SOURCE: LECTURE OF BRAD DELONG
INCLUSIVE INSTITUTIONS DEFINED
 INCLUSIVE
INSTITUTIONS (p.
74): “Inclusive economic
institutions…are those that allow
and encourage participation by the
great mass of people in economic
activities that make best use of their
talents and skills and that enable
individuals to make the choices they
wish.
MORE ON INCLUSIVE INSTITUTIONS



(p. 75): Inclusive economic institutions foster economic activity,
productivity growth, and economic prosperity. Secure private property
rights are central, since only those with such rights will be willing to
invest and increase productivity. A businessman who expects his output
to be stolen, expropriated, or entirely taxed away will have little
incentive to work, let alone any incentive to undertake investments and
innovations. But such rights must exist for the majority of people in
society.
(p. 76): Inclusive economic institutions create inclusive markets, which
not only give people freedom to pursue the vocations in life that best suit
their talents but also provide a level playing field that gives them the
opportunity to do so. Those who have good ideas will be able to start
businesses, workers will tend to go to activities where their productivity
is greater, and less efficient firms can be replaced by more efficient ones.
SO WHY DO INSTITUTIONS MATTER?
EXTRACTIVE INSTITUTIONS DEFINED
 EXTRACTIVE
INSTITUTIONS
(p. 76): “We call such institutions,
which have opposite properties
to those we call inclusive,
extractive economic
institutions—extractive because
such institutions are designed to
extract incomes and wealth from
one subset of society to benefit a
different subset.”
THE OUTPUT RECIPE
Think of national output like a cake recipe.
 What are the ingredients?

 Land
 Labor
 Capital
(i.e. machinery,
buildings, etc…)
LAND AND DIMINISHING RETURNS
Typically land cannot be increased (except for warfare,
where you take land from your neighbors).
 So land is the limiting factor!
 This means that the “Law of Diminishing Returns” is
important.


Adding more workers – holding all else constant (all else
includes land) – will eventually result in the productivity of
each additional worker to decline.
CAN A NATION GROW BY JUST ADDING
MORE LABOR AND CAPITAL?
Nations can grow temporarily by adding more
labor and/or more capital.
 The Law of Diminishing Returns, though, tells us
that changing the quantity of labor and capital
can only work temporarily.

HOW CAN NATIONS GROW PERSISTENTLY?
If quantity changes are temporary, how can a
nation’s economy grow persistently?
 The key is changing the QUALITY of a nation’s
labor and capital.
 And that means the nation must create and
adopt better technology.

CREATIVE DESTRUCTION
OR WHY IS NEW TECHNOLOGY RESISTED
 As
noted in “Why Nations Fail”…
 New technology replaces past technology
(i.e. creating new ideas destroys past ideas).
 Therefore, the process of “create
destruction” tells us that people who benefit
from existing technology will see new
technology as a threat.
 If the people who benefit from existing
technology are making decisions for society,
that society will not tend to adopt new
technology.
 And therefore, that society will not see
economic growth.
THE IMPORTANCE OF INCLUSIVE
INSTITUTIONS

Just to review…
economies can only grow persistently if new
technologies are adopted
 leaders in a society dominated by extractive
institutions will see new technology as a potential
threat


Therefore… only societies that adopt inclusive
institutions will see persistent economic growth.
WHY EXTRACTIVE INSTITUTIONS DON’T
LEAD TO GROWTH




Why Nations Fail (p.430)
What is crucial, however, is that growth under extractive
institutions will not be sustained, for two key reasons.
First, sustained economic growth requires innovation, and
innovation cannot be decoupled from creative destruction,
which replaces the old with the new in the economic realm
and also destabilizes established power relations in politics.
Because elites dominating extractive institutions fear
creative destruction, they will resist it, and any growth
that germinates under extractive institutions will be
ultimately short lived.
Second, the ability of those who dominate extractive
institutions to benefit greatly at the expense of the rest of
society implies that political power under extractive
institutions is highly coveted, making many groups and
individuals fight to obtain it. As a consequence, there will
be powerful forces pushing societies under extractive
institutions toward political instability.
POLITICAL MONOPOLY?
KEY
IDEA: If one group has a
political monopoly, then a
society will not likely
embrace technological
change. In other words,
there has to be a possibility
that everyone in society can
enjoy a leadership position.
Extractive Economic Systems




Feudalism - an economic system in which traditions rule.
Mercantilism - an economic system in which the government determines
the allocation of resources by assigning the rights to certain economic
activities.
Socialism (according to Marx) - an economic system where the incentive
system of capitalism remains in place, but the workers own the means
of production.
Socialism (as it is practiced) - an economic system where the four
economic questions are primarily addressed by government actions, not
unregulated market forces.
Inclusive Economic Systems


Capitalism -an economic system based upon private
property and the market in which, in principle, individuals
answer the basic questions of the economic system.
Mixed Capitalism - an economic system characterized by
largely private ownership of the factors of production,
market allocation of resources, and decentralized decision
making. Most economic activities take place in the private
sector in this system, but government plays a substantial
economic and regulatory role.
GOODS
MARKET
INTERNATIONAL
CONNECTION
HOUSEHOLDS
(Consumption)
INTERNATIONAL
CONNECTION
GOVERNMENT
BUSINESS
(Production)
FACTOR
MARKET
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 Households supply the labor with which businesses
produce and government governs
 The largest source of household income is wages
and salaries
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 Businesses are private producing units in our society
 Businesses in the U.S. decide what to produce,
how much to produce, and for whom to produce it
 Businesses produce what they believe will sell and
make a profit
 The desire to make a profit leads businesses to
produce – in general – the goods that make society
better off.
 Although businesses decide what to produce, they
are guided by consumer sovereignty
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




Conventional wisdom (orthodox theory) focuses on
scarcity and posits the idea of consumer sovereignty.
These concepts lie at the heart of demand theory.
John Kenneth Galbraith argued that the issue of scarcity
has been solved. He laments the obsession society places
on growth and ever expanding output.
Business now busies itself convincing people to buy
goods that are sold as necessities to this generation, yet
were luxuries or non-existent to past generations.
“One cannot defend production as satisfying wants if that
production creates wants”
Galbraith notes that because public goods – like national
parks and roads -- are not advertised, these goods are
under produced at the determinant of society.

Sole proprietorships – businesses that have only
one owner

Partnerships – businesses with two or more owners

Corporations – businesses that are treated as a
person, and are legally owned by their stockholders,
who are not liable for the actions of the corporate
“person”
Flexible-purpose Corporations, Benefit Corporations
(B-corporations), L3C
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Advantages
Disadvantages
• Minimum bureaucratic
hassle
• Direct control by owner
• Limited ability to get
funds
• Unlimited personal
liability
Partnership
• Ability to share work and
risks
• Relatively easy to form
• Limited ability to get
funds
• Unlimited personal
liability (even for
partner's blunder)
Corporation
• No personal liability
• Increasing ability to get
funds
• Ability to avoid personal
income taxes
• Legal hassle to organize
• Possible double
taxation of income
• Monitoring problems
Proprietorship
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BASIC GOVERNMENT STATS
 The United States has a federal government system,
which means we have various levels of government
(federal, state, and local) each with its own powers
 Together all levels of government consume about 20%
of the country’s total output and employ about 22 million
individuals
 The state and local levels of government employ over
19 million people and spend about $2.1 trillion a year
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FEDERAL GOVERNMENT EMPLOYMENT
RECENT CHANGES IN ALL GOVERNMENT
EMPLOYMENT
GOVERNMENT:
INCOME OF STATE AND LOCAL
GOVERNMENTS
Intergovernmental
26%
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GOVERNMENT:
EXPENDITURES OF STATE AND LOCAL GOVERNMENTS
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GOVERNMENT:
INCOME OF THE FEDERAL GOVERNMENT
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TYPES OF TAXES
Progressive – as income rises, the percentage
you pay increases. (i.e. an income tax)
 Regressive – as income rises, the percentage
you pay decreases (i.e. a sales tax)
 Proportional – as income rises, the percentage
you pay stays the same (i.e. a flat tax)

TAXES OF THE FEDERAL GOVERNMENT

http://www.ustreas.gov/education/factsheets/taxes/ustax.shtml
 The
income tax was instituted in
1913
 The social security tax was instituted
in 1935
RECENT TAX HISTORY

Effective tax rates from 1979 to 2007
 http://www.taxpolicycenter.org/taxfacts/displayafa
ct.cfm?Docid=456

Marginal tax rates from 1913 to 2011
 http://www.taxfoundation.org/publications/show/1
51.html
 In
recent years taxes in the United
States have declined.
THE U.S. IS A RELATIVELY
LOW TAX NATION
CONSEQUENTLY… DEBT IS
ALSO USED TO FINANCE THE
GOVERNMENT
We will discuss the
National Debt later
in the course
GOVERNMENT:
EXPENDITURES OF THE FEDERAL
GOVERNMENT
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FEDERAL GOVERNMENT SPENDING
GROWTH IN SPENDING UNDER DIFFERENT
PRESIDENTS
GROWTH IN SPENDING UNDER DIFFERENT
PRESIDENTS
SOCIAL SECURITY AND MEDICARE


Why can’t we rely on markets to provide retirement insurance
and health insurance for the old?
 For the former, individuals do not do well with the
“retirement decision”, since it doesn’t have a good feedback
mechanism.
 For the latter, who would sell insurance to someone who is
almost guaranteed to use it?
Prior to these programs being enacted (Social Security came
into existence in the 1935 and Medicare in 1965) senior
citizens were the poorest people in the nation. That is no
longer true today.
EISENHOWER (REPUBLICAN PRESIDENT FROM
1953 TO 1961) ON THE NEW DEAL


from Land of Promise: An Economic History of the United States (Michael Lind)
”On November 8, 1954, in a letter to his brother Edgar, President Dwight Eisenhower reacted
angrily to the criticism that his administration was continuing the policies of his immediate
predecessors Franklin Roosevelt and Harry Truman: “Now it is true that I believe this country is
following a dangerous trend when it permits too great a degree of centralization of
governmental functions. I oppose this—in some instances the fight is a rather desperate one.
But to attain any success it is quite clear that the Federal government cannot avoid or escape
responsibilities which the mass of the people firmly believe should be undertaken by it. . . .
Should any political party attempt to abolish social security, unemployment insurance, and
eliminate labor laws and farm programs, you would not hear of that party again in our political
history. There is a tiny splinter group, of course, that believes you can do these things. Among
them are H. L. Hunt (you possibly know his background), a few other Texas oil millionaires, and
an occasional politician or business man from other areas. Their number is negligible and they
are stupid.”
EISENHOWER AND THE MILITARY INDUSTRIAL
COMPLEX (1961)
 "In
the councils of government, we must
guard against the acquisition of
unwarranted influence, whether sought or
unsought, by the military-industrial
complex. The potential for the disastrous
rise of misplaced power exists, and will
persist."
MILITARY SPENDING AROUND THE WORLD
HTTP://WWW.SIPRI.ORG/RESEARCH/ARMAMENTS/MILEX/FACTSHEET2010
MORE ON US MILITARY SPENDING
Six Roles of a Government in a
Market
In its role as both an actor and a referee, government
plays a variety of specific roles in the economy
These roles include:
1. Providing a stable set of institutions and rules
2. Promoting effective and workable competition
3. Correcting for externalities
4. Ensuring economic stability and growth
5. Providing public goods
6. Adjusting for undesirable market results
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Thomas Hobbes
Leviathan (1651)

"Whatsoever therefore is consequent to a time of Warre, where every
man is Enemy to every man; the same is consequent to the time,
wherein men live without other security, than what their own strength,
and their own invention shall furnish them withall. In such condition,
there is no place for Industry; because the fruit thereof is uncertain;
and consequently no Culture of the Earth; no Navigation, nor use of the
commodities that may be imported by Sea; no commodious Building;
no Instruments of moving, and removing such things as require much
force; no Knowledge of the face of the Earth; no account of Time; no
Arts; no Letters; no Society; and which is worst of all, continuall feare,
and danger of violent death; And the life of man, solitary, poore, nasty,
brutish, and short."
Provide a Stable Set of
Institutions and Rules



As Hobbes notes, without government
establishing order very little good can
happen
Government can create a stable
environment and enforce contracts
through its legal system.
Economic growth is difficult when
government does not provide a stable
environment.
Promote Effective and Workable
Competition

Government promotes competition and
protect against monopolies.



Monopoly power is the ability of individuals
or firms currently in business to prevent other
individuals or firms from entering the same
kind of business
Monopoly power can also be defined in terms
of price setting ability.
Adam Smith – in the Wealth of Nations –
was very concerned about the problem of
monopoly (which was quite prevalent in
the 18th century).
Correct for Externalities




An externality is the effect of a decision
on a third party not taken into account by
the decision maker.
Unless they are required to do so, parties
to any exchange are unlikely to take into
account any externality.
Pollution is a negative externality.
Education is a positive externality.
Market produce too much of negative
externalities and not enough of positive
externalities.
Ensure Economic Stability and
Growth



Most Americans look to the government to
deal with macroeconomic externalities.
Macroeconomic externalities are
externalities that affect the levels of
unemployment, inflation, and growth in
the economy as a whole.
Since 1945 the federal government has
taken action to offset recessions (and
these actions have generally been
successful).
Provide for Public Goods


Government steps in to provide public
goods and requires that everyone pays for
them, thereby reducing the free rider
problem.
The military is a good example of the free
rider program. The military protects
everyone in society. If we were not
required to pay taxes for the military, a
person would be tempted to not pay
knowing the other members in society had
paid. After all, the military will defend
everyone, not just those who paid taxes.
Adjust for Undesired Market Results




A controversial role for government is to make
markets fairer.
Determining what is fair is a difficult
philosophical question.
Demerit goods or activities are things
government believes are bad for you, although
you may like them.
Merit goods and activities are things the
government believes are good for you, although
you may not like them.
Market Failures and Government
Failures


Market failures are situations in which the
market does not lead to a desired result.
Government failures are situations where
the government intervenes and makes
things worse.