The Importance of Institutions

Course Outline

The Importance of Institutions

In today’s video, we discuss a topic critical to understanding economic growth: the power of institutions.

To better shed light on this, we're going to look at an example that's both tragic and extreme.

In 1945, North and South Korea were divided, ending 35 years of Japanese colonial rule over the Korean peninsula. From that point, the two Koreas took dramatically different paths. North Korea went the way of communism, and South Korea chose a relatively capitalistic, free market economy.

Now—what were the results of those choices?

In the ensuing decades after 1945, South Korea became a major car producer and exporter. The country also became a hub for music (any K-pop fans out there?), film, and consumer products. In stark contrast, North Korea's totalitarian path resulted in episodes of famine and starvation for its people.

In the end, South Korea became a thriving market economy, with the living standards of a developed country. North Korea on the other hand, essentially became a militarized state, where people lived in fear.

Why such an extreme divergence?

It all comes down to institutions.

When economists talk about institutions, they mean things like laws and regulations, such as property rights, dependable courts and political stability. Institutions also include cultural norms, such as the ones surrounding honesty, trust, and cooperation.

To put it another way, institutions guide a country's choices -- which paths to follow, which actions to take, which signals to listen to, and which ones to ignore.

More importantly, institutions define the incentives that affect all of our lives.

Going back to our example, in the years after 1945, North and South Korea took dramatically different institutional paths.

In South Korea, the institutions of capitalism and democracy, promoted cooperation and honest commercial dealing. People were incentivized to produce goods and services to meet market demand. Businesses that did not meet demand were allowed to go bankrupt, allowing the re-allocation of capital towards more valuable uses.

Against that grain, North Korea's institutions produced starkly different incentives. The totalitarian regime meant that the economy was centrally planned and directed. Most entrepreneurs didn't have the freedom to keep their own profits, resulting in few incentives to do business. Farmers also didn't have enough incentive to grow sufficient food to feed the population. This was due in part to price controls, and a lack of property rights.

As for capital, it was allocated by the state, mostly towards political and military uses. Instead of going towards science, or education, or industrial advancement, North Korea's capital went mostly towards outfitting its army, and making sure that the ruling party remained unopposed.

And now, look at how different the two countries are as a result of those differing institutions. When it comes to economic growth, institutions are critically important. A country's institutions can have huge effects on long-term growth and prosperity. Good institutions can help turn a country into a growth miracle. Bad institutions can doom a country to economic disaster.

The key point remains: institutions are important.

They represent the choices that a country makes, and as the Korean peninsula shows you, choices on this scale can have staggering effects on a nation's present, and future.

Teacher Resources


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?


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