The Importance of Institutions

When it comes to understanding economic growth, institutions are often critically important. First, let's define that concept of institutions. When economists talk about institutions, they mean laws and regulations, including property rights, reliable courts, and political stability. They also mean cultural institutions, including norms around honesty, trust, and cooperation.

To illustrate the importance of all these institutions, let's look at a story that is both tragic and extreme. Here is the Earth at night. Even from space, you can see where people live by the clusters of lights. Look more closely at this area. In our last video, we discussed the big divergence. The divergence in this example is so dramatic, it can even be seen from outer space. This is the Korean Peninsula. Here's South Korea, a developed, modern economy, a very pleasant place to live, or visit, or work. And here's North Korea -- mostly darkness, with the exception of the capital, Pyongyang, where the ruling elite lives.

So, what's behind this divergence? The splitting of Korea into two distinct countries provides an almost perfect natural experiment to demonstrate the power of institutions. Originally, the two Koreas had basically the same people, the same culture, the same language, the same history, and pretty similar economies. If anything, the northern part was wealthier. But, starting after the Second World War, the two Koreas ended up on very different institutional tracks. Communism was imposed on North Korea, but South Korea, broadly speaking, ended up with capitalism, and a relatively free market economy.

So, what happened? It all comes down to incentives. Different institutions create different incentives. In South Korea, the prevailing incentive was for commercial cooperation. Entrepreneurs would produce goods and services, which consumers wanted. And if they succeeded, they were allowed to earn profit and keep that profit. Alternatively, businesses which were not successful were allowed to go bankrupt, so capital was reallocated to more valuable uses. And a society evolved based on cooperation and trust and honest commercial dealing. So, over the next few decades, South Koreans became major car producers and exporters, such as the Hyundai, producers of music on a global scale -- I enjoy listening to K-pop. Movies from South Korea have taken Asia by storm, and it's a major location where women go to buy high-quality cosmetics. It's a pretty well-functioning, market economy responding to consumer demands, and the standard of living in South Korea is fully that of a developed country.

In contrast, in the North, there's been a totalitarian state where the economy is centrally planned and directed. Those rules meant that most people didn't have the freedom to start businesses. They weren't allowed to keep their own profit. Prices are controlled. Capital is allocated by the communist party, so human energies go into trying to influence politics, to try to have people you didn't like branded as political enemies or enemies of the state. The final result was tragic. And over the last several decades, there have been periodic episodes of starvation, because prices and property rights did not give farmers the right incentives to grow enough food to keep people well-nourished.

In essence, North Korea has been a militarized state where people live in fear. I've seen this difference with my own eyes. I've been to the border. When you look back to the South, it's a very pleasant, beautiful, and prosperous place. When you look ahead to the North, well, at the time, I wasn't even allowed to enter the country, because they were so afraid of outside influence. And as an economy, it's so backward that as you can see, it is literally nearly black at night. Let that sink in for a second. The economy in North Korea is so underdeveloped that at night, it is literally quite dark. Growth miracle and growth disaster, light and dark. This is an extreme example, but it's one that helps make clear the importance of institutions.

Now, let's turn back to the map. We're going to consider something else you can see in this picture of the Earth at night. People aren't spread randomly across the Earth's surface. Instead, they tend to cluster in certain areas. Can you see where?