Political Economy of Development

Stockholm Doctoral Course Program in Economics Development Economics II

Lecture 5

Political Economy of Development

Masayuki Kudamatsu

IIES, Stockholm University Big question today How does politics

affect development?

Endowment

A continuum (of measure 1) of

agents Each agent: endowed w/ 1 unit of
labor & managerial talent θ Fraction λ: θ = 1 (talented)
− λ: θ = θ(≤ 1)

Fraction 1

(untalented)

Model: Demography & Endowment (cont.)

Fraction η: also endowed w/ a firm

(incumbent)

e.g. Family-owned firm

Fraction 1 − η: (outsiders)

None own wealth
⇒ Financial reform matters

Model: Technology

If agent w/ talent θ owns a firm and

hires l labor (incl. his own):

1 −α

y = θl α: degree of decreasing return to

scale

See sec. V.B. for constant return to

scale

Model: Market for control

Outsiders can buy a firm from an

incumbent by paying price p Each agent can run at most 1 firm
⇒ Talented incumbents cannot buy a

firm from untalented incumbents

Main results would still hold if

otherwise (p. 1227)
⇒

No market for managers

Incumbent cannot hire talented agent as manager of their firm Model: Policy variable 1

ε(≥ k ): cost of setting up a firm for outsiders

k (> 0): technologically determined fixed cost
If k = 0, no role of market for control (pp. 1206-7)
ε − k : degree of entry regulation
Bureaucratic setup costs (incl. bribes) cf. Djankov et al. 2003

Model: Policy variable 2

φ: fraction of borrower’s profit that lenders can recover in case of default Quality of financial legislation /

contract enforcement

As no agents has assets, they need • to borrow for setting up / buying a firm ⇒ φ ↑: financial reform

Credit supply: perfectly elastic w/

Model: payoffs

Workers: w

Incumbents who don’t sell: π + w
(profit plus his own wage) Incumbents who sell: p + w
Outsiders who set up a firm:

Model: Timing of events

1. Outsiders: decide whether to

become a firm owner (either by paying setup cost ε or paying p to an incumbent) by borrowing money

2. Firm owners: hire workers by

paying wage w

3. Production takes place

4. Borrowers: decide whether or not to Assumptions 1. η < λ < 1

To focus on whether talented

outsiders can set up a firm

α−1

= αλ

2. k ⇒ At first best, no untalented agent runs a firm

Main results would still hold if _α−1

αλ > k > 0 (p. 1206)

Analysis: How to proceed

Characterize equilibrium choice of

outsiders by:

f : total # of firms (entrepreneurship) s

: share of firms run by talented agents (meritocracy )

= η and s = λ Initially we have f

First best: f = λ and s = 1 (Lemma
1)

Analysis: How to proceed (cont.)

1. Derive payoffs as functions of (f , s)

2. Analyze how (f , s) change with ε

φ and

3. Identify winners and losers from

reforms ( ε ↓ and φ ↑)

⇒ Assess political feasibility of

reforms (by assuming the more winners, the more feasible) Analysis 1: equilibrium payoffs

given w

clearing c. Obtain π as a function of exog. variables & (f , s) Analysis 1a: labor market

1 −α

Firm owner solves:

max θl − wl

By FOC, the optimal labor demand

by firm owner of talent θ is: _{� (1 − α)θ �}

₁

∗ α

l (θ) = w

Analysis 1b: labor market (cont.)

∗ ∗

Labor market clearing:

= fsl (1) + f (1 − s)l (θ)

1 _{� 1 − α �} ₁ _α _α ₁ = f (s + (1 − s)θ ) w

⇒ Equilibrium wage: ₁ α α _α

w (f , s) = (1 − α)f [s + (1 − s)θ ] Analysis 1c: profit function

To obtain profit function

1 ∗ −α ∗

π(θ) = θl (θ) − w(f , s)l (θ)

∗

we also need expression for l (θ) optimal labor input

∗

(θ) = ^� [(1 − α)θ] w (f , s) ^� ¹ ^α

= [(1 − α)θ] ¹ ^α

[(1 − α)f

[s + (1 − s)θ ¹ ^α ]

] ¹ ^α =

θ ¹ ^α f [s + (1 − s)θ ¹ ^α ] Analysis 1c: profit function (cont.)

π(θ) = θl

∗

(θ)

1 −α

− w(f , s)l

∗

(θ) =

θ ∗ θ ^{1 −α} ^α [f [s + (1 − s)θ ¹ ^α ]]

1 −α

− (1 − α)f

[s + (1 − s)θ ¹ ^α ]

θ ¹ ^α f [s + (1 − s)θ ¹ ^α ] =

αθ ¹ ^α

Analysis 1c: profit function (cont.)

For talented firm owners

H α−1 α−1

π (f , s) ≡ αf [s + (1 − s) g ] For untalented firm owners

L H

π (f , s) ≡ π (f , s)

where _α ₁

g ≡ θ (≤ 1)

< 0:

∂π ^L (f ,s) ∂s

< 0,

(f ,s) ∂s

< 0: ⇐ More firms push up wage

∂π ^L (f ,s) ∂f

< 0,

(f ,s) ∂f

(f , s)

(f , s) ≡ gπ

Analysis 1c: profit function (cont.)

α−1

[s + (1 − s)g]

α−1

(f , s) ≡ αf

∂π ^H
∂π ^H

As f or s goes up:

H _H _α _(1−α) _1−α

π (f , s) + w(f , s) decreases

π (f , s) = [ ]

_{w (f ,s)}

As a function of w , minimized at
w = 1 − α _α _{{f ,s}} max w (f , s) = (1 − α)λ < 1 − α
⇒

Talented incumbents prefer lower f , s if they don’t sell Untalented incumbent’s payoff (See Proof of Proposition 3)

As f or s goes up:

L _α π (f , s) + w(f , s) is...

Minimized at w (f , s) = (1 − α)g

Max w (f , s) = (1 − α)λ could be
larger than this λ is large Which happens if
We’ll see in such a case no one will
set up a firm and thus wage does not reach its maximum

a. Set up a firm by paying ε

An outsider’s decision to

paying p

Either way, an outsider needs to

borrow How much can they bor

Let L be amount of loan, π profit Repay: π − L

Default: π − φπ
⇒ ≤ φπ

Repay iff L Lenders’ profit

− L = 0 if L ≤ φπ
L
φπ − L < 0 if L > φπ •

⇒ Maximum loan: φπ See fn 7 for what if wage can be • Analysis 2a: entry

want to set up a firm if π(f , s) ≥ ε

Outsiders:

can set up a firm if φπ(f , s) ≥ ε

If ⇒ φ < 1, credit constraint (want to own a firm, but cannot borrow for it)

Deregulation & financial reform both

encourage entry

Lemma 2: No untalented outsiders set up a firm under assumption 2 (ie.

α−1

k = αλ ) This simplifies analysis below

All the results would still hold
otherwise

π > π

⇒ If some untalented enter, all

talented should have already entered

π : largest when 1st untalented

enter after all talented entered (w/ no firm sale)

L ⇒ If such π is smaller than ε/φ, Proof of Lemma 2 (cont.)

φπ (η + λ(1 − η), ) η + λ(1 − η)

≤ π (η + λ(1 − η), ) η + λ(1 − η) _{� � α−1}

λ + η(1 − λ)g

α−1

= α(η + λ(1 − η)) η + λ(1 − η)

α−1

= α[λ + η(1 − λ)g]

α−1

< αλ = k (by Assumption 2) Proposition 1

Assume no market for control. The unique equilibrium is:

(η, λ) ≥ ε

Entry iff φπ
At least some talented outsiders set up new firms

φπ

(η, λ) < ε

No Entry iff
No outsider sets up a firm

φπ

(η, λ): Amount of money talented agents can borrow if no one sets up a firm in the equilibrium

If larger than the set-up cost ε, talented agents enter the market ( ⇒ f ↑, s ↑) until π

(f , s) goes down to ε. Corollary 1

Without market for control, ε ↓ or φ ↑ ⇒ Both f & s: ↑

Untalented outsiders won’t set up a
firm (lemma 2)

⇒ # of talented outsiders setting up a firm ↑ ⇒ f ↑ & s ↑

1st best cannot be achieved

1st best: no untalented owns a firm

π : lowest at ε = k , φ = 1

But π > 0, ∀f , s (by α > 0)

≥ π (f , s) want to sell if p

Untalented incumbents:

Talented outsiders:

want to buy if π (f , s) ≥ p _H • can buy if p ≤ φπ (f , s)

⇒ Transaction takes place if L H

π (f , s) ≤ p ≤ φπ (f , s) ⇐⇒ φ ≥ g Talented incumbents won’t sell

Financial reform encourages the sale of a firm from untalented to talented
Consistent w/ evidence by Rossi & Volpin (2004)
p: determined by bargaining power btw. seller & buyer
For much of analysis, the exact p does not matter (fn. 17)

If market for control exists, the unique equilibrium is

No Sales if φ < g
NO untalented incumbents sell

(η, λ) < ε

No Entry if φπ ^H
Entry otherwise (by Proposition 1)

φ ≥ g

All Sell if
ALL untalented incumbents sell

(η, 1) < ε

No Entry if
φπ
^H
Entry otherwise

φ ε g

1 k φ

= ε/π

(η, 1) φ

= ε/π

(η, λ)

Entry No sales Entry All sell

No entry All sell

No entry

No sales Proposition 2 (cont.)

Why all sell, not some sell? One more untalented incumbent

sells

⇒ Labor demand ↑ (talented demand

more)

H ⇒ ↑, π ↓

Wage But this does not affect the

condition for sale as long as φ ≥ g:

If φ does not cross the φ = g line, ε ↓ or φ ↑ ⇒ Both f & s: ↑

Transition from φ < g to φ ≥ g: s jumps up to 1
This change would be smooth if
continuous θ (p.1233)

H ⇒ π (f , s) goes down

⇒ Fewer talented agents set up a firm

Consistent w/ empirical findings

φ ↑ or ε ↓ ⇒ s ↑
Djankov & Murrell 2002
ε ↑⇒ f ↓
Klapper, Laeven, & Rajan 2004
Fisman & Sarria-Allende 2004
?

Who are the winners and losers

from the two reforms? Assumption 3:
In the status quo ( ε , φ ), the
equilibrium is No Entry No Sale

Outsiders: always win (Prop 4
• Their payoff: at least w (f , s)
Talented incumbents: always lose (Prop 4(ii))

more than they increase wage

Both φ ↑ & ε ↓ erode π ^H
Maximum wage (w

(λ, 1)) at 1st-best is not large enough to compensate profit loss

Can untalented incumbents be winners

Proposition 4 (iii)

Untalented incumbents’ payoff: Always ↓ by deregulation

For φ < g, wage cannot be large
enough to compensate profit loss
For φ ≥ g, price of firm ↓
_H

where ε ∈ [k , π ˜ (η, 1))

↑ by financial reform if ε > ˜ ε Why untalented incumbents’ payoff goes up with φ ↑?

Once All Sell equilibrium achieved, their

payoff: w (f , 1) + φπ (f , 1) No Entry equilibrium: wage

constant at w (η, 1) while the firm price increases Entry equilibrium: wage goes up
with φ via f ↑ while the firm price is

induces entry before All Sell equilibrium achieved In this case, untalented incumbents’
payoff goes down with φ ↑ due to profit erosion

Untalented incumbents:

endogenously compensated by market for control

Welfare gain by financial reform: firms

run by more talented By selling firms to talented,
untalented incumbents share the benefit of financial reform

Untalented incumbents: more likely

to support financial reform w/ higher ε ⇐ Because higher entry barrier kills the profit-reducing effect of financial reform

⇒ To enact financial reform, raising ε

is a good idea! Optimal sequence of reform can then be

(section IV.C)

First, financial reform without entry

deregulation

so untalented incumbents support the

reform
Now untalented incumbents have

Then entry deregulation

become workers supporting the reform

incorporates political-economy But perhaps naive to assume that
political feasibility goes up with # of supports What’s the role of political
institutions?

Democracy: perhaps most

important political institutions Development assistance

Figure 1 (Besley 2006, p. 5)

What is democracy, BTW?

Definition in this lecture: A political system in which

policy-makers are chosen in a competitive popular election

Digression: Democracy datasets

treats different aspects of democracy as

Polity IV or Freedom House

substitutes

(recently updated by Cheibub et al. 2010)

Przeworski et al. (2000)

treats different aspects of democracy as complements cf. Munck and Verkuilen (2002) for

2-1. Evidence

Large social science literature on

which political regime can achieve higher growth cf. Przeworski & Limongi (1993) for an early literature survey Acemoglu et al. (2008) provide
three stylized facts

2-1 Evidence (cont.)

democratic (Fig.2)

Figure 2 (Acemoglu et al. 2008, p. 809)

2-1 Evidence (cont.)

democratic (Fig.2) This could be either due to

1. Democracy ⇒ Development

2. Development ⇒ Democracy 3. 3rd Factor ⇒ Development & Democracy

2-1 Evidence (cont.)

income and changes in democracy in 20th century

1975-1990 (Fig.3)

1900-2000 (Fig.4)

Figure 4, 1900-2000 (Acemoglu et al. 2008, p. 812)

2-1 Evidence (cont.)

changes in income and changes in democracy in the very long run: 1500-2000 (Fig.5) Figure 5, 1500-2000 (Acemoglu et al. 2008, p. 832)

2-1 Evidence (cont.)

run: 1500-2000 (Fig.5) This could be either due to

1. Very long-run effect of democracy on

development

on democracy

3. 3rd factor driving both changes

2-1 Evidence (cont.)

Positive cross-sectionally

Correlation with health

Zero for changes after WWII (Besley
& Kudamatsu 2006, Ross 2006)
Positive cross-sectionally • Zero for changes after WWII, if years • of schooling used (Acemoglu et al. 2005) Positive for changes after WWII or

Correlation with education

1865, if enrollment ratio used

2-1 Evidence (cont.)

Very difficult to identify causal effect of democracy Democracy: endogenous

education, emergence of middle
class, etc. (Lipset 1959)
transitory negative income shock
(Brucker & Ciccone 2011)

Kudamatsu (2012): use

cross-counry micro panel data on survival of a woman’s babies to

2-2 Beyond simple comparison

4 reasons for why simple comparison is fruitless

⇒ Heterogenous treatment effect

b. Accountability theory of politics

⇒ Complementary institutions to make

⇒ Autocracy: highly heterogenous Digression: 2 views on politics

Conflict of interest

Representation

among citizens

cf. Persson & Tabellini (2000, ch. 3 & 5)

Conflict of interest

Accountability

between govt & citizens

cf. Persson & Tabellini (2000, ch. 4),

2-2a Representation perspective

Firm managers and Workers • Firm managers prefer
Low tax rate
Entry barrier to keep wages low
Workers prefer

Tax ↑ ⇒ Investment ↓ ⇒ Short-run growth ↓ ↑ ⇒ Innovation ↓ • Entry barrier ⇒ Long-run growth ↓

Autocracy: Firm managers decide policies •

1. Tax: low ⇒ Short-run growth: high

2. Entry barrier: high ⇒ Long-run growth: low

Tax ↑ ⇒ Investment ↓ ⇒ Short-run growth ↓ ↑ ⇒ Innovation ↓ • Entry barrier ⇒ Long-run growth ↓

Democracy: Workers decide policies •

1. Tax: high

⇒ Short-run growth: low

2. Entry barrier: low

⇒ Long-run growth: high Impact of democracy on growth has

two channels

Investment

Innovation
Democracy: good for growth in

2-2b Accountability perspective

Democracy: regularized leadership

contest Citizens can replace incompetent

This argument makes (at least) 3

implicit assumptions

1. Voters know what leaders did ⇒ w/o free media, this is unlikely

2. Voters behave as one agent

⇒ w/ conflict of interest among

3. Challenger is better than bad-behaving incumbent

⇒ w/o complementary institutions, democracy won’t work

2-2c One more stylized fact

More volatile economic growth in autocracy than in democracy Performance varies a lot more for

autocracy (Fig.7)

2-2c One more stylized fact

More volatile economic growth in autocracy than in democracy Performance varies a lot more for

autocracy (Fig.7) Jones & Olken (2005): Natural
death of a leader ⇒ Changes in growth in autocracy, but not in democracy

⇒ Autocracy appears to be VERY heterogeneous ⇒ Not an ideal control group to estimate the impact of democracy

2-2d de facto political power

Acemoglu & Robinson (2008): Rich

may intensify de facto political power to nullify de jure political power of poor ⇒ Regime change may not be followed by policy change

Research question

What characteristics of autocracy &

economy explain these three stylized facts?

A continuum of infinitely-lived

citizens of mass 1 Proportion π
A : group A; the rest

group B

Group identity: observable &

impossible to change (e.g. skin color)
t

∈ {A, B} in Leader of group S

power (government) Model: technology & citizens’ actions _{a A}

ω = 0) _{a A A} _t if engage in activity a (z

Group A:

ω − θ if activity b (z = 1) • _t _{b B}
ω if engage in activity b (z = 0) • _{b B B} _t _t
ω − θ if activity a (z = 1)

Group B:

i θ (i ∈ {A, B}): comparative adv.
e.g. tree crops (cocoa etc.), ethnic

network (Banerjee & Munshi 2004, Model: leader S

’s actions (policies)

S _t a t

, τ

S _t b t

⇐ No state capacity to tax income

Tax on each activity: τ

S _t A t

, η

S _t B t ⇐ Group identity observable

Patronage to each group: η

S a A a _t

Group A citizens

(1 − z )(ω − τ )

t t

z (ω − θ − τ )

t t S A _t

R(η )

_{� �� }

R > 0, R < 0, R(0) = 0, R (0) > 1 • S A _t

⇒ Social optimal η > 0, satisfying

Group B citizens

(ω

S _t B t

)

S _t a t

− τ

− θ

)

S _t b t

− τ

)(ω

B t

(1 − z

Model: preference (cont.)

z
R(η

) Model: preference (cont.)

t S a _t

Leader of group S

A A A B

τ [π (1 − z ) + (1 − π )z ]

t t t S b _t A A A B

τ [π z + (1 − π )(1 − z )]

t t t S A S B

A A

_{t t}

− π η − (1 − π )η

t t If ousted, leader’s payoff is 0 from t on

δ: discount factor for both group

S _t

Group S t : decide whether to

support leader S t (s = 1) or to

t S _t

oust him (s = 0)

t S _{t S} _t

t = S t w/ prob. γ

If s = 1, S

1 t S _t

S _t

If s = 0, S = S w/ prob. γ

1 t S S ^t ^t

Uncertainty of leadership succession

γ > γ

in autocracy

1 Leader of S chooses policy vector

S a S b S A S B

_{t t t t}

P ≡ {τ , τ , η , η }

t t t t t

2 Group S decides whether to t S _t

support leader, s ∈ {0, 1}

3 Both groups decide whether to A B

switch activity, z , z ∈ {0, 1}

t t

Model: Timing of events (cont.)

= 1, P

4(a) If s t implemented, payoffs

= S realize, S t t w/ prob. γ

1 S _t

4(b) If s = 0, leader ousted, t

P ≡ {0, 0, 0, 0} implemented,

r payoffs realize, S = S w/ prob. t t

1 S _t

γ Model: discussion on assumptions

(1) No collective action problem (2) No repression

(3) Group j �= S never supports leader

of S t (1) & (2): fine as leader would

otherwise steal more (3): Why not leader seeks sup

Focus on Markov Perfect Equilibrium (MPE)

Strategies: contingent only on the

payoff-relevant state variable S &

prior actions within the same period

Exclude history-dependent strategies

such as trigger strategy (see sec 3.1)

⇒ Below time subscript t dropped

State transitions: as described in

Digression: Equilibrium concepts

A repeated game has many SPEs ⇒ Economists focus on a subset of them that are most plausible

1. Stationary SPEs

2. SPEs on the Pareto frontier (& take

a stance on relative bargaining power of players)

⇐ Baland & Robinson (2008) Definition of equilibrium (cont.)

Pure-strategy MPE: set of the following 4 strategies that are best responses to each other

= P Leader of A: P

Leader of B: P = P

Group A citizens:
A S A A

σ (S, P ) = {s , z } Group B citizens:

Case of S = B can all be analyzed
symmetrically

V (S): value function for group j

citizens in state S

(S): value function for leader of j W

in state S _{A B}

(B) = 0, W (A) = 0 W

Choice of z : no impact on

continuation value

B b Ab b B Aa

< ω

⇒ z = 1 iff ω − τ − θ − τ t A

A a Aa a A Ab

Likewise, choice of z :

< ω z = 1 iff ω − τ − θ − τ

t Analysis: switching (cont.)

Tax revenue from a citizen of group B

Ab B Ab B Aa

Aa B Ab B Aa

τ if z = 0 ⇐⇒ τ ≤ θ + τ

Ab B Aa

τ if z = 1 ⇐⇒ τ > θ + τ

⇒ Maximized at τ = θ + τ

Tax Revenue from a citizen of group B _τ _Aa ₄₅ o _{B Aa} _Ab

τ _τ

Same is true for tax revenue from

group A

Aa Ab ⇒ Leader sets (τ , τ ) so that

A B

z = z = 0

⇒ Upper limit on tax rates: Aa A Ab

τ ≤ θ + τ

Ab B Aa

τ ≤ θ + τ

If s

R(η
δγ

V A (A) + δ(1 − γ

(B)

V A (A) + δ(1 − γ

)

− τ

= 1 (support) ω

Analysis: support for incumbent

If s = 0 (oust)

δγ

(B)

Analysis: support for incumbent

⇒

s = 1 iff

Aa AA

τ − R(η )

A A A A

≤ δ(γ − γ )(V (A) − V (B))

≡ Φ

LHS: Net tax payment

(1 − π

(A) subject to

≤ θ

, τ

≤ θ

− R(η

) ≤ Φ

Analysis: leader’s problem

max

τ Âa ,τ Âb ,η ÂA ,η ÂB

(τ

− η

)

)(τ

− η

δγ

1. = 0: no transfer to excluded

group

⇐ Excluded group cannot affect leader’s survival

Ab B Aa 2. τ = θ + τ : tax revenue from

excluded group maximized

Excluded group cannot affect leader’s • survival ⇒ Leader can tax them until they are

indifferent btw. activities a & b _{Aa A Ab} Lemma 1 (cont.) Aa A AA

3. τ = Φ + R(η ): tax on leader’s

group constrained

⇐ Leader’s group would kick leader out _Aa if higher τ than this In equilibrium, leader is always

supported

⇒ Leader’s objective function:

A A AA AA

π max (Φ + R(η ) − η ) _AA

η A B A AA

Political Economy of Development