Comparative Institutional Advantage

This paper discusses the implications of basic trade theory for our understanding of the economic performance of national institutional networks. A nation’s institutional configuration importantly shapes the incentives of its economic actors and thereby affects its productive capacities in various economic sectors. I.e., firms’ production functions, and thereby the shapes of national production possibility frontiers, depend, inter alia, on networks of national institutions. Basic trade theory then implies that, ceteris paribus, nations will produce relatively more of and export goods in which they are comparatively institutionally advantaged. Three substantive conclusions follow that previous empirical and theoretical work has generally missed. First, trade specialization in some sector evidences that a nation’s institutions are comparatively, not necessarily absolutely, better than other nations’ institutions in fostering that sector’s production. Indeed, even if a nation is a strong exporter of some goods, its national institutional networks could be pareto-dominated, i.e. weakly inferior in all goods, including those it exports. Second, increasing trade and financial integration alters the costs and benefits to different domestic interests of both inferior and superior national institutions and so may upset domestic political equilibria that maintain those institutions. Thus, globalization could lead to either international institutional convergence or divergence and provides no guarantee of institutional improvement. Third, additionally, expanding trade and financial exposure may reduce the short-run net incentives for institutional convergence by offsetting the costs of inferior institutional frameworks, thus reducing domestic pressures for institutional change. I. Varieties of Capitalism, National Institutional Networks, and Comparative Advantage Market capitalism, wherever it emerges, is predicated on preponderance of private ownership Mosher and Franzese, Comparative Institutional Advantage Page 2 of 21 of the means of production and reliance upon markets to organize economic interaction. However, recent scholarly discussions of the varieties of capitalism (e.g., of Anglo-Saxon, Rhenish, or German capitalism, or of Japan Inc.) stress that, this common base notwithstanding, different marketcapitalist societies may exhibit markedly distinct institutional and organizational features that condition their economic and political performance in myriad, importantly different, ways. Recent social-scientific and journalistic literature addresses national institutional variety in at least three contexts. First, many emphasize that, because institutions affect economic outcomes and vary cross-nationally, varieties of capitalism produce differences in national aggregate economic performance. Second, some argue further that increasing globalization will increasingly force nations to converge on one set of institutional arrangements, and, in particular, that they will converge on (a single set of) Pareto-improving arrangements. Third, others stress instead that the institutional differences across varieties of capitalism can impact countries’ advantages in trade, and thereby alter the pattern of product specialization across nations. E.g., the US tends to specialize in knowledgeintensive industries and services (computers, biotechnology, financial services, etc.) while Germany specializes in high-quality, high-diversity product markets: diversified, quality production, or DQP (complex machine tools, upscale automobiles, etc.). This product specialization appears to exceed that which differences in factor endowments and classical trade theory alone could explain. Some link this apparent US (German) advantage in knowledge-intensive (skill-intensive) goods at least in part to differences in national institutional structure. Whether they emphasize performance, convergence, or specialization, analysts arguing varieties of capitalism agree that institutions shape economic activity within nations and, in particular, the set of national institutions interacts to produce certain economic advantages or disadvantages. The precise meaning of economic (dis)advantage, however, seems to vary across these analyses with the Mosher and Franzese, Comparative Institutional Advantage Page 3 of 21 simplest conceptualization being that a set of national institutions is better, in aggregate or for some industries, than another set of institutions if countries with the first set engage in more production of certain kinds than countries with other institutional arrangements do. However, anticipating later arguments, obviously no country can produce relatively more of all types of goods; rather, all countries will make relatively more of and export some goods and make relatively less of and import others, whatever the (dis)advantages conferred by their national-institutional frameworks. We argue that this confusion stems from the implicit conflation in much of the literature of two variants of institutional advantage, comparative and absolute (competitive) institutional advantage, and we show how basic trade theory can sharpen our conception of how institutions affect economic performance. We develop this theoretical contrast between comparative and absolute advantage in the paper as follows. First, section II clarifies what we mean by national institutions and how we see them affecting economic performance. Then, section III presents a graphical two-good, two-country model of trade to clarify the distinction between absolute and comparative institutional advantage, demonstrating that previous empirical work addresses the latter though often claiming to address the former. Section IV then uses this model to provide further insights into the role of institutions and economic performance and, in particular, the impact of globalization on international institutional convergence and divergence. Section V concludes and suggests further analytic extensions. II. National Institutional Networks and Economic Performance We define a country to be absolutely better at producing some good than other countries if it can produce more of that good than others can at the same factor-input cost (i.e., if it has a higher totalfactor-cost productivity). One country could, therefore, be better at producing a good than is another country for many reasons. It could, e.g., be better at producing food (capital goods) if it is relatively more abundant in land (capital) because, by supply and demand, the same land-inputs would be Mosher and Franzese, Comparative Institutional Advantage Page 4 of 21 relatively inexpensive (assuming limited factor mobility). Thus, factor endowments are central to shaping a country’s production advantages. Technological differences, too, could make one country absolutely better in some productive activities than other countries. Indeed, neo-classical economics typically limits its focus to technology and factor endowments in comparing nations’ productivity. We will focus, instead, on how nations’ institutional configuration shapes their sectorial patterns of productivity, effectively assuming ceteris paribus on technological and factor-endowment fronts. Among national institutions affecting economic performance, sociologists and political scientists have recently begun to emphasize those in the financial, education and training, industrial relations, and inter-company governance systems (see, e.g., Hall and Soskice 1999), though, of course, the tax, court, and property-rights systems, etc., remain equally central. Each of these institutional subsystems creates economic advantages and disadvantages. E.g., financial-system arrangements might facilitate certain types of loans, promoting some kinds of investment, but also pay low interest rates, discouraging savings or otherwise hampering other kinds of loans and investment. The education system may produce a highly trained general workforce but produce very few advanced graduates or research scientists. Although these many national institutions and their varied effects deserve careful analysis of their own, we aggregate ruthlessly for present purposes. In this paper, “the set of national institutions” refers to all of a nation’s institutions that affect its economy, and “their effect on the economy” to the net effect of all those institutions. National institutions’ economic effects occur along two broad causal pathways. First, institutions can shape governmental economic policymaking (Hall 1986) directly; i.e., they can alter a nation’s economic politics. E.g., concentrating trade-policy authority in politicians directly elected from and responsive to national constituencies might produce freer trade policy than would dividing authority among multiple representatives responsible many sub-national constituencies. Much economic Mosher and Franzese, Comparative Institutional Advantage Page 5 of 21 policy is similarly institutionally shaped, and these policies affect economic performance. Second, more directly, but at a more decentralized, micro-level, institutions can shape the incentives facing economic actors in their market activities; i.e., they can alter nations’ economic production functions Hall and Soskice 1999, XXXX). E.g., British common-law derived legal systems seem to support production based on cooperative contractor-subcontractor relationships less well relative to those based on more competitive, adversarial contractor-subcontractor relationships than does, e.g., the German legal system (Casper 1995). Admittedly, these two pathways are more analytically than practically distinct, and here we primarily analyze the latter type. Along that second causal pathway, many specific mechanisms operate. New institutional economics, e.g., emphasizes institutions’ reduction or increase of transaction costs as fostering or hindering economic performance. Others, e.g., stress degrees to which firms and/or workers organize into collectivities capable of unified action, which can change what economic actions are optimal. Important to note is that all such institutional effects alter rates of production/accumulation of labor, physical and human capital, and technology; thus institutions affect economic performance, in part at least, through their effects on variables traditionally viewed as “purely economic”. I.e., as North writes, “institutions affect the performance of the economy by their effect on the costs of exchange and production” (1990: 5). Institutions are thus a form of “soft technology,” not only affecting aggregate economic performance, but also altering how various inputs are most efficiently combined to produce different goods and thus differentially impacting various economic activities. E.g., suppose legal-system safeguards for contracts and property rights were to weaken. Productivebut-risky exchange and, with it, aggregate efficiency would decline. Economic actors would also substitute other activities insofar as possible for risky exchanges as the optimal combination of subprocesses to produce final outputs will have changed. Note especially in this regard that, since some Mosher and Franzese, Comparative Institutional Advantage Page 6 of 21 productive activities rely more heavily upon risky exchanges than others do, the efficiency loss from weakening property rights would vary across the economic sectors. In sum, institutions can affect economic performance by directly altering conditions of economic activity and/or, partly thereby, by altering economic policies and politics. Next, we ask how, then, and under what conditions, we can compare the impacts of institutions on economic performance, and specifically on production in and exchange among different countries. III. Basic Trade Theory and Comparative versus Absolute Institutional Advantage The first insight from basic economic trade theory is that, when two countries trade, one country will focus on producing some goods and the other country on other goods, the two will trade to satisfy their domestic demands, and both will benefit thereby. In short, trade induces specialization among and produces gains for all parties. The second basic insight is that, in trade, each country specializes into (out of) and exports (imports) the goods in which it is comparatively advantaged (disadvantaged). Critical here is that comparative as opposed to absolute advantage is doubly relative. Obviously, if England is absolutely better at making cloth and absolutely worse at making wine than Spain while Spain is absolutely better at wine and absolutely worse at cloth than England, then England could make cloth and Spain wine, they could trade, and both would benefit. That, however, is more than required. Even if England is absolutely more productive in both, e.g., trade produces specialization and gains. What determines the direction of trade, specialization, and gains is the productivity in activity 1 relative to productivity in activity 2 in country A relative to the same ratio in country B. Thus, e.g., if the ratio of England’s productivity in cloth to its productivity in wine exceeds the ratio of Spain’s productivity in cloth to its productivity in wine, then trade induces England (Spain) to specialize in and export cloth (wine), and they both gain by this transaction, all regardless of their respective absolute productivities. Mosher and Franzese, Comparative Institutional Advantage Page 7 of 21 Figure 1: Absolute Institutional (Dis-)Advantage