Problem Set 4

by Sarah A.

1. Economic Institutions and Development

Have a look at Figure 1. Can we infer that latitude is a good explanation for differences in per capita incomes between countries? Explain.

a) Latitude

Interpretation of strong correlations between geographical variables like latitude and income per capita
European had no immunity to tropical diseases during colonial period and colonies tended to be created in temperature latitudes
Thus the historical creation of economic institutions was correlated with latitude.
Today there is no causal effect of geography on prosperity today, though geography may have been important historically in shaping economic institutions

1. Economic Institutions and Development

How do Acemoglu and Robinson (2012) define extractive institutions? What is the impact of such institutions on modern economic development?

b) Extractive Institutions

Extractive economic institutions are so structured to extract resources from many by the few and that fail to protect properly rights or provide incentives for economic activity
Extractive economic institutions are synergistically linked to extractive political institutions, which concentrate power in the hands of a few, who will then have incentives to maintain and develop extractive economic institutions for their benefit and use the resources they obtain to cement their hold on political power
These tendencies do not imply that extractive economic and political institutions are inconsistent with economic growth. On the contrary, every elite would, all else being equal, like to encourage as much growth as possible in order to have more to extract
Extractive institutions that have achieved at least a minimal degree of political centralization are often able to generate some amount of growth.

1. Economic Institutions and Development

Briefly explain the idea of the Reversal of Fortune. How is it related to institutions?

c) Reversal of Fortune

The tropics in the Americas were thus much richer than the temperature zones
Making the places that were previously relatively wealthy in the Americas relatively poor
While the geography stayed the same, the institutions imposed by European colonists created a “reversal of fortune”

2. The Colonial Origins of Development

Acemoglu et al. (2001)1 attempt to measure the causal effect of institutions on economic performance. The baseline OLS model they estimate is as follows:

𝑙𝑛𝑦𝑖 = µ + 𝛽1𝑅𝑖 + 𝑋𝑖′ϒ + 𝜀𝑖

where 𝑦𝑖 is income per capita in country 𝑖, 𝑅𝑖 measures protection against expropriation, 𝑋𝑖 is a vector of covariates and 𝜀𝑖 is a random error term.

What does the coefficient 𝛽1 measure? How would you interpret a negative sign of 𝛽1? Please give a brief answer.

a) β1

It measures the coefficient of interest, the effect of institutions on income per capita
A negative Beta would express a negative impact and influence on the income per capita
β1 is a regression coefficient. It shows the contribution on the influencing variable Ri to the explanation of the target variable vi
If the factor changes by one unit, then the dependent variable changes by one unit

2. The Colonial Origins of Development

Acemoglu et al. (2001)1 attempt to measure the causal effect of institutions on economic performance. The baseline OLS model they estimate is as follows:

𝑙𝑛𝑦𝑖 = µ + 𝛽1𝑅𝑖 + 𝑋𝑖′ϒ + 𝜀𝑖

where 𝑦𝑖 is income per capita in country 𝑖, 𝑅𝑖 measures protection against expropriation, 𝑋𝑖 is a vector of covariates and 𝜀𝑖 is a random error term.

𝛽1 is expected to be biased in a standard OLS regression. Briefly mention at least two potential sources of endogeneity in this model and explain them.

b) Sources of Endogeneity

Endogenity = The presence of a correlation between regressor and cofounding term
Potential causes are for example
- the omission of important explanatory variables
- faulty measurement
- simultaneity in the variables
- serial autocorrelation with lagged dependent variables
- self-section problems

2. The Colonial Origins of Development

Acemoglu et al. (2001)1 attempt to measure the causal effect of institutions on economic performance. The baseline OLS model they estimate is as follows:

𝑙𝑛𝑦𝑖 = µ + 𝛽1𝑅𝑖 + 𝑋𝑖′ϒ + 𝜀𝑖

where 𝑦𝑖 is income per capita in country 𝑖, 𝑅𝑖 measures protection against expropriation, 𝑋𝑖 is a vector of covariates and 𝜀𝑖 is a random error term.

In the first stage of a 2SLS regression, the authors model 𝑅𝑖 as 𝑅𝑖 = 𝜔 + 𝛽𝑙𝑛𝑀𝑖 + 𝑋𝑖′𝜑 + 𝜐𝑖, where 𝑀𝑖 is a measure of historical European settler mortality. Name the exclusion restriction in this model. Name one significant threat to this exclusion restriction.

c) Exclusion Restriction

The exclusion restriction is that the mortality rates of European settlers more than 100 years ago have no effect on GDP per capita today, other than their effect through institutional development
The major concern with this exclusion restriction is that the mortality rates of settlers could be correlated with the current disease environment, which may have a direct effect on economic performance

2. The Colonial Origins of Development

Acemoglu et al. (2001)1 attempt to measure the causal effect of institutions on economic performance. The baseline OLS model they estimate is as follows:

𝑙𝑛𝑦𝑖 = µ + 𝛽1𝑅𝑖 + 𝑋𝑖′ϒ + 𝜀𝑖

where 𝑦𝑖 is income per capita in country 𝑖, 𝑅𝑖 measures protection against expropriation, 𝑋𝑖 is a vector of covariates and 𝜀𝑖 is a random error term.

Refer to Panel B of ‘Table 4 – IV Regressions of Log GDP Per Capita’ in the paper. Does 𝑀𝑖 appear to be a relevant instrument for 𝑅𝑖? How can you tell?

d) Measure of historical European settler mortality

Looking at the values, a consistently negative significant influence between 0.43 and 0.59 on the model can be found
Accordingly, it can be concluded that Mi has a relevant influence on Ri. Adding one unit of Mi to the model decreases Ri between 0.43 and 0.59 units.

2. The Colonial Origins of Development

Acemoglu et al. (2001)1 attempt to measure the causal effect of institutions on economic performance. The baseline OLS model they estimate is as follows:

𝑙𝑛𝑦𝑖 = µ + 𝛽1𝑅𝑖 + 𝑋𝑖′ϒ + 𝜀𝑖

where 𝑦𝑖 is income per capita in country 𝑖, 𝑅𝑖 measures protection against expropriation, 𝑋𝑖 is a vector of covariates and 𝜀𝑖 is a random error term.

The authors find that the 𝛽1 in 2SLS is higher than in the OLS regression. How do they explain this negative bias of the OLS?

e) 2SLS vs. OLS regression

the difference could be due to measurement error in the institutions variable by making use of an alternative measure of institutions, for example, the constraints on the executive measure
Using this measure as an instrument for the protection against expropriation index would solve the measurement error, but not the endogeneity problem
This exercise leads to an estimate of the effect of protection against expropriation equal to 0.87 (with standard error 0.16). This suggests that “measurement error” in the institutions variables is of the right order of magnitude to explain the difference between the OLS and 2SLS estimates.