On EconomicsA review of “Why Nations Fail” by D. Acemogluand J. Robinson and “Pillars of Prosperity” by T.

Besley and T. Persson

W. Bentley MacLeod∗

December 26, 2012

JEL Classification: B15, D02;D23; E02; O010; P00

Under-recognition of the power of what psychologists call “re-inforcement” and economists call “incentives.”—Well I think I’vebeen in the top 5 percent of my age cohort all my life in under-standing the power of incentives, and all my life I’ve underesti-mated it. And never a year passes but I get some surprise thatpushes my limit a little farther.

Charlie Munger’s first cause of human misjudgment, Speech at Harvard LawSchool.

1 Introduction

On June 19, 2007 the Economist Magazine asked "Is economic theory dead?".The aftermath of the financial meltdown seemed to suggest that the hubris∗Department of Economics, Columbia University, 420 West 118th, MC 3308, New York,

NY 10027-7296, USA. email: bentley.macleod@columbia.edu. I am extremely grateful toChristopher Blattman, Janet Currie, Lewis Kornhauser and Suresh Naidu for very helpfulcomments and discussions. They are not associated in any way with the views and errorsin this manuscript!

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exhibited by the economics profession warranted a serious downgrade. Yet,there have a been a number of recent books that, if anything, solidify theplace of economics in modern policy making. This trend began before thecrash with books such as the wildly successful “Freakonomics” by Levitt andDubner (2006). It provided a theory of “everything” and introduced to awider audience how economics is developing a set of tools that can tease outcausal chains of events (except of course the causal chain that led to thefinancial crises).

One of the central tools in Freakonomics is the natural experiment - atechnique that requires persistence and luck to discover seemingly randomshocks that can be viewed as experimental treatments in the wild. “PoorEconomics” by Banerjee and Duflo (2011) is some ways a natural successorto this book and the winner of the 2011 Financial Times and Goldman SachsBusiness Book of the Year prize. It applies these ideas to the problem ofeconomic development to illustrate how one can use carefully designed ex-periments in developing economies to see how individuals respond to variouspolicies, such as cash transfers for education and health services, or regularlyphotographing teachers to ensure that they actually show up for work.

A common critique of these two books is that they "think small" - theyprovide decisive answers to small questions, in the hope that if we makecontinual small improvements in economic performance by reducing corrup-tion in specific cases or improving education one school at a time, that thiswill eventually lead to a much better world.1 The two books covered inthis review, Why Nations Fail? by Daron Acemoglu and James Robinson,and Pillars of Prosperity by Timothy Besley and Torsten Persson think big.They are written by distinguished academics concerned with the issue ofnational performance and how national institutions can explain why somenations perform much better than others.

Pillars of Prosperity is written for graduate students, and uses a commonformal model to explore the factors that they have identified as importantfor national performance. In contrast, Why Nations Fail? is intended for

1For example, the reviews by Ravallion (2012) and Rosenzweig (2012) are sympatheticto the work, but conclude that fighting poverty requires one to think big.

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a wider audience, and has received a great deal more attention in the press(for example, it was short listed for the 2012 Financial Times and GoldmanSachs Business Book of the Year prize - it is a remarkable achievement thatthe MIT economics department has been on this list two years in a row!).

Both books argue that successful national performance depends upongood institutions. However, even though both books provide some impres-sive evidence in support of their arguments, they come to rather cautious anddifferent conclusions. Pillars of Prosperity is organized around a commonpolitical economy model, that is used to organize a number of cross-countryregressions based upon data from 1950 till now. Besley and Persson concludethat the evidence is consistent with the hypothesis that successful develop-ment depends upon the state’s capacity to raise revenue, enforce the rule oflaw and to avoid political conflict. These are the pillars of prosperity thatare alluded to in the title of the book (which unfortunately is the same titleas Ron Paul (2008)’s somewhat different book). They conclude with a longlist of issues that require more research, including bridging the micro andmacro perspectives, the focus of this review.

Why Nations Fail? is a very different and explicitly more ambitious book.It is organized around an impressive array of case studies illustrating thatpro-growth decisions are made by “inclusive institutions”, while “extractiveinstitutions” enrich decision makers at the expense of economic growth. Thebook begins with a discussion of theories that do not work, and conclude thatthe choice between exclusion and extractive politics is the key ingredientfor economic growth and prosperity. Acemoglu and Robinson also arguethat there is a certain amount of serendipity in the selection of effectiveinstitutions, and hence they conclude the book with a discussion of why onecannot “engineer prosperity”.

Both books highlight the importance of power politics in determiningthe economic success of a nation. This might seem to be an obvious pointto many, but it does reflect a break with the standard competitive modelthat, in part, led to the pre-financial crash view that free markets were theonly necessary ingredient for a well functioning economy. Why Nations Fail?addresses a wide audience, and in making the point that power is important,

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makes the claim that the concentration of power in the hands of the fewinhibits the economic success of nations in wide variety of situations. Suchuni-causal explanations clearly cannot be the whole story, as pointed outin the excellent reviews by Diamond (2012) and Sachs (2012). These greatpublic intellectuals have their own axes to grind, with the consequence thatcontrast between these alternative theories makes for entertaining readingthat helps sell books. However, this back and forth does do not address themore fundamental question of why the allocation of power is important foreconomic growth?

Power is clearly important for the allocation of resources in society (asthe work of Ricardo and Marx observed in the 19th century), but does notnecessarily imply economic inefficiency. The Coase (1960) theorem impliesthat in the absence of transactions costs, the initial allocation of propertyrights, as well as the liability arising from tort law, should have no effectupon the efficiency of the market. More generally, this result implies thatthe concentration of power might affect the distribution of resources in so-ciety, but by itself it does not necessarily imply economic waste, nor slowgrowth. This is a non-trivial observation. The drama of conflict between themarket and socialist economies during the 20th century is one in which manygreat societies were built upon the belief that growth and equality could beachieved with a planned economy with power concentrated at the center.

The purpose of this review it to discuss these books in the context ofrecent research in economics that helps us better understand the efficiencyconsequences of different allocations of power, and to provide some themesfor future research. I begin with a brief outline of the contents of each book.I then discuss why power is important for modern economics. In short,the allocation of power has efficiency implications for two reasons. First,information in any large complex economy is decentralized, an idea thatgoes back to the important work of Hayek (1945). Self-interested individualscannot be relied upon to reveal their information truthfully. Second, it isdifficult to incentivize individuals to reveal private information because it isnot possible to anticipate all the information a person might have - marketsand contracts are necessarily incomplete.

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Section 3 briefly discusses how this perspective can explain why effectivefirms, organizations and nations carefully distribute control rights. HereI rely upon the recent advance in the theory of the firm, particularly thework of Klein, Crawford and Alchian (1978), Grossman and Hart (1986) andWilliamson (2000).

Even if one has the appropriate information, it needs to be translatedinto appropriate action. In a complex world individuals cannot be expectedto understand all the consequences of their actions, but nevertheless theymust act. The work of Savage (1972) was a major breakthrough becauseit showed how to model rational choice in a world with incomplete andimperfect information. Both Why Nations Fail? and Pillars of Prosperityassume that individuals are rational in the sense of Savage - they buildmodels of the world and then act based upon these models. Yet, at the sametime Why Nations Fail? poses the conundrum of why nations do not chooseprosperity?

The tricky part is how individuals should build their model of the world(an issue that is never directly addressed by Savage)? Both books are in thebusiness of convincing the reader that they have a useful way to think aboutthe world, and hence can be used to inform decision making. In particular,both books claim there is a causal link between the structure of power andpolitics in a nation and national performance.

Yet, Why Nations Fail? ends with the caveat that one cannot engineerprosperity, while Pillars of Prosperity cautions that their empirical workin preliminary. The problem here is crucial for understanding the role ofeconomics in public policy debates. The core issue is that while we nowhave clear notions of what constitutes evidence of a causal effect, they aresufficiently stringent that they can be tossed aside in public policy debates,often with little discussion of how tenuous the evidence in support of anyparticular policy position really is. Hence, while the homily that correlationis not causation is well known, it is almost completely ignored in many (ifnot most) public policy debates.2

2See Coleman (1994)’s discussion on page 59 of how his landmark study on educationalopportunity was used in the public policy depends regarding busing.

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Yet, both books suppose that decision makers are rational in the sensethat they have clear preferences over alternatives, and then choose the al-ternative they prefer given the constraints that they face. These constraintsinclude both resource constraints and contracts imposed upon them by otheractors in the economy. In section 4 I revisit the issue of what exactly con-stitutes rational choice, and how causal evidence is used to make rationalchoices. The point is to highlight the many pitfalls that arise from using themost elemental model of rational choice.

At the core of the argument in both books is the issue of effective organi-zational design. Yet neither book draws upon the voluminous literature onhow to effectively organize groups of individuals. Whether one is trying todesign a firm or nation state, both require a governance structure that moti-vates and reward individuals in the organization. It is common in economicsto suppose that the firm is a profit maximizing organization that choosesinputs to efficiently produce output. Yet, even a cursory review of the pagesof the Wall Street Journal or the Financial Times yields a quite differentpicture. Firms are complex organizations, where power is allocated amongshare-holders, the board of directors, and the senior officers of the company.In section 5 I suggest that there are some useful lessons from this literaturethat may explain the wealth of nations.

Finally, I come to the conclusion of Why Nations Fail?: That one cannotengineer growth. If true, one wonders what we are to make of the analy-sis? If a particular institution causes growth, this means that choosing thatinstitution will have a positive effect upon growth. If that is not the case,then we are necessarily in the realm of omitted variable bias - there mustbe some unobserved factor that is truly responsible for growth that has notbeen considered by the authors?

Taylor (1911), one of the creators of modern management practice, ob-served that in many situations employment relationships are very inefficient -the worker would prefer to be paid more in exchange for producing more out-put, while the firm would happily pay for that additional output. The goal ofTaylor’s book is to encourage managers to introduce better monitoring andcompensation of workers. Yet, sixty-four years later, Kerr (1975) documents

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a long list of examples where firms incompetently manage performance paysystems. In section 6 I discuss insights from modern micro-economics thatcan help explain these observations, and provide some guidance on how onemight more effectively “engineer prosperity”, something that managers ofsuccessful firms do on a daily basis.

2 The Books in a Nutshell

Why Nations Fail? is a monumental book, both physically (in the soon to beobsolete physical form, the book is long (529 pages) and thick (2 inches)), andin historical scope (covers the full span of human history). It is written for awide audience, eschews equations, and it is full of insightful and entertainingexamples. The stories are linked with a common narrative theme, namelythe distinction between inclusive and extractive institutions. The claim isthat nations with “inclusive institutions” are in the long run more successfulthan nations with “extractive institutions”.

The notion of an inclusive institution is defined on page 74:

Inclusive economics institutions, such as those in South Korea orin the United States, are those that allow and encourage partic-ipation by the great mass of people in economic activities thatmake the best use of their talents and skills, and that enable indi-viduals to make the choices they wish. To be inclusive, economicinstitutions must feature secure private property, an unbiasedsystem of law, and a provision of public services that provides alevel playing field in which people can exchange and contract; italso must permit the entry of new businesses and allow peopleto choose their careers.

In essence, inclusive institutions epitomize “the good society.” The authorsargue that nations fail when they are built upon extractive institutions, ex-plicitly defined on page 81 as the opposite of inclusive institutions:

Extractive political institutions concentrate power in the handsof a narrow elite and place few constraints on the exercise of this

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power. Economic institutions are then often structured by thiselite to extract resources from the rest of society. Extractive eco-nomic institutions thus naturally accompany extractive politicalinstitutions..

As a style this book is in the tradition of institutional economics in whichthe objects of study are observed economic institutions (Hamilton (1919)).The book draws upon a rich collection of examples from human history toillustrate how inclusive institutions enhance performance relative to extrac-tive institutions. The punch line is that human institutions are key to goodperformance.

To prove this point, they point to the city of Nogales that straddles theUS/Mexico and observe that a small change in the location of an individual(namely in US Nogales versus Mexican Nogales) can result in a large changein life outcomes. Here they are implicitly using a form of “regression discon-tinuity” analysis (Lee and Lemieux (2010)). The idea is that productivitydepends in part upon physical location, and hence production in locationsthat are very close in principle have similar endowments. Thus if geographyis key to development, as argued by Diamond (1997), people in both halfsof Nogales should have similar outcomes. However, the quasi-experiment isthat the institutions on each side of the barrier are very different, and hencethe observed large differences in outcomes, both in terms of productivityand worker well being, must be due to the differences in institutions and notgeography.

After making the basic argument, Chapter 2 discusses a number of the-ories that do not work, including the idea that geography is a determiningfactor. Jared Diamond (2012) has a review of the book that nicely illustratesthat while institutions and governments are essential, geography is also animportant ingredient that cannot be ignored. To avoid discussing explic-itly the role of natural resources, Acemoglu and Robinson proceed by goingthrough a sequence of historical case studies of situations where thing workedout well (such as Jamestown in the 16th century, the Glorious Revolution inEngland and post war South Korea). These are contrasted with examples of

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poor institutions, such as the modern Congo and North Korea.The argument is incredibly erudite. The authors draw upon evidence

from a few thousand years of human history to detail a wide variety ofexamples illustrating why institutions matter and how in each case extractiveinstitutions, lead to bad outcomes, while inclusive institutions lead to goodoutcomes. For most readers it is really impossible to evaluate each of theircases in turn. The scope of the difficulty is illustrated in figure 1.

Figure 1: Century of Historical Citation by Page in “Why Nations Fail?”

Each point in the figure is a case study by page and century from whichthe example is taken (for illustrative purposes I coded all the references before500BC to be in the same century). Many examples are repeated, so some ofthe cases refer to the same historical example. Nevertheless, there is a verylarge number of cases considered. The dip around page 150 corresponds to adiscussion of neolithic times, as well as examples from the history of Rome.The figure also illustrates a fitted trend line showing that on average wemake about 1 century of progress for each 100 pages.

This structure makes for fascinating and interesting reading, though likea Russian novel with its many characters, I did find it very difficult to keeptrack of all the cases. Many Russian novels include a guide to the characters;I would certainly recommend in any future revision that such a reference be

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added, maybe organized along a time line.For each historical vignette, it is assumed that the individuals with con-

trol rights are choosing the option they prefer. In this regard the book can beviewed as the historical analogue to Becker’s economic approach to humanbehavior.3 Rational choice theory is used to organize the vast array of ex-amples considered in the book. The message is that when control rights aregiven to a small group one has extractive institutions and leaders that hurttheir citizens. In contrast, when control rights are constrained by the pref-erences of the population, then one has an inclusive institution with checksand balances that lead to higher growth and well being.

One of the nicest points in the book is that common shocks can havevery different outcomes, depending upon the institutions that are in place.Figure 1 from Coy (2012)’s review of the book illustrates this point clearly. Itillustrates three major shocks, the bubonic plague, the discovery of Americaand the industrial revolution, and how different societies responded to theseshocks. The ones on the left have “inclusive institutions”, while the ones onthe right have “extractive institutions”.

At the core of their argument is a theory of human behavior that is basedupon classic incentive theory: individuals care about resources and takeactions to either increase their resources, or to protect the resources theyhave. In each example they consider how inclusive institutions encourageactions that benefit all individuals. However, when we get to the end ofthe book they conclude by arguing “You Can’t Engineer Prosperity”4. Theythen discuss a number of failed reforms to support this claim.

This leaves open the question of why engineering prosperity is not pos-sible? Some progress on this question is made in Pillars of Prosperity. Thisbook is, in many respects, the technical counterpart to Why Nations Fail?Rather than drawing upon the full scope of human history, the narrativetheme in this book is built upon a simple political economy model that iselaborated in each subsequent chapter.

The base model supposes that society is divided into two groups who3See chapter 1 of Becker (1976).4Page 446.

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Figure 2: The Differential Responses of Different Institutions to CommonShocks.Source: Coy (2012).

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compete for power. This model is able to capture formally many of thethemes that are discussed informally in Why Nations Fail? Inclusivenessis measured in part by the rents that one group willingly shares with theother group. Pillars of Prosperity goes on to explain that successful statesrequire a number of additional ingredients for high performance, which theycall “pillars of prosperity”.

Chapter 2 introduces the base model in which the government providestransfers to individuals and supplies a single public good. National politicsis characterized by the level of turnover in political power between the twogroups, and the extent to which their preferences are aligned (national cohe-sion). In the core model, the job of government is to invest in fiscal capacityto fund transfers and public goods. In particular, they predict that fiscalcapacity should be correlated with national income, a prediction that is con-sistent with the evidence at the end of the chapter. They also point out howa greater natural resource base and associated revenue may not necessarilylead to better institutions.5

Chapter 3 discusses the role of legal capacity, namely investments bythe government to protect private property. Proposition 3.5 is particularlyinteresting because it shows that all else equal, a more productive economywill have greater investments in fiscal and legal capacity in common-interestand redistributive states, than in less cohesive states. In other words, weshould observe a correlation between inclusive institutions and national pro-ductivity. However, this is not a causal relationship in the sense that theseinstitutions cause higher productivity. Rather, these move together, withgood institutions magnifying the impact of a productivity shock. They con-clude the chapter with some evidence on the correlation between the legalorigin of a society and growth.

The final pillar is the potential for violence. Chapter 4 introduces violenceas a way of obtaining control over government. The neat insight is that theincentive to use violence increases when the government has a weak tax baseand low investment into public goods. Thus control of government leads tomore resources for the group in power. However, when there is well developed

5Page 68.

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fiscal capacity, and a high level of public goods, then both groups benefit fromgovernment, reducing the incentive to use violence to obtain control. Theauthors distinguishes between civil war, where two parties vie for control, andrepression, where one party uses violence to suppress the other party. Theyconclude with some evidence that looks at the effect of natural disasters,and finds that they are positively correlated with political violence and civilwar. They also find an effect of security council membership upon violence,though it is not clear how to interpret this relationship.

Chapter 5 puts it all together into a complete package. The model is thenused to evaluate development aid in chapter 6. It is possibly not surprisingthat it is found that aid works best in countries with cohesive (inclusive?)institutions. This argument suggests that the key ingredient for growth ispolitical reform, the topic of chapter 7. In a model with endogenous reformit is shown, consistent with Why Nations Fail?’s point on the difficulty ofengineering prosperity, that cohesive political institutions are not globallystable. That is societies will not naturally move towards such a state, eventhough the average person may be made better off.

Pillars of Prosperity has an intriguing discussion of Jones and Olken(2009) comparing the effects of successful to unsuccessful assassinations uponreform. One can view the outcome as a random, and hence a credible in-strument to explore the impact of the loss of a leader. It is shown that asuccessful assassination leads to an increased likelihood of a durable movetowards democracy, and hence the paper reports evidence on the causal im-portance of leadership (in maintaining an autocracy). It also illustrates howa single random event can influence history and the course of institutionalchange, a result that is consistent with the thesis of Why Nations Fail?

The final chapter of the book uses insights from the analysis of the differ-ent factors that affect national performance to define a Pillars of ProsperityIndex that ranks the potential for growth of countries in the world. LikeWhyNations Fail?, Besley and Persson do not claim that is possible to engineergrowth. Rather, the research suggests that national performance dependsupon a number of interlocking elements, of which inclusive institutions isone important element.

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While the method of Pillars of Prosperity is based upon careful formalmodeling, the book observes that there is a need for an integration of micro-economic analysis with their macro analysis. This is likely to be important,not only to understand why we cannot “engineer prosperity”, but also to helpin using this work for the purpose of formulating economic policy.

3 Incomplete Contracts and the Economic Founda-tions for Authority

The topic of economic development is vast and hence it is natural that thesebooks do not touch upon all subjects. However, it is surprising that nei-ther book discusses the role of markets, nor cites Milton Friedman (1962)’sbook Capitalism and Freedom. These days few economists would argue thatcentral planning is more effective than a market economy. Disagreementstend to arise regarding the optimal amount of regulation and redistribution,and not so much as to whether or not one should have a market economy orregulation.

This was not always so. Oskar Lange, the great University of Chicagoeconomist, is often claimed to have won the argument with von Mises re-garding the efficiency of planned economies versus market economies. Theformal argument is made in Lange (1936), later Lange (1949) in Economet-rica where he cites post war Eastern Europe in support of his argument:

Through the adoption of planned economy and all the so-cial changes connected with it these countries, which before thewar were countries of chronic industrial and economic stagna-tion, have entered into a period of great and dynamic economicdevelopment, with a great rapid reconstruction, industrialization,undoubted increase in national income, diminution if not full dis-appearance of their large agricultural surplus population (a formof disguised unemployment), the disappearance of unemploymentin industry which existed in the period between the two worldwars or at least over a part of this period. The planned economies

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undoubtedly are an economic success.

This quote illustrates the dangers of using an example to support an ar-gument, in this case that central planning is the solution to the problemsof growth and inequality. Lange’s point was really not an ideological pointbecause it was based upon the tremendous advances in economic theorythat occurred in that period, including his own work. Ten years later De-breu (1959)’s Theory of Value showed that when markets are complete thencompetitive equilibria are efficient. Conversely, the second welfare theoremshows that any efficient allocation can be achieved with the appropriate real-location of initial endowments followed by goods allocated via a competitiveequilibrium.

This model is not so much a description of how a market economy works,but provides the theoretical basis for planning. Lange (1936)’s earlier argu-ment was a combination of computational issues and a worry regarding thecosts of monopoly. He felt that markets were too disorganized to effectivelycompute prices, which could be more effectively achieved via a central plan-ner. As a theoretical point he was right, but as a practical matter we haveseen that in the longer term central planning does not seem to work verywell.

One can easily see how general equilibrium theory also inspired Friedman(1962)’s advocacy of free markets, particularly the second welfare theorem.It shows that under appropriate conditions, every efficient allocation canbe achieved via a two step process. In the first step one allocates initialendowments to deal with equity issues, and then one lets a free marketdetermine the final allocation. This is precisely Friedman’s voucher systemfor the allocation of education services - students are given vouchers by thegovernment that are then used for buying schools services from the market.Another example is Friedman’s idea for a “Negative Income Tax” as an anti-poverty program.

Forty years later the consensus view is that markets do appear to be animportant ingredient for economic growth, but free markets alone are nota panacea. One reason is that the welfare theorems require the existence

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of complete contingent markets, something that simply is not possible inpractice. The lack of complete markets also provides an explanation for whycentral planning does not work in practice. A complete market is one forwhich the set of possible future goods and services are known in advance. Inother words, at the time Lange wrote there would have had to be a futuresmarket in which individuals anticipated the possibility of an iphone 5, andthen actively traded assets based upon whether or not one was designed bya certain time.

This is clearly impossible. What is possible, and what does occur inpractice, is the creation of thicker markets. Over time more goods andservices get commodified and traded on a market.6 One would hope thatsuch expansion of the market would lead to increases in efficiency, yet asOliver Hart (1975) showed in his brilliant PhD thesis, more complete marketsdo not necessarily lead to a more efficient allocation of resources. This resultprovides a way to link modern general equilibrium theory to Ronald Coase(1937)’s observation that firms can improve upon the allocation of resourcesby moving resource allocation from the market to inside the firm. In somerespects, Lange (1936) and Coase (1937) had similar views - markets havedeficiencies that can be overcome with planning. The difference was thatLange thought that the whole economy should be inside a single firm, whileCoase saw firms as small planned economies actively competing with eachother, and then growing to an optimal size.

Coase (1960) later argued that in the absence of bargaining costs, theinitial allocation of bargaining power should have no effect upon the effi-cient operation of an economy. In order for power to matter there must besome form of transactions cost or market incompleteness. The focus uponinclusive versus exclusive institutions in Why Nations Fail? suggests thatbargaining power does matter, and that shared bargaining power shouldenhance national performance.

This is a question that has been intensely studied in micro-economics, andwhat we know is that there are at least two contexts in which the allocation ofbargaining power matters. The first is when there is asymmetric information

6See Allen (2012) for historical account of commodification.

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between parties. The second is when available contractual instruments areincomplete, and hence an investing party cannot capture the future returnsfrom an investment.

Beginning with the seminal work of Akerlof (1970), there is a vast litera-ture that explores the optimal design of economic institutions in the presenceof asymmetric information (see Laffont and Martimort (2002) for a good re-view). One of the lessons of the literature is that power can be important.Gibbons (1987) provides an elegant model of worker-firm bargaining thatcan explain why extractive institutions may be inefficient. He shows thatwhen the owner of the means of production tries to extract rents from work-ers with superior knowledge regarding production, then the consequence isinefficient. In the context of agrarian societies this result illustrates thatgiving more power to workers, which we might interpret as a move to moreinclusive institutions, can improve matters.

However, giving more power to workers is not always efficient. There is along history of experiments with worker managed firms built upon the ideathat shared power should be more effective, but these have not been uni-formly successful (Dow and Putterman (2000)).7 One reason is that workersmay not have information regarding some important inputs to production,such as the cost of capital. When information is dispersed between two ormore parties, then as Myerson and Satterthwaite (1983) show for the bilateralcase, and Mailath and Postlewaite (1990) show for multilateral bargaining,no re-allocation of power can restore efficiency.

One solution that does work is to increase the quality of information.As Allen (2012) illustrates, economic growth is closely associated with thecreation of new ways of measuring the quality of products, and hence al-lowing the creation of new markets. The ancients were clearly aware ofthe management issues that arise from asymmetric information, see in par-ticular Columella’s advice on how to manage a Roman estate in the firstcentury AD. The book reads like a modern human resources text. Pliny theYounger also clearly understood the trade-off between the use of a rental

7MacLeod (1987) discusses the literature and some conditions under which we wouldexpect labor cooperatives to be efficient.

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contract and a share cropping contract, an insight that was later formalizedby Stiglitz (1974)’s seminal paper on share cropping (see Pliny, Book IX,section XXXVII - page 157).

A second source of transactions costs associated with the allocation ofbargaining power is identified in a series of important papers by Klein, Craw-ford and Alchian (1978), Grout (1984) and Grossman and Hart (1986). Theybegin with the observation that the level of specific investments in a rela-tionship depends upon obtaining a fair rate of return on that investmentin the future. Grout shows that if firms and unions cannot write completecontingent contracts, then the fact that the union always has some powerleads to an extraction of rents from the firm, that in turn leads to lowerinvestment by the firm. The reason for this is due to a quirk in British lawthat does not allow parties to have a long term contract that is renegotiatedas needed. Rather, contracts are of fixed duration, and must be renegoti-ated from scratch when they are renewed, which in turn reduces investmentincentives.8

More generally, Grossman and Hart (1986) observe that a key charac-teristic of a firm is its control rights over the assets it owns. Control rightsencourage investment into the assets owned by the firm. In a sense, it is theright to exclude individuals, rather than inclusion that allows for effectivemanagement of a firm (see also Rajan and Zingales (1998)). As the union-firm bargaining example illustrates, when an inclusive institution is forcedupon the firm (more union power), then one may obtain a less efficient out-come.

The right to exclude is particularly difficult to achieve in the case of intel-lectual property. Why Nations Fail? discusses an interesting property rightscase concerning the invention of unbreakable glass during the reign of Em-peror Tiberius 9. When Tiberius learned of the invention he had the inventorkilled and the technology suppressed. The authors cite this as an example

8Grout (1984) shows that this rule leads to an inefficient outcome, while MacLeod andMalcomson (1993) discuss this rule and show how one can design multi-period agreementsto ensure efficient investment.

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of an extractive institution undermining the process of creative destruction.The property rights approach provides an alternative interpretation as anexample of weak enforcement of the property right to the idea. It was theemperor’s lack of absolute power, and inability to extract rents from the ideathat lead to the suppression of the idea, not extractive institutions per se.

In both books allocation of power via the political process is central tothe argument. In neither book is there much discussion of the costs andbenefits from the allocation of power to specific individuals. What we learnfrom the recent theory of contract is that the allocation of power has costsand benefits that are a function of both the dispersion of information in theeconomy, and the allocation of investment returns. It would be helpful to seehow these distinct effects play out in the political economy stories in thesebooks.

4 Human Action

In chapter 3, Why Nations Fail? asks the question: “Why not always chooseprosperity?” They begin with the observation that everybody should wantmore prosperity. Hence it must be the case that decision makers do notchoose more effective institutions because they do not share in the newwealth, particularly decision makers who have made specific investmentsinto technologies that would have lower returns under the new institutions- here they cite Joseph Schumpeter’s observation that change often involvescreative destruction, the loss of well being for some individuals as resourcesare put to more effective use in other sectors.

Notice that the logic here is another example of the failure of the Coasetheorem.10 A net gain for society is not realized because one cannot effectthe necessary transfers. Yet, as we know from the work on Mailath andPostlewaite (1990), the existence of many individuals makes it difficult tocarry out an efficient bargain, and hence it is not at all clear why inclusive

10This is sometimes called the “political Coase theorem”. The earliest use of the termcan be found in Flocos (1990) who applied it to rule making by the securities and exchangecommission (see footnote 139).

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institutions would lead to a Coasian outcome?In Pillars of Prosperity this problem is studied via the lens of a two

party conflict. As in Why Nations Fail?, the Glorious Revolution in 1688England is cited as an example of an improvement in political institutions,but for quite different reasons. In Why Nations Fail? the Glorious Rev-olution marked a period of power shifting from the monarch to the state,that allowed for more democratic participation in government. In Pillars ofProsperity it is characterized as a period of stability in which the Whigs hadthe upper hand, which they used to increase their ability to raise taxes. TheWhigs also improved the protection of private property, which both booksagree led to an improvement in economic performance, and ultimately to theindustrial revolution.

At stake here is why these changes were brought about? Both booksare built upon the standard economic model in which choices are made byforesighted decision makers. In Pillars of Prosperity the decision makers aretwo groups that vie for power. They choose the level of public goods, trans-fers between the groups they represent and investment into fiscal capacity -the ability to efficiently raise revenue via taxation. They vary their actionsas a function of the probability of staying in power (which may be affectedby their choices), and the extent to which their preferences are aligned withthe other group. Why Nations Fail? is chock full of examples of individualswho make choices that are in their private interest. The main point is thatinstitutions affect the extent to which private and public interests line up.Given the maintained assumption that individuals care only about access toresources, then inclusive institutions should lead to more resources for all,and ultimately more prosperity.

This version of the rational choice assumption is at the core of moderneconomics. Yet, neither book addresses in detail the issue of belief forma-tion, a pre-condition for coordinated rational action. The great economistsKeynes, Knight and von Mises all emphasized the importance of belief for-mation in understanding the evolution of markets and social institutions.There are at least three significant issues at stake. First, there are the basicpreferences over goods and services. Then there are the beliefs that individ-

20

uals have over future outcomes, and finally there is the process of a group ofindividuals agreeing upon the likely consequences of different actions.

We already know from the celebrated Arrow theorem that when there issufficient dispersion in preferences then efficient social choice mechanisms arenecessarily dictatorial. This result has spawned a large literature on socialchoice that I will not discuss here. However, it is somewhat surprising thatWhy Nations Fail? does not even mention Arrow’s theorem, while Pillarsof Prosperity devotes only a few lines to the issue on page 299. At the veryleast it would be helpful to have some discussion of why social choice theoryis not useful for understanding national decision making.

One lesson from Arrow’s theorem is that efficient decision making iseasier when individuals have common interests and shared goals. One waythis commonality is manifested is for individuals to act on behalf of theirgroup, and for political leaders to create a sense of group identity. HerbertSimon felt that this was an important element in the theory of organization(I have correspondence from Simon (1997) that makes this point explicitly).More recently, Akerlof and Kranton (2000) have argued for the importanceof incorporating identity into economics. Both books take preferences, andthe interest groups represented by their leaders as exogenous, yet part ofeffective leadership is to help all members of society feel that they sharecommon interests.

4.1 The Problem of Information

The second issue is the formation of beliefs. Both books assume that agentsunderstand the consequences of their actions. Why Nations Fail? explicitlydiscounts the importance of information in a section they call The IgnoranceHypothesis 11. It claims that lack of knowledge cannot explain nationalsuccess. Yet, in complex systems it is a fact of life that we do not knowthe consequences of our actions. The rational choice model developed inthe 1950s by Savage (1972) explicitly includes beliefs as a key ingredient inrational choice. In his model decision making is a two step process.

11See the discussion of the ignorance hypothesis on pages 63-68.

21

Step one entails the creation of a model of how the world will evolve inthe future. The deep insight of Savage is that the creation of such a modeldoes not in fact require parties to know or to agree on how the future willevolve, but only that they create a model of the relationship between theirchoices and future consequences. Given the model, individuals then choosethe outcome they prefer. This work highlights the fact that any description ofrational choice necessarily entails both describing preferences over outcomesand beliefs regarding the likelihood that an action will leads to a particularoutcome. Another way to phrase this insight, is that model building is oneof the tools that individuals use to make sense of the world, and to guidetheir future choices. In this regard politics plays two roles. Leaders play arole by creating a vision of the world for others to follow.12 Second, inclusiveinstitutions can play a role in providing a way for individuals to express theirprivate interests and concerns that might not be known to decision makers.13

Both books wish to change the way we think about the world, yet assumethat private actors already understand the consequences of their actions. TheSavage model provides a way to address this issue because it allows one tosuppose that individuals are both rational, and yet mistaken in their beliefsregarding the world. It is beyond this review to explore the issue of howinstitutions affect our beliefs. What I will do in the next section is brieflydiscuss the most popular approach in economics to the problem of inferringthe consequences of a choice or institution. This background will be used toevaluate some of the arguments in these books.

4.1.1 Learning from evidence

It is well known that correlation is not causation, yet this homily is widelyignored in practice. One reason, as mentioned above, is that humans are nat-ural modelers. We all use our past experiences to evaluate the consequencesof future choices. When used in this way, a model of the world is essentiallydescriptive - it provides a succinct way to organize our experiences that we

12See Van den Steen (2005) for a model of vision for managers.13See Kuran (1997) for a nice discussion of the tension between private and public

preferences.

22

hope is valid for new situations.A popular model of causal analysis is based upon the idea of “potential

outcomes” that is beautifully exposited in Holland (1986).14 It begins withthe question of what is the implication of choosing option A over option Bfor a unit i ∈ I? The notion of a unit is very broad, and thus the theory canbe applied to the empirical analysis of institutional choice, where the unitis a country, the choice is say between free elections and a dictator, and theoutcome is economic growth.

These choices entail outcomes that we care about and certainly shouldconsider before acting. Let Y (d, i, θ) be the outcome of decision i ∈ A,B -these are the potential outcomes from unit i′s choices. For unit i the causaleffect of A relative to B is:

O(A,B, i, θ) = Y (A, i, θ)− Y (B, i, θ).

Measuring this quantity might seem simple enough, but note that it dependsupon conditions characterized by θ which are in general time varying. Theonly sure way to measure O(A,B, i, θ) is to take decision A, observe theoutcome, and then go into a time machine to go back and redo the decisionwith option B. This is much like Bill Murray in the movie Ground Hog Day,who must live the same day over and over again as he learns to make betterchoices in his life. As he makes different choices he can see the causal impactby comparing them to the other choices during his previous experience withthe same day. As Holland (1986) observes, since time travel is impossible,measuring the causal impact of a decision is impossible! He calls this thefundamental problem of causal inference.

This simple definition does help to clarify why it is so difficult to buildgood social science theories. In physics it is assumed that the laws of naturedo not vary with time, and hence one can experiment at different points intime and compare the results. This is not the case with complex social sys-tems that are constantly changing over time. Frank Knight (1921) struggled

14In statistics there is quite a bit of controversy regarding exactly who had the ideafirst. What is the case, is that Holland has a really clear exposition of what constitutes avalid estimate of a causal effect.

23

with this problem in chapter 11 of his great book, but had no solution.Holland’s model provides a way forward because it focuses clearly upon

the basic elements necessary for a good social science theory. The first in-gredient is a clear definition of the units that are taking the action, denotedby i ∈ I - in the case of the books under review these are nations. Next isa description of the environment (denoted by θ ∈ Θ). Finally, there is thespecification of the outcome as a function of this data, Y (D, i, θ). The keyidentifying assumption is that our background parameters are sufficient tomodel the issue at hand. More precisely, suppose we are able to measureθ ∈ Θ each period, and whenever θt = θt′ for some times t and t′, it is thecase that for any decision or treatment D ∈ {A,B}:

Y (D, i, θt) = Y (D, i, θt′) .

When this is true and the theory is correct, then the causal effect of A relativeto B is:

O(A,B, i, θ) = Y (A, i, θt)− Y (B, i, θt′),

where θt = θt′ = θ.Formal models are used to state precisely what we mean by the underly-

ing conditions in θ, and to show how the choice between A and B varies withconditions represented by the background parameters. Notice that even ifwe do not know the exact form that the outcome function Y takes, a theorycan have a great deal of content by specifying the appropriate backgroundparameters to be included in θ. Then with sufficient observations regard-ing θt and outcomes Yt, one can estimate a function representing Y (D, i, θ).Much of the work in artificial intelligence and computer decision making canbe viewed as providing techniques for estimating Y (D, i, θ). 15

This seems well known, and in fact I have been criticized by economistswho have read this review for repeating the obvious. Yet, a key featureof the model is that in order to make a causal statement there has to besomething that is time invariant. For example, rational choice theory has

15See the excellent book by Russell and Norvig (2010).

24

no empirical content until one adds the assumption that the preferences wemeasure today will be the same tomorrow. In practice when dealing withcomplex systems millions of factors change over time, and hence in order tohave a theory with empirical bite one has to assume that something is notchanging. Neither book under review is very clear regarding the factors thatthey assume are time invariant. Hence, it is never clear how one can use pastmeasurements to infer what will happen in the future.

Pillars of Prosperity comes closest to following Holland’s model. Theunits are nations. The model includes two decision makers correspondingto the two political parties vying for power. Pillars of Prosperity implicitlyassumes that the groups they represent are fixed over time, and that thepreferences of these groups are stable. The theory identifies a number ofparameters that are key to understanding national performance, including ameasure of inclusiveness (called “cohesiveness” in Pillars of Prosperity), fiscalcapacity and the value of public goods. Given these parameters, the modelmakes a number of predictions regarding outcome measures that includeeconomic performance and political violence. The books reports empiricalevidence on the relationship between these endogenous and exogenous vari-ables using a panel of countries. In practice many factors are changing overtime, yet there is very little discussion of dynamics in the book. It mightbe helpful to rely on the type of reasoning that was so common in classicaleconomic analysis. For example, Marshall (1948) is very explicit about dis-tinguishing between the long and short run behavior of the firm. In the caseof a political economy model it would be helpful to discuss which factors arelikely to be stable over time, and which are likely to vary and be amenableto counter-factual analysis.

Why Nations Fail? is much less formal, but also relies upon a structurethat is consistent with Holland’s framework. The central thesis is that a sin-gle parameter is central to economic performance, and that a change froman extractive to inclusive institutions leads to better economic performance.By eschewing formal models, Why Nations Fail? is able to use as evidencean impressive set of historical case studies. This makes for far more enter-taining reading than Pillars of Prosperity. The approach is in the tradition

25

of both institutional economics (Hamilton (1919)) and the new institutionaleconomics (for example Williamson (1975) and Ostrom (1990)). With thefocus upon actual events one creates a compelling narrative that allows thenon-technical reader to see the implications of economics for the shaping ofobserved institutions.

The difficulty with a historical analysis is that while it appears to begrounded in facts, given that outcomes are the result of thoughtful decisionmakers one has be careful when ascribing a causal implication to an observedcorrelation between an institution and performance. In this next section weaddress this concern in more detail in an application of the Roy model toinstitutional choice.

4.2 The Institutional Roy Model

Suppose that we are able to observe decisions in circumstances θ. If theunit is a person, firm or nation that satisfies the assumptions of the rationalchoice model, then the unit will choose actions to maximize the payoff U (Y ),where Y is income. We can define the optimal choice as follows:

D∗i (θ) = argmaxd∈{A,B}U (Y (d, i, θ)) .

This is a version of the well known Roy model, for which there is a longliterature that explores the problem of estimating the casual impact of de-cision A versus B.16 The problem is illustrated in Figure 3. Suppose thatB corresponds to a stronger property right enforcement regime relative toA, and that Y is national income. Suppose that θ represents the charac-teristics of a country. The law and economics movement, beginning withDemsetz (1967) and Posner (1977) takes the view that the law, and henceproperty right protection, is endogenous, and evolves over time in responseto underlying conditions given by θ.

In the figure to the left of θ∗, corresponding to poorer countries, aresituations where it is optimal to have weak protection of property, whileto the right one has strong protection of property. One reason why poorer

16See for example Heckman and Honore (1990).

26

countries may have optimally weaker property rights enforcement is that theyhave less developed insurance markets and hence must rely upon informalinsurance via within village reallocation of resources. The importance of thishas been documented for Africa (Udry (1994),Platteau (2000),) and India(Townsend (1994)).

Yet, as one can see, the correlation between strong property rights en-forcement (decision A) and income (Y) is clearly positive. Hence, the care-ful institutional economist would document that poor countries have weakerproperty rights enforcement than rich countries. One might naturally con-clude that if poorer countries would implement better property rights sys-tems they would become richer, even though the true model is that they areselecting optimal property rights given their environmental constraints.

}.. .

..

Figure 3: Roy Model

The distinction between correlation and causation is well known, yet hu-mans are natural decision makers who are designed to look for correlations,and then to use these for predictive purposes.17 In the context of economicgrowth, we can look back to the 1960s where the observation that poor coun-tries lacked capital led to the belief that with sufficient foreign aid growth

17See the fascinating book by Churchland and Sejnowski (1993).

27

would take off. In practice large amounts of foreign aid have sometimesbeen accompanied by growth, and have sometimes been accompanied withstagnation. The failure to predict which is which is due to lack of thoughtnor poor research by policy makers. Ranis and Fei (1961) present, in theirwords, a “rigorously formulated” theory of economic growth. Later, Cheneryand Strout (1966) use this framework to evaluate the likely impact of foreignaid upon economic growth. What this earlier research did not do is providean insight into why some countries would take off and others would not. Nordid this earlier research explicitly address the issue of causation.

Even though the institutional approach deals with real cases and exam-ples, since one never observes the counter-factual (what would have happenedif nation i, for whom we observe Di (θ) = A, had chosen B instead), thenone cannot answer the question regarding what would happen if a countrywere to change its policies from A to B. 18 In response to this problem, theliterature on experimental economics has attempted to provide more con-vincing evidence regarding the causal impact of policy choices (see Banerjeeand Duflo (2011) for an excellent review of this approach applied to devel-opment).

The experimental approach in the context of the Holland model be-gins with a target population of individuals (for example persons, firms orschools), denoted by N . One then selects a random sub-sample, NS . Wecan then further divide this sample into two randomly selected groups, NA

and NB. Individuals in NA are exposed to A, while individuals in NB areexposed to B. One then measures the effect of A relative to B by:

O(A,B,NA, NB) =∑i∈NA

Y (A, i)/nA −∑i∈NB

Y (B, i)/nB, (1)

where nA and nB are the number of individuals in the two groups NA andNB. Normally these would be the same, though they do not have to be.What is interesting is the fact that each sub-population is a random sample

18On page 319, they explicitly state: “That is, we make no claims whatever aboutisolating a causal relation”.

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and since expectation is a linear operator we have:

E{O(A,B,NA, NB)

}= E

∑i∈NA

Y (A, i)/nA −∑i∈NB

Y (B, i)/nB

.

= E

∑i∈NA

Y (A, i)/nA

− E∑

i∈NB

Y (B, i)/nB

.

= E {Y (A, i)|i ∈ N} − E {Y (B, i)|i ∈ N}

= E {Y (A, i)− Y (B, i)|i ∈ N}

= E {O(A,B, i)|i ∈ N} .

Although it seems almost magical, this result is purely mechanical and it isthe result of the randomization procedure.19 We can see this by supposingthat the treatment effect is deterministic, and information regarding indi-vidual i provides no information regarding the effect for individual j. Thenwe have for a randomly drawn individual:

E{O(A,B,NA, NB)

}=∑i∈N{Y (A, i)− Y (B, i)} /n.

This expression states that the expected value of the measurement is equalto the average for the population. This is a statement regarding the averagecausal effect for the population. Without additional assumptions it providesvery little information regarding the value of:

E {Y (A, i)− Y (B, i)} ,

for a given individual i.The crucial point is that even if one has a carefully crafted experiment,

without some explicit theory or model regarding how the world operates, onecannot measure the causal effect of a given decision. A typical assumption isthat the mean effect is the same for each individual, but there is randomnessin the outcome. In that case (1) is indeed a good measure of the expected

19SeeDeaton (2010) for a discussion. Imbens (2010)’s provides a thoughtful response.

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casual effect of A relative to B for each person. Though such a hypothesisis in principle testable with more data, it is always the case that one needsto have some understanding of the mechanisms involved in order to knowwhether or not it is sensible to expect the treatment effect to be stable overtime.

The authors of Why Nations Fail? are well aware of these issues. In afamous paper, Acemoglu, Johnson and Robinson (2001) introduce a cleverway to measure the effects of institutions upon economic growth. The basicidea is that Europeans would implement extractive institutions in countrieswhere settler mortality is high (such as the Belgian Congo), and create “neo-European” states where mortality is low (as in the United States). WhyNations Fail? updates these ideas in two ways. In the case of the settlementof Jamestown, it is argued that neo-European institutions were establishedin part because of the failure of extractive institutions. This leads to thenew idea in the book that small differences can matter.

In terms of establishing the causal impact of institutions Why NationsFail? relies upon a regression discontinuity or “RD” argument (Lee andLemieux (2010)). An RD analysis is build upon two ingredients. The first isthat the causal effect of a choice changes continuously with the environmentalparameter θ. The second assumption is that either agents are constrained tomake non-optimal choices, or that the treatment can be observed to changefor well defined values of θ.

This idea is illustrated in Figure 3. Suppose that there is a constraintthat forces decision makers with characteristics θ < θ̄ to take decision A ,while decision B is taken when θ > θ̄. The heavy dashed line is the payofffrom decision A to the left of θ̄. Then under the appropriate conditionsHahn, Todd and Klaauw (2001) show that one can identify the causal effectof A relative to B by comparing the outcomes for units on each side of θ̄.

For example, the effect of a union upon a firm can be found by looking atclose certification elections. Whether or not one wins is viewed as a randomassignment of a firm to a regime with a union, or to a regime with no union.DiNardo and Lee (2004) use this approach to show that the unionization of afirm has no effect. Of course, if elections are close when there is little benefit

30

(the case in which θ = θ∗ in Figure 3), then we should not expect to see ameasured effect. Thus a crucial identifying assumption is that agents are notable to take optimal decisions as a function of the underlying parameter.

In the Nogales example in Why Nations Fail?, location is the backgroundvariable. This example satisfies the two conditions for a valid RD. First, theclimate and agricultural conditions are very similar on both sides of theborder, and thus local physical endowments are similar on both sides of theborder. The second ingredient is that individuals and capital are not freeto move across the border, and hence they are constrained by the humaninstitutions on each side. Given that the US side is much more successfulthan the Mexican side one can conclude that US institutions have “caused”the people on the US side to be much better off than on the Mexican side.20

A similar argument is used for Korea. Map 7 in Why Nations Fail? providesa stunning demonstration of the greater prosperity in South Korea comparedto North Korea. It shows a night time picture of Korean with the south litup relative to the dark north. These examples prove that the differences inprosperity cannot be due to physical differences in geography, but must beattributed to man made factors.

It is interesting to observe that exclusive institutions are a necessarycondition for this argument to work. If people could freely move acrossthe border then they would migrate unless indifferent between staying andleaving. In the case of North Korean, citizens who move south without per-mission have committed an act of treason and may end up in a penal colonyor kwan-li-so. This is consistent with the hypothesis that the leaders of thecountry have managed to set up an extractive regime that takes resourcesfrom a captive population for their own benefit.

The case of Nogales is somewhat different. Mexico is a democracy, andits citizens have the right to leave at will. However, the United States doesnot allow free entry - in other words it has a strong exclusive institutionthat restricts the rights of other individuals in the world to share in its good

20One reviewer noted that there is another possible interpretation. Within Mexico,Nogales is quite well off. Hence, one could argue that it is relatively well off in Mexicobecause it is close to the United States.

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fortune. Putting aside the issue of whether the US should or should not allowfree entry, the real point is that the enforcement of property rights is a keyingredient in any well functioning economy, which entails the right to excludeothers from entering the state, and hence it is certainly not an “inclusiveinstitution” from the perspective of individuals outside the US. Hence, inorder to demonstrate the importance of inclusive institutions the Acemogluand Robinson must rely upon the existence of exclusive institutions.

5 Lessons from the Theory of Organizations

The use of national borders as part of an RD design is not only a clever wayto illustrate that institutions are important, it also draws attention to therole of the free mobility of labor and exclusive institutions for understandingeconomic performance. In this section I briefly discuss some of the relevantinsights from the theory of organization with respect to the roles that in-clusive, exclusive and extractive institutions play. This literature is relevantif only to highlight the limits of our knowledge with regards to managingorganizations on the scale of hundreds or thousands of individuals, let alonedealing with the challenge of managing a nation with hundreds of millionsof individuals.

It is worthwhile recalling that there is a long tradition of advocacy of thevalue of inclusive institutions for the performance of an organization. Thefounders of the London School of Economics, Webb and Webb (1920), wereearly advocates of more inclusive institutions in firms. There was a movementtowards inclusive management of firms in Yugoslavia (see Ward (1958)),which also led to a flurry of interest in labor cooperatives as an alternative toprivately held firms. We now know that effectiveness of inclusive institutionsat the firm level depends upon the conditions.

For example, forced collectivization/inclusion in China in the 1950’s wasbelieved to result in a massive famine. Lin and Yang (1998) argue that thisis because individuals could not exercise their rights to leave a collectivefarm. Conversely, there are many examples of successful labor cooperatives,particularly in occupations with high levels of human capital such as medicine

32

and law (see Pauly and Redisch (1973)).A challenge that any organization faces is the coordination of activities

within the organization, and hence inclusive decision making can be costlyand difficult to implement (MacLeod (1987)). Hirschman (1971) observedthat the ability of individuals to leave may undermine the incentive for themto learn and cooperate together. One can show formally, that such exit costsare a necessary condition for efficient outcomes (see MacLeod (1988) and thesubsequent discussion by Dong and Dow (1993) and Lin (1993)).

If anything, the recent trend in research on the theory of the firm is toemphasize the ability to increase the rights of the the owner - in essencemaking firms less, rather than more inclusive (Jensen and Meckling (1979)).Alchian and Demsetz (1972) argue that the allocation of residual claimsto an owner provides the owner with the appropriate incentives to monitorand reward employees. The property rights literature (Grossman and Hart(1986) and Hart and Moore (1990)) emphasizes the importance of givingextractive rights (they call them residual control rights) to individuals whomake relationship specific investments. Rajan and Zingales (1998) suggestthat within the firm there is also a need for the careful allocation of the rightto access physical capital.

What this literature illustrates is the importance of carefully designingthe allocation of authority to enhance performance. It might be the casethat national governance is very different from the problem of managinga firm. Yet in Why Nations Fail? Acemoglu and Robinson explicitly ap-ply their framework to the very micro problem of compensation design, andclaim that the distinction between inclusive and extractive institutions canexplain the performance of compensation systems. The book considers anexample from a program to improve the performance of nurses in the Udipurdistrict of Rajashtan. A group of economists introduced time clocks to recordwhen nurses were at work. It was found that the local administrators under-mined the system, and so in the end the intervention had no impact uponperformance. They claim:

“the local health administration and nurses (who) were able

33

to sabotage Seva Mandir’s and the development economists’ in-centives scheme. This suggests that many of the micro-marketfailures that are apparently easy to fix may be illusory:”21

They are correct in pointing out that many economists believe that the intro-duction of incentives schemes will necessarily improve performance. Whatis unfortunate, is that it is also well known that designing such schemes isdifficult. Taylor (1911) provides the classic analysis of incentive pay. Hisanalysis begins with the observation that many work relationships are in-efficient - the worker would like to work harder for more pay, and the firmwould like to pay for this additional work. In practice it turns out to beincredibly difficult to do this consistently well. In a human resources clas-sic, Kerr (1975) provides a long list of failed incentive plans where haplessmanagers intend to improve matters, but only made things worst.

The fundamental reason that it is difficult to design reward systems is,as discussed in section 3, the problem of information. The preferences ofworkers are not observed, the difficulty of the task is not observed and theproductivity of tasks may be hard to measure or only measurable with alag. Despite this, as Ichinowski and Shaw (2003) show, there has been muchprogress.

Another reason why organizational design is hard is because efficientproduction often requires the coordination of many inputs. The existence ofcomplements in production makes figuring out how to design good incentivesystems via experimentation very hard. To see this, consider a situationwhere performance depends upon two decisions, D ∈ {A,B} and d ∈ {a, b}.In the context of the nurses example, the unit is the hospital, and D isthe rewarding of attendance (A) or not (B). Let d represent rewardingcompliance with the reward system (a) or not (b). In a prototypical incentiveexperiment one can control compliance, and hence the background conditioncan be written as θa = {a, ε}, where ε are other background conditions in

21page 448.

34

addition to compliance. The measured effect of the incentive system is thus:

O(A,B, i, θa) = Y (A, i, θa)− Y (B, i, θa) > 0. (2)

However, when implementing the scheme, compliance is not controlled, andso in fact one has the background given by θb = {b, ε}, and thus in practicewe observe:

O(A,B, i, θb) = Y (A, i, θb)− Y (B, i, θb) = 0. (3)

This is just another way of making the well known point that the externalvalidity of an experiment depends upon adequately controlling for the envi-ronment. The example also illustrates the danger of looking for a “theory”that can explain performance based upon a randomized control trial. Theexperiment underlying the causal effect in equation (2) can be used to saythat economic performance relies upon getting incentives right. However, wecan redo the experiment conditional upon having the incentives, but varyingcompliance:

O(a, b, i, θA) = Y (a, i, θA)− Y (b, i, θB) > 0, (4)

where θA = {A, ε}. In that case, the experimenter would conclude thatsuccessful institutions require getting compliance right. Getting complianceor incentives wrong in this example yields no benefit, and hence each one is100% responsible for performance.

The idea that performance depends upon a number of interlocking fac-tors is explicit in the title of Pillars of Prosperity. 22 This raises the issueof how to learn what works in the presence of complements. The history ofthe study of organizations and incentive pay illustrates that experimenta-tion alone is not sufficient to discover the best design for a complex system.There are many ways to put together a complex organization, and in somecases this may entail using more inclusive institutions. The evidence sug-

22See Milgrom and Roberts (1990) for discussion in the context of modern manufactur-ing.

35

gests that inclusive institutions are neither necessary nor sufficient for goodperformance. In the micro-economics literature it is well understood thatincentive contracts are complex, and that small changes in the informationstructure can lead to large changes in observed contracts and in the overallefficiency of an organization.

6 Concluding Observations

Why Nations Fail? and Pillars of Prosperity both address the issue of howto bring about prosperity in our time. Both books make important contri-butions to the economics literature by furthering the task of incorporatingpolitics into models of economic development.

Pillars of Prosperity is written for a professional audience, and as such,its conclusions are more cautious. The basic point is that the prosperityof a nation depends upon a number of interlocking factors. They use theirmodel to build a single index of a nation’s prospects for growth, which isnot always successful in ranking countries as a function of current success.They conclude that these failures of the model point to new directions forresearch. They also mention a need to incorporate more micro-economicfactors into the model. As I have pointed out, the micro-economics literaturealready has a great deal to say about the performance of organizations, andso I certainly agree with these conclusions. This book will be very usefulfor graduate students and professional economists who are interested in theinterface between politics and economics.

In the court of public opinion Why Nations Fail? has been far moresuccessful. It is on the short list for the 2012 Financial Times and GoldmanSachs Business Book of the Year prize, and has been widely reviewed inthe press, including a generally favorable review in the New York Review ofBooks by Jared Diamond (2012). One reason is that it is a great read. Thebook provides a wealth of examples of human successes and failures takenfrom the full span of human history. This is very impressive.

The second reason for its success is that it relentlessly takes a singularview regarding why nations fail. It feeds our desire to have a single, simple

36

solution for all our ills. In this review I discussed the case of incentive payin some detail for a number of reasons. First, like Why Nations Fail?, thecore model is one in which individuals are assumed to respond to materialrewards. It illustrates how the core model of economics has come to dominatethe way we think about social institutions.

Of course any single explanation for successful growth cannot be thewhole story. The goal of a good model is to provide an elegant way toorganize facts regarding how the world works. One is reminded of Pauli’scomment regarding a colleague’s model: Das ist nicht nur nicht richtig, es istnicht einmal falsch! 23 His point being that models provide useful approxi-mations of natural phenomena, and hence cannot be expected to always becorrect. In fact, we may learn as much about the world when a model fails,as we do when it is successful.

There are, however, dangers of using an elegant model to guide real worlddecision making. This can be illustrated by recalling an earlier era when cen-tral planning was consider the silver bullet for national prosperity. This wasproposed by by Oskar Lange (1936) who attacked Ludwig von Mises (2012)’sin support of free markets. Lange argued that market economies were fun-damentally unstable; a problem that can only be addressed with centralplanning. At the time, Lange’s argument was cogent, and convincing tomany. Yet today, after the downfall of the Soviet Union and the high growthin China after they liberalized markets, there would be few economists whowould argue that central planning is superior to a market economy.

Second, the history of incentive pay, beginning with Taylor (1911)’s bookon management, is also an illustration of the desire for simple solutions tohard problems. Today many policy makers are considering the mandatedintroduction of performance pay for teachers in the hope that it will im-prove America’s education system. It may help bring in new ideas, but itis extremely unlikely it will be as successful as the promoters expect. Kerr(1975)’s article provide a number of examples of successful private sectorfirms failing to introduce incentive pay systems that actually work. The Na-

23This is not only not right, it is not even wrong! See Peierls (1960) page 186 for adiscussion of the incident.

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tional Academy of Sciences explored this idea in detail in an excellent 1991report (Milkovich and Wigdor (1991)). The question before the panel ofexperts was whether or not performance pay would improve the efficiency ofthe public sector. They concluded that while there is a great deal of evidenceto support the hypothesis that individuals respond to incentives, the cost ofintroducing effective evaluation systems would likely outweigh any benefit.

This is not to say that such systems cannot work, but in practice theyrequire continual oversight.24 Inside a large organization this oversight isin effect “politics”. Large organizations must delegate power and decisionrights to units within the organization, but must also be vigilant and takeback those rights when performance fails. The process by which this is doneis not always straightforward, but entails the use of “political skills” to getstake holders to change their behavior or to agree to new control structures.25

Both Why Nations Fail? and Pillars of Prosperity are right to focusupon understanding the role of power in the functioning of the state. Wemight make speedier progress if some of the lessons from the recent litera-ture on firms and organizations were integrated into the analysis. The mostimportant insight is the conditional nature of rights. In all political systems,the government has control rights that cannot normally be exercised by cit-izens. As we know from the literature on labor cooperatives, joint control isnot necessarily efficient. Rather, all successful human institutions delegatecontrol rights to those individuals and groups that have the best information,and the best incentives to decide appropriately.

In civil society there are a number of mechanisms by which these del-egated control rights are altered. Within the firm, the rule of forbearancegives the owner the residual control rights (Williamson (1991) and Hart andMoore (1990)). Tort law gives rights to an individual to recover damageswhen she is harmed by a negligent individual or firm. Contract law gives

24MacLeod and Parent (1999) document the incident of performance pay use in the US,and find that it is widely used when individual performance can be reliably measured.

25Aghion and Bolton (1992) provide a really nice formal analysis of the reallocation ofcontrol rights that takes place via bankruptcy proceedings. See also Aghion and Tirole(1997) for a discussion of control rights allocation in an organization, and Maskin andTirole (2004) for a model of the allocation of control rights between politicians and judges.

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individuals the right to sue when there is breach of contract.26 Democracygives citizens the right to change their rulers. In a sense, what we observeare conditional extractive rights. Parties are given control rights, and withthose rights can do what ever they wish, subject to the possibility that thoserights will be revoked.

Both authors seem to miss the point that is an essential feature of opensocieties, such as the US, is the freedom to act. In the US, individuals are freeto steal, shoot their colleagues at work, take bribes, threaten others and drivedangerously. We observe all these behaviors. What keeps things under moreor less control is that there are sanctions for each of these choices that determost individuals. Repressive societies often control some of these behaviorswith closer monitoring of individuals (as in the former Soviet Union), forexample by closely monitoring the movement of individuals via check points.

This point also highlights the fact that a common method for obtainingcontrol rights in a society is violence. Though violence is unfortunately quitecommon in the workplace, for the most part it has not been integrated intothe theory of organization. Pillars of Prosperity devotes a chapter to thisimportant issue. They make progress by showing that weak institutions areassociated with more violence. Put another way, in societies with bettersystems for reallocating control rights there is less need to rely upon ineffi-cient violence to achieve politically preferred outcomes. The recent book byPinker (2011) supports the hypothesis that over time human societies havedeveloped institutions that have reduced the over all level of violence.

In this review I have outlined some of the related ongoing themes in thetheory of organizations that are relevant to a more complete understandingof nations as organizations. Nations, like the modern firm, are character-ized by a complex web of overlapping jurisdictions, including municipalities,counties, states and nations. Both books focus upon the nation state, butfor many individuals, local governance dealing with issues such as the supplyof water, electricity, and security can be far more important than matters ofstate. In the case of China, even though it is a one party state, Martinez-Bravo et al. (2011) find that local elected officials are responsive to the needs

26See MacLeod (2007) for a discussion of contract breach in economics.

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of the electorate. It is difficult to predict if this local democracy will grow,but it certainly points to a need for more research that connects the politicaleconomy at the local level with national and international politics.

In particular, we need to better understand the extent to which markettype mechanisms, such as those studied by Tiebout (1956), can be used atthe national and international level. Neither book discusses the role of inter-national competition for both capital and labor. As discussed in section 4.2above, both books effectively rely upon national differences in performanceto demonstrate the importance of institutions. The Roy model teaches usthat this approach can only work when we can somehow restrict competition.It is not at all clear what is the best way to evaluate the impact of differentinstitutional forms given that there is so much international competition.

A key feature of successful civil societies is the right of individuals tobring action in court against others for a variety of harms. In a globalworld economy it would be useful to know more about the role played byinternational courts that allow citizens of any state to bring a variety ofactions against others in their home state, including human rights violationsand the expropriation of resources. Even if we cannot make a particularnation more inclusive, maybe it is possible to make the legal system moreinclusive.27

Finally, as I write this, we are currently in the aftermath of HurricaneSandy (Fall 2012). While driving to New York city one feels as if one is in adystopian Hollywood movie, the flashing lights of police cars at intersectionswith no functioning traffic lights, long lines and fights for scarce gasoline, theview of the New York skyline with half the island of Manhattan darkened.These type of experiences teach us not only the great benefit of living withmodern conveniences, but also that prosperity can be fleeting. It is mayalso be worthwhile to try and understand, not only the mystery of successfuleconomic growth, but also the factors that can cause a successful society to

27This is a large and complex area. See Mackenzie et al. (2010) for a review.

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fail.28

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