be private owned and regulated in some (efficient way) for consumers and why?
3. What sectors can be privately owned and operated in a competitive environment TODAY.
(Think about what conditions do you need for a market for a private-type good work efficiently) Ignore external
costs right now, but not other causes for “market failure”. Think also of efficiency SMB=SMC
“Natural monopolies” that distribute goods and services to households and businesses (gas, water, electricity,
telephone, trash pick up, cable, internet) l
Television and Radio Broadcasts
Electric power generation in a large market
Long distance telephone. Cell phone service, and Internet service
Roads of various types (streets in residential and business areas, high-speed expressways)
Tunnels, Bridges, Canals
Railroads tracks
Railway commuter service
Railway freight service
Airports
Airlines
Urban Public transport (buses, subway, trolley)
Long distance bus services (say, NYC to the Hamptions)
Fire Houses and EMT services
Postal Services performing many services for government and to unprofitable places and times
Parcel (Package) Delivery (Fedex, UPS, etc)
Major Banks (really big ones)
Savings band and regular commercial banks
Foreign trade state monopolies
Major Natural resources (Oil, gas, minerals and specific agricultural resources (rubber, coffee, cocoa beans, spices)
(Often exploitable and marketable with large capital investment and foreign expertise and technology).
Great temptation to “nationalize” them away from foreign ownership..
Land ownership and use (Careful)
Problem with state ownership with soft budget constraints and banks and governments willing to cover losses long-term
Tendency to overstaffing with bureaucracy, hiring of relative and friends, reducing unemployment, etc
No profit maximizing incentives to cut costs and trim capacity to demand
Lack of transparency in operation especially if there is no incentive to audit and report operations
Corruption and self serving contracts to friends
Problems setting prices, especially if product is subsidized or there is no permitted competition or regulation
Problems with private ownership in the production of some private-type goods and services
Michael D. Dohan, Ph.D. Associate Professors of Economics, Queens College, 2014
Institutions, Preconditions and Industrialization, Dohan Revised 5/7/14
Private ownership, I suggest, is only “Pareto-efficient” in producing goods and services where the quality and
quantity of outcomes are “defined” by the buyer and can be measured so that profit maximization is functional.
Where it probably has failed:
For profit education institutions especially if financed with government loans and where there is asymmetric
information in knowing the quality of information.
Privately run prisons (how do you measure quality)
For profit hospitals (pricing of services in hospitals is truly arbitrary)
This does not hold true for real non-for-profit organizations providing services such as education, charitable work,
private not-for-profit clubs (tennis club, sports club for kids, etc, which are run by a board of trustees without
compensation, - see definition above)) and where all funds good to providing the services.
Michael D. Dohan, Ph.D. Associate Professors of Economics, Queens College, 2014