Institutions and property rights

Say why enforceability explains more of the wealth gap than resources do.

Institutions is the vaguest word in this section, so this lesson makes it a number. An institution here is whatever makes a promise enforceable: courts that will rule against the government, a record of who owns what, and the practical ability to collect on a judgment.

One decision, made by one person

You can invest in something that pays back over years, or do something that pays today. The long project is worth more, and only if you are still holding it when it pays.

That gives one line of arithmetic. A project's value is its payoff times the chance you still own it at the end, and the chance compounds. At 95% a year over ten years, 60% of the value survives. At 80% a year, 11% does. The drop is not linear and the interesting range is narrow.

Buy and resell goods0.5 yr
Worth 1.32x of the 1.35x it promises. The regime took 2%.
Open a shop2 yr
Worth 1.80x of the 1.9x it promises. The regime took 5%.
Plant an orchard7 yr
Worth 3.59x of the 4.2x it promises. The regime took 14%.
Build a factory12 yr
Worth 5.80x of the 7.5x it promises. The regime took 23%.
Build a rail line25 yr
Worth 10.70x of the 18x it promises. The regime took 41%.

what it promises what it is worth here the bar it has to clear

Longest horizon anybody starts

25 yr

Projects abandoned

Best available

10.70x

Potential given up

41%

Everything on the list is worth starting, including the rail line that takes twenty-five years to pay anything. Note that even here 41% of the potential is gone: twenty-five years is a long time to hold anything, and perfect enforcement is not on the menu in any country.

Chance your property is still yours next year98%The one that compounds. Five points here is worth more than any court reform.Years to get a judgment0.5 yrOnly bites the quarter of projects that end up in dispute.What enforcing a contract costs5%Also diluted by how rarely anybody needs a court at all.

Switch to weak institutions and watch which projects die. It is not a random selection.

Worked example

The list dies from the bottom up

Five projects in order of how long they take to pay: a six-month trade, a shop, an orchard, a factory, and a rail line. Under strong institutions all five are worth starting.

The rail line goes first. Twenty-five years at 84% yearly security leaves 1.3% of it. It promises eighteen times its cost and is worth 0.19.
Then the factory. Twelve years leaves 12%, and 7.5 times becomes 0.77. Below the bar.
The trade is completely fine. Six months, and almost nothing can happen to you in six months. Its value falls by a quarter and it still clears.

So the economy is full of trading and short of factories, and not for any lack of enterprise. Every project anybody starts there mostly succeeds. The loss is the ones nobody started, and no statistic anywhere records a decision not to begin.

Two numbers from the model that I did not expect. Even under strong institutions, 41% of the potential is gone, because twenty-five years is a long time to hold anything and perfect enforcement is not available in any country. And a slow court is a much smaller problem than an insecure year: taking a factory's yearly security from 98% to 93% costs it nearly half its value, while taking the courts from six months to twelve years costs it about five percent. Insecurity compounds over the whole horizon and the court delay only bites the fraction of projects that end up in dispute.

The argument is Douglass North's, developed in Institutions, Institutional Change and Economic Performance, 1990. Acemoglu, Johnson, and Robinson's work on colonial origins is the best-known attempt to measure it, and it is contested, largely over whether the instruments they use are as clean as they claim. The model on this page is stylized and unit tested; the figures are its own rather than anybody's data.

ConventionProperty rights in this sense are not about who is listed as the owner. They are about what happens when somebody disputes it: whether there is a record, whether a court will hear it, whether the ruling goes against a powerful party when the facts say it should, and whether anybody enforces the ruling afterwards. A country can have excellent laws on all four and still fail on the third, which is why the written law is a poor guide to the actual regime.

Why this beats geography and resources

Resources are the explanation people reach for first and they explain the least. Oil, land, and minerals are inputs that a country either has or buys, and buying them is not expensive relative to what a functioning economy produces. The countries with the most valuable subsoil are not reliably the richest, and several of them are conspicuously not.

What resources do reliably produce is a fight over who gets them, which is a question about institutions again. A large deposit under a weak state is a reason for somebody to seize the state, and the seizing is what lowers the security number that kills every long project.

What breaks

Reading the written law. Most weak-institution countries have perfectly good statutes. What differs is whether a court will apply them to somebody powerful, and that does not appear in the text. The measure that matters is what an investor expects, and expectations are formed by what happened to the last person, not by what the code says.

Assuming the fix is fast. The security number in this model is a belief about the future, and beliefs are formed from a track record. A government can change the law in an afternoon and cannot change its track record in less than a decade, which is why reforms take so long to show up in investment.

Treating strong institutions as a settled state. They are a running achievement rather than a possession, and the number in this model can fall in a rich country as easily as it can rise in a poor one. Nothing in the arithmetic distinguishes the two directions.

What to do with this

When you are comparing two countries, ask what the longest project anybody is starting there is. Not the growth rate and not the resources. The horizon of the investment tells you what people actually expect, and it is a belief revealed by an action rather than stated in a survey.

And apply it at a smaller scale, because the arithmetic does not care about the unit. Any arrangement where the payoff is distant and the promise is weak produces the same result: a company where nobody starts anything that outlasts the current management, or a job where the useful work takes two years and the review cycle is quarterly. The projects that die are the long ones, and nobody has to decide to kill them.

Test yourself

01Two countries have the same minerals, the same coastline, and the same climate. One is four times richer. What is the most likely difference, and what is the mechanism?

Whether a promise can be enforced. The mechanism is not that the poorer country works less hard; it is that the projects worth doing there are all short ones. A factory that pays back over twelve years is only worth building if you expect to still own it in twelve years, and that expectation is what an institution is.

The resources are close to irrelevant in that comparison, and the model on this page shows why: a fifteen-point difference in yearly security wipes out more value on a long project than any plausible difference in what is under the ground.

02A government wants foreign investment and announces a large tax break for new factories. Why might that not work?

Because the tax rate affects the payoff and the enforceability affects whether you collect it. A generous share of nothing is nothing. If the concern is that the plant might be seized, licensed away, or tied up in a court that takes six years, a tax holiday does not speak to any of it.

Worse, a government that can grant a discretionary tax break can withdraw one, and the ability to change the terms is itself the thing being priced. The announcement can lower confidence in the rules while appearing to improve them.

03Why is the cost of weak institutions almost impossible to measure directly?

Because it is made of things that did not happen. Every project that does go ahead in a weak-institution country mostly succeeds, so the failure rate looks fine. What is missing is the factory nobody built and the orchard nobody planted, and no statistical agency records a decision not to start. The visible economy looks healthy and the invisible one is where the loss is.

A tutor that knows this lesson. It asks before it explains, and it will not tell you what to do with your own money.

Educational material, not investment or policy advice. Figures are cited where they come from a filing or a statistical series, and labelled as illustrative where they do not.