The impacts of institutional implementation on provincial economic performance the case of vietnam (2007 2011)

UNIVERSITY OF ECONOMICS

INSTITUTE OF SOCIAL STUDIES

HO CHI MINH CITY

THE HAGUE

VIETNAM

THE NETHERLANDS

VIETNAM - NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE IMPACTS OF INSTITUTIONAL
FACTORS ON PROVINCIAL ECONOMIC
PERFORMANCE: THE CASE OF VIETNAM
(2007-2011)
By

PHAN THACH TRUC

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

Ho Chi Minh City, December, 2013


UNIVERSITY OF ECONOMICS

INSTITUTE OF SOCIAL STUDIES

HO CHI MINH CITY

THE HAGUE

VIETNAM

THE NETHERLANDS

VIETNAM - NETHERLANDS PROGRAMME
FOR M.A. IN DEVELOPMENT ECONOMICS

THE IMPACTS OF INSTITUTIONAL
FACTORS ON PROVINCIAL ECONOMIC
PERFORMANCE: THE CASE OF VIETNAM
(2007-2011)
A thesis
submitted in partial fulfillment of the requirements for the degree of
Master of Arts in Development Economics

By

PHAN THACH TRUC

Academic supervisor
Dr. TRUONG DANG THUY

Ho Chi Minh City, December, 2013

DECLARATION
I declare that: "The impacts of institutional factors on provincial economic
performance: The case of Vietnam (2007-2011)" is my own work; it has not been
submitted to any degree at other universities.

I confirm that I have made all possible effort and applied all knowledge for finishing
this thesis to the best of my ability.

Ho Chi Minh City, December 2013
PHAN THACH TRUC

i


ACKNOWLEDGEMENTS
First and foremost I would like to extend my gratitude to my supervisor, Dr. Truong
Dang Thuy, for invaluable comments, guidance and engagement through the learning
process of the thesis. I am much obliged to Dr. Pham Khanh Nam for introducing me to
the topic as well as for the availability of the dataset. In addition, I am thankful for Le
Duc Anh for all your kind help during my time in class 17. Then I feel lucky to have
time doing the thesis with Nguyen Thi Ngoc Linh and Nguyen Quang, from whom I
have a lot of things to learn. Lastly and obviously, I am deeply indebted to my family
members for all the kind understanding and spiritual support. Forever, I will be
wholeheartedly grateful for your love.

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ABSTRACT
Given the intensive PCI score race among Vietnamese provinces in the past year so as

to improve the enabling environment for local economic development, this study is to
justify the imperativeness of such a race. Employing the PCI and its nine sub-indices as
proxies for institutional quality, we explore the institutional impacts on GDP for the
dataset of 58 Vietnamese provinces from 2007 to 2011. In realizing this objective, we
make an attempt to incorporate into the estimation models of both Cobb-Douglas and
Translog functional form the de facto overstatement of provincial GDP. While the
positive impacts of PCI on provincial GDP are statistically confirmed, the regression
results obtained for the nine sub-indices are divergent across functional forms and
outlier treatment approaches. To the extent that the economic significance of different
institutional factors is assessed, our research objective is realized and respective policy
implications are then suggested.
Key words: PCI, GDP overstatement, institution, Cobb-Douglas, Translog

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TABLE OF CONTENTS
DECLARATION ............................................................................................................. i
ACKNOWLEDGEMENT ............................................................................................ii
ABSTRACT ...................................................................................................................iii
TABLE OF CONTENTS .............................................................................................. iv

Chapter 1 INTRODUCTION ....................................................................................... 1
1.1

Problem statement ............................................................................................. 1

1.2

Research objective and research questions ........................................................ 3

1.3

Contribution of the study ................................................................................... 4

1.4

Organization of the study .................................................................................. 4

Chapter 2 LITERATURE REVIEW ......................................................................... 5
2.1

Theoretical literature: The New Institutional Economics .................................. 5

2.1.1

A renewed interest – some distinct features ............................................... 5

2.1.2

Institutions matter for economic performance ........................................... 7

2.2

2.1.2.1

Theoretical approaches ....................................................................... 7

2.1.2.2

Mechanism and channels of influence ................................................ 8

Theoretical model: the aggregate production functions .................................. 11

2.2.1

History of the production functions ......................................................... 11

2.2.2

Properties of the production function ....................................................... 14

2.3

Empirical literature ......................................................................................... 15

Chapter 3 DATA AND RESEARCH METHODOLOGY ...................................... 19
3.1

Data and variable measurement ....................................................................... 19
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3.1.1

Data collection.......................................................................................... 19

3.1.2

Variable measurement .............................................................................. 21

3.1.2.1

Response variable ............................................................................. 21

3.1.2.2

Explanatory variables ........................................................................ 21

3.1.3
3.2

Descriptive statistics ................................................................................. 29

Research methodology .................................................................................... 33

3.2.1

Model specifications ................................................................................ 33

3.2.2

Estimation methods .................................................................................. 35

3.2.2.1 Data cleaning – OLS regression for panel data ....................................... 35
3.2.2.2 Modeling the overstatement of growth data – The Stochastic Frontier
Analysis (SFA) .................................................................................................... 37
3.2.3 Model validation ........................................................................................... 41
3.2.3.1 Testing the model overall significance .................................................... 41
3.2.3.2 Statistical test of individual coefficient significance ............................... 41

3.2.4 Analytical framework .................................................................................... 42
Chapter 4 EMPIRICAL RESULTS AND DISCUSSION ...................................... 43
4.1

Overall explanation and hypothesis testing ..................................................... 43

4.1.1

Overall explanation of model regression ................................................. 43

4.1.2

Hypothesis testing .................................................................................... 44

4.1.2.1 Statistical test of model overall significance ........................................... 44
4.1.2.2 Statistical test of individual significance of institution variables ............ 45
4.2

Model estimation – Institutional impacts on GDP .......................................... 46

4.2.1 Transaction cost institution: Entry cost, Time cost and Informal charges .... 46
4.2.2 Property right and Contract enforcement institution: Access to Land and
Legal Institution ..................................................................................................... 53
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4.2.3 Information problem institution: Access to information, Private sector
development and Pro-activity of provincial leaders ............................................... 56
4.2.4 Labor policy and training .............................................................................. 62
4.2.5 The PCI ......................................................................................................... 64

Chapter 5 CONCLUSION AND PERTAINING ISSUES ....................................... 70
5.1

Conclusion ....................................................................................................... 67

5.2

Policy implications .......................................................................................... 68

5.3

Limitations and further studies ........................................................................ 69

REFEERENCES.......................................................................................................... 70
APPENDIX ................................................................................................................... 74

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LIST OF TABLES
Table 3.1 Variable summary .......................................................................................... 28
Table 3.2 Summary statistics of key variables ............................................................... 29
Table 3.3 Between and within variations of key variables ............................................ 30
Table 3.4 Overstatement of provincial growth data ....................................................... 35
Table 4.1 Attempted regressions of this study ............................................................... 44
Table 4.2 Hypothesis testing of overall significance of multiple regression ................. 44
Table 4.3 Hypothesis testing of individual significance for institution variables .......... 45
Table 4.4 Regression result– Transaction cost institution.............................................. 48
Table 4.5 Regression result - Property right and Contract enforcement institution ....... 54
Table 4.6 Regression result – Information problem institution ..................................... 56

Table 4.7 Regression result – Labor policy and training ............................................... 62
Table 4.8 Regression result –the PCI ............................................................................. 64

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LIST OF FIGURES
Figure 3.1 Institution and economic outcomes: mechanism and channels of influence 27
Figure 3.2 Time-series plots of real GDP against year and PCI against year ................ 31
Figure 3.3 Overall scatter plot of real GDP against PCI ................................................ 32
Figure 3.4 Scatter plots for within and between variations of real GDP against PCI .... 32
Figure 3.5 Illustration of growth data overstatement ..................................................... 38
Figure 3.6 Different distributions of u .......................................................................... 39
Figure 4.1 Effects of Time cost scores on GDP ............................................................. 51
Figures 4.2 Effects of Informal charge scores on GDP .................................................. 52
Figure 4.3 Effects of Information access scores on GDP............................................... 59
Figure 4.4 Effects of Private sector development scores on GDP ................................. 60
Figure 4.5 Effects of Pro-activity of provincial leader scores on GDP .......................... 61
Figure 4.6 Effects of Labor policy and training scores on GDP .................................... 63
Figure 4.7 Effects of the PCI scores on GDP ................................................................. 65

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Chapter 1
INTRODUCTION
1.1

Problem statement

There has recently been a resurgence of interests and discussions on the relationship
between institutional framework and economic performance among economists and
policy-makers across countries. The interest in investigating this issue has been
motivated by the increasing consensus in considering institutions as a crucial
determinant shaping economic performance. From a methodological perspective, the
study of this relationship has been initiated by the debut of the New Institutional
Economics, the origin of which could be traced back to Coase (1937) with the wellknown message emphasizing the importance of institutions in the presence of high
transaction costs “When it costly to transacts, institution matters”. According to Bates
(1995), this strand of analysis contributes to explaining sources of economic growth by
integrating institutions, which are defined as the formal and informal “rules of the
games and their enforcement characteristics” (North, 1994, p.361) into economic
theory. The basic argument for the roles of institution in the growth literature is that in
the absence of efficient institutions, it is challenging for standard factors of production
to deliver rapid growth (Eicher, Garcia-Penalosa & Teksoz, 2006), especially in
transition economies. Theoretical and empirical literature on the issue suggests that
channels of institutional influence on economic outcomes may be direct via affecting
relevant costs incurred or indirect via affecting the incentives for investment in factors
of production. Despite a great number of studies in the empirical literature focusing on
the institutions – growth nexus, institutional analysis is still in its development stage
(Brousseau & Glachant, 2008; Chang, 2006) and further research needs to be conducted
“before the institutional perspective can be fully operationalised” (Pelikan, 2003;
Rodrik, Subramanian & Trebbi, 2004).

Being a transition economy experiencing recent institutional reforms, Vietnam offers
an appropriate empirical context for addressing the above-mentioned issue. A
provincial level study for the country is of imperative concern for plenty of reasons.
Since the 1986 economic reform called “Doi moi”, Vietnam has witnessed a significant

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growth of the non-state sector with its legal recognition in the early 1990s and
remarkably, the promulgation and enactment of Enterprise Law in the year 2000.
Despite this legal milestone, the sector still faces numerous constraints to its
establishment and business operation, the majority of which is closely related to the
implementation of central policies by local governments, which varies substantially
across provinces. Such institutional variations arise, for the most part, due to the
complexity of law, which entails the issuance of quite a great number of sub-law
gazettes for enforcement purposes. This, in turns, makes the implementation of laws
depend a great deal on the interpretation of local officials, who can always apply their
own interpretation to central policies even when regulations are not vague (Nguyen,
Pham, Bui & Dapice, 2004; Tenev, Carlier, Chaudry & Nguyen, 2003). Put differently,
there exists a high level of discretion by Vietnam’s local authorities compared with
other developing countries, which is a prominent feature of Vietnam’s institutional
reforms (Fforde & Vylder, 1996; Tran, Grafton & Kompass, 2009).

On the other hand, Vietnam’s provinces differ substantially in their achievement of
economic outcomes. A preliminary analysis reveals, to some extent, high dispersion of
income both in terms of growth and level across provinces for the 2007 – 2011 periods.
Notably, the provincial GDP 5 - year average growth rate ranges from a striking low
2.92% to an approximate ten-time greater figure of 29.52%. Similar divergence is
evident in provincial output levels as well. In particular, Ba Ria- Vung Tau exhibited
highest GDP of around VND122,000 billion and VND170,000 billion for the year 2007
and 2008, respectively.

Likewise, Ho Chi Minh City maintained its reign as top

performer with impressive figures of VND131,000 billion, VND 151,000 billion and
VND158,000 billion respectively in the 2009, 2010 and 2011 scores. Standing at the
other end were Bac Can for the year 2007-2009 and Lai Chau for the 2010-2011

period with GDP scores even below the VND3,000 billion level.

Against this

background, a crucial question was posed on the contribution of institutions in
explaining tremendous variations in economic performance among Vietnam’s
provinces.

As the concept of institution means different things to different scholars and varies
from studies to studies (Nelson & Sampat, 2001), inquiries firstly fall on how to

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measure such a multi-dimension notion. Compiled from survey-based responses of
randomly selected private enterprises and hard data from published sources, which is
subsequently aggregated into a provincial level score, the Provincial Competitiveness
Index (PCI) is an annual composite index representing the voice of the local business
community in ranking Vietnam’s provinces according to their governance quality.
Specifically, nine aspects of governance are measured by nine corresponding subindices, namely Entry costs, Land access and security of tenure, Transparency and
access to information, Time costs of regulatory compliance, Informal charges, Proactivity of provincial leadership, Business Support Services, Labor and Training and
Legal institutions. Since its launch in 2005 by the collaboration of the Vietnamese
Chamber of Commerce and Industry (VCCI) and the United States Agency for
International

Development-funded

Vietnam

Competitiveness

Initiative

(USAID/VNCI), PCI has been considered as a critical tool for analyzing and
monitoring progress in the local regulatory environment from the perspective of the
private sector. Importantly, using PCI ranking to measure progress in provincial
institutional reform, Schmitz, Dau, Pham and McCulloch provide evidence for the
essential role of Vietnam’s private sector in driving the economic reform at provincial
level, stating that “there was no formal public-private coalition but the dynamic was
one of proactive government seeking the input from the private sector, and the latter
lobbying for and contributing to responsive and effective government” (Schmitz et al.,
2012, p. 3). On the other hand, facts and figures obtained from VCCI at the relevant
website www.pcivietnam.org reveal that there has been an intensive race to improve
PCI scores among provinces in the past years in an effort to create a better enabling
environment for economic development. This context raises the imperative question of
whether higher PCI scores really result in better economic performance for provinces in
Vietnam. Employing PCI and its sub-indices as proxy variables for institution, this
study investigates the impacts of institutional implementation on economic
performance of Vietnam’s provinces for the 2007-2011 period.

1.2

Research objective and research questions

This thesis aims to investigate the contribution of institutional factors to Vietnam’s
provincial economic performance through answering the following research question:

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-

How much of the variation in cross-provincial GDP of Vietnam could be
explained by institutional quality, both in a broad sense and as specific
factors of economic governance?

In an attempt to explain the economic differentials across Vietnam’s provinces, the
thesis explores the contribution of institutional factors, particularly the PCI and its subindices, including Entry Costs, Time Costs and Regulatory Compliance, Informal
Charges, Land Access and Tenure Security, Legal Institution, Transparency and Access
to Information, Labor Policy and Training, Business Support Services and Pro-activity
of Provincial Leadership.

1.3

Contribution of the study

This study contributes to the existing literature in the following two ways. First, since
there have been few studies on the issue for the case of Vietnam so far, this thesis is an
attempt to provide the first empirical evidence for the impact of institutional factors on
the country’s provincial economic outcomes. Specifically, using PCI as the proxy for
institution quality, a limited number of previous researches examine the issue for
Vietnam at firm-level in a particular year, that is they offer a cross-section analysis of
how institutional implementation impact on firm’s productivity. This study, on the
other hand, explores the issue at provincial-level over a five-year time span. Second, in
realizing the above-mentioned objective, efforts are made to incorporate the de facto
overstatement of growth data into estimation models. Treating such a sensitive dataset
in this way helps, to some extent, to deliver a more reliable regression results for
analysis.

1.4

Organization of the study

The thesis is structured in the following way. The second chapter reviews the theoretical
literature underlying the institution – economic growth nexus along with the empirical
dimension of this relationship. Chapter 3 describes the data, research methodology and
empirical models for investigating the impacts of provincial institutional quality on
economic performance. Chapter 4 reports and analyses the regression results. The last
chapter concludes the study with policy implications and discusses the limitations and
directions for further research.

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Chapter 2
LITERATURE REVIEW
This chapter is to review the theoretical and empirical literature on the central role of
institution quality on economic performance. The chapter is divided into three sections.
The first section reviews the prominent economic theory underlying the relationship
and discusses the theoretical models to be applied. The second part reviews empirical
studies on the issue. The final section concludes the chapter with summary of empirical
evidence and conceptual framework.

2.1

Theoretical literature: The New Institutional Economics

There has been a resurgence of interest in institution literature during the last few
decades. From a methodological viewpoint, the incorporation of institutional
perspective into economic analysis was initiated by a particular strand of analysis: the

New Institutional Economics (NIE). Crucially, NIE covers a wide range of institutional
issues with a growing proliferation of literature devoted to study the impacts of
institution quality on economic performance.

2.1.1

A renewed interest – some distinct features

Despite an early interest in the institution literature dated far back to the time of Adam
Smith’s work, institutions did not regain its prominence in mainstream economics until
the 1990s in response to the failures of neoclassical economics in interpreting economic
growth and development issues (Nye, 2008). Specifically, experience of the ex-Soviet
regimes in their transition period of worsening economic performance lends significant
support to the essentiality of including “institutional factors in the corpus of mainstream
economics” (North, 1994, p.367). In addition, given the technology diffusion and
capital mobility as the expected result of globalization, the widening gap of intercountry inequality in the late twenties has justified for the World Bank’s
acknowledgement that “the main challenge for development policy at the turn of the

5


twenty-first century was the supply of effective market supporting institutions, and the
creation of demand for such institutions” (World Bank, 2002, p.4)

NIE draws on the backbone analysis of Williamson (1985) and North (1990), with their
definitions of institutions as “governing structures” and “rules of the game”,
respectively. As such, NIE assumes that individuals have incomplete information and
limited rationality, which accounts for the arising of uncertainty and transaction costs
(Menard & Shirley, 2008). In this light, humans create institutions, both in written
forms (the formal institution) as well as norms of conduct and beliefs (the informal

ones). In addition, they develop organizational arrangements to support transactions
and cooperation in production and exchange. According to Brousseau and Glachant
(2008), substantial efforts have been made in studying how institutions interact with
these organizational arrangements as well as “how these arrangements act in turn to
change the rules of the game” (Menard & Shirley, 2008, p.12)

NIE differs from its former variant, the Old or Traditional Institutional Economics,
whose name and core elements were owed to Hamilton (1919) in his article “The
institutional approach to economic theory”, in two significant ways. Firstly, NIE is built
on the fundamental assumption of neo-classical assumption of scarcity and
competition. Secondly, while the former being shortage of “a systematic theoretical
foundations as well as supportive empirical analysis” (Joskow, 2003, p.6), NIE is,
according to Menard and Mary (2008), “built around a backbone of some fundamental
and original contributions” and has so far been characterized by extensive empirical
studies.
Remarkably, NIE is not an integrated theory; but a “combination of bricks coming from
different traditions” (Brousseau & Glachant, 2008, p.2). Being the outcome of an
evolutionary process, NIE is open to academic contributions of scholars from a wide
range of social and scientific backgrounds. This high level of openness, to a certain
extent, helps to explain for NIE’s evolutionary perspective as well as the heterogeneity
of academic contributions in NIE.

Overall, in exploring the contribution of institutional factors to variations in economic
performance, NIE does not reject the basic progress and analytical tools that has been
6


developed in the neoclassical tradition (Joskow, 2003); rather it acknowledges the
latter’s strengths and drawbacks as well as employs existing tools in its own way to
address a broader set of relevant issues.

2.1.2

Institutions matter for economic performance

According to Smith (1976), institutional factors can explain not only the cross-country
economic differences in growth rates, but also regional disparities within a country.
Institutions being “the underlying determinants of the long-run performance of
economies” (North, 1990), a significant body of institution literature has recently been
revolving around the inquiry: “How do institutions matter?”

2.1.2.1 Theoretical approaches

From a theoretical perspective, the research of institutional issues proposed within NIE
falls into three broad categories of theoretical approaches, namely The Historical
Perspective Approach, The Comparative Institutional Analysis and the Imperfect
Information Theory.
Pioneered by North (1990), “The Historical Perspective Approach” analyzes
institutions from a historical perspective. As institutions are historically specific, it is of
vital importance that historical context be taken into consideration when coping with
institutional change (Alston, 1996). In an attempt to accomplish this purpose, North
(1990), in his seminal book “Institutions, Institutional Change and Economic
Performance” combines a theory of Human behavior with a theory of Transaction cost.
The main message delivered is that institutions matter for economic performance by
eliminating uncertainty and transaction costs incurred in social transaction, thereby
enhancing economic growth.
The second strand of theoretical framework, The “Comparative Institutional Analysis”,
owes its most systematic elaboration to Aoki (2001). Attempting to include both
Evolutionary and Repeated game theory into analysis, Aoki’s definition of institution
reflects the presence of these two sub-strand of approaches, whereby institution is

considered as “self-sustaining system of shared beliefs” (Aoki, 2001) that may change
7


the incentive structures of games, thus influencing the strategic choices of and
interaction between agents.
Another influential strand of NIE is the one associated with the “Imperfect Information
Theory”, according to which, institutions are explained “in terms of strategic behaviors
under asymmetric information among the different parties involved” (Bardhan, 2000).
This analytical framework emphasizes that information and enforcement costs drive
some markets to be non-existent and others uncompetitive. Against this background,
institutions may be relied on as a response to missing markets or may help to eliminate
information problems in other ones (Hoff, Braverman, Stiglitz, & Arnott 1993).

In brief, the basic difference among these three approaches lies in their analytical tools
to conduct investigation. While there is an attempt to integrate economic theory and
economic history in the Historical Perspective approach, the second one of
Comparative Institutional approach makes good use of game theory in addition to
historical information. Finally, the Imperfect information framework is the most
mathematically-oriented out of the three lines of study (Nabli & Nugent, 1989).

2.1.2.2 Mechanism and channels of influence

The above-mentioned theoretical approaches lay fundamental analytical frameworks
for analyzing the “institutions matter” issue, specifically the institutional mechanism
and channels of influence on economic performance.

Among the institutions that are significant determinants of economic performance are
those involving property rights and contract enforcement. According to Coase (1937),
one way in which institutions can help resolving the problems of prisoners’ dilemma as

well as overcome the failures of their collective action is to provide for a well-defined
property right. Being norms and rules that confer the control of the returns to invested
assets and/or produced values as well as stipulate the procedures for exchange of
executive, institutions provide the essential level of internal security and trust. By
eliminating the potential risks of expropriation, institutions affect the economic agents’
decisions and extent of saving and investing in physical and human capital. Put another

8


way, the lower the risk of expropriation and the higher the level of security, the higher
is the level of investment and growth, all other factors remain unchanged.

Moreover, institutions that provide for secure property rights lend great support to the
process of patent registration, ideas dissemination, to list some, across creative
individuals; all factors that stimulate research and development activities. In this sense,
good institutions contribute to boosting an economy’s rate of innovation (Tebaldi &
Elmslie, 2008), thereby promoting economic growth.

With reference to contract enforcement, institutions stipulate rules and regulations that
can prevent or mitigate market failures and agency problems. Measured by the extent of
regulatory burden, tax evasion, corruption and the like, institutions affect economic
performance by enhancing the efficiency of public policy and by mitigating the risk of
anti-competitive behaviors and rent-seeking by corporate actors. Only with the right
institution in place that the collective action problem is resolved and the scope for rentseeking is minimized.

In the same line of study on collective action problems, Olson (1982) argues that facing
these problem prevent large groups of “self-interested economic agents” from
cooperation. Subsequently, Axelrod (1997), in his comprehensive analysis of cooperation, raises the importance of internalized norms that encourage cooperative
behavior within such groups. In the context that cooperation is essential for individuals

to capture trade gains in societies, the evolution of institutions helps facilitate a more
favorable environment for cooperative solutions, thereby stimulating economic growth.

Besides, institutions that set ground for a well-functioning human capital market affect
the rate of returns to education, which, in turn, affects the productivity and allocation of
labor. In this sense, institutions stimulate human capital accumulation. According to
Wolf (1955), the “right institutions” are conducive to the formation of productive
capital as well as the adoption of new technology across regions and nations.

In general, in terms of property rights and contract enforcement, institutions create an
incentive structure that leads to the reallocation of efforts to engage in productive legal
market activities. Put differently, it facilitates the conduct of appropriate and
9


constructive property transactions as well as other contracting of mutual interests
among economic agents; thereby promotes economic outcomes.

Another predominant source of institutional factors contributing to economic growth is
those closely related to transaction costs. According to North (1990), this point justifies
for the existence of institutions”. In the sense that institutions, in combination with
other factors of production, determine the structure of exchange that influences
production and distribution costs, they affect the feasibility and profitability of
economic activities. It is through this mechanism that institutions are considered the
“underlying determinant of long-run economic performance”, according to North
(1990).

In addition, transaction costs being on the path upward together with the increasing
level of development (Wallis and North, 1986), institutions emerge as a significant
factor that offer a two-fold contribution to economic growth: one is efficiency gained

implied by a lower measurement of costs per transaction and the other is a growing
number of activities of mutual economic interest signaled by a higher volume of
transactions. Institutions are, therefore, conducive to better economic performance in
the long run.

The relevance of the underlying institution economic theory of information problems to
that of transaction costs lies in the fact that the former represents a significant source of
the latter (Stiglitz, 1985). In this line of study, institutions are considered to be “wellunderstood rules of the game” that bring about a certain degree of predictability to
individual or corporate behaviors. With the right institutions in place, uncertainty is
reduced and contracting activities of mutual interests between economic agents will be
encouraged to a certain extent, which results in better economic performance.

The mechanisms of how institutions contribute to economic performance illustrated by
previous paragraphs reveal relevant channels of influence. First, institutional factors
may enter a growth regression in a linearly additive term. As such, they may display a
direct, linear effect on growth, which is the direct channel of influence. Second, in
interacting with standard factors of production, institutions may have indirect effects on
growth by altering the marginal effects of these production factors, which is the
10


interactive effect. Another possibility that institutions indirectly matter to economic
performance is by affecting the relationship between economic growth and its
determinants through the latter’s parameter heterogeneity, which is the threshold effect
(Minier, 2007). The basic argument for such an effect is that how growth fundamentals
determine a country’s growth may, to a certain extent, depend on relevant institutions
being adequately strong. In other words, there exist some possible threshold levels of
institutional quality that must be reached before say, physical and human capital as well
as technological advances could exert their influences on growth. There are theoretical
reasons to expect such indirect effects. According to Wolf (1955), “growth-promoting

institutions” stimulate, rather than impede the formation of physical and human capital
as well as allow for the adoption of technological advances; and thereby promote
economic growth. In a nutshell, the literature review on the contribution of institutions
to economic performance from the perspective of NIE shows that institutional
economists have “won the war” in the sense that much insight has been increasingly
provided on the proposition that “institutions matter for growth” (Joskow,2003).
Despite substantial endeavors as well as progress having been made in the field over
the last three decades, pertaining inquiries about the institution-growth nexus, for
instance the potential endogeneity of institutional variables, the causality of the
relationship, to name some, are still open for further research. And the hard work is still
ahead.

In modeling institutional effects, a large number of empirical works on institutionsgrowth make use of the production function. Section 2.2 provides a brief introduction
to the development of the production function. The section also discusses the properties
of the production function that are relevant for the application of institutions-growth
analysis.

2.2

Theoretical model: the aggregate production functions

2.2.1

History of the production functions

There is widespread consensus among scholars in considering production function as a
critical tool of analysis in the neoclassical economics. According to Schumpeter (1954),
the history of the production function dates back to the year 1767 when Turgot, in his

11

work of Observations on a Paper by Saint-Peravy, discusses how the variations in the
proportion of standard factors of production account for marginal productivities,
whereby the production function was implicitly formulated. Later on, Philip Wicksteed
(1894) was generally believed to be the first economist to algebraically formulate the
input-output relationship as P  f  x1 , x2 ,..., xm  . On the other hand, Humphrey (1997)
provides some evidences for the fact that the first formulation of production function
was owed to Johann von Then in the 1840’s.
During the 1950’s-1970’s period, production function attracted the attention and
discussion of a large number of economists, which results in various propositions and
analysis of the specifications for input-output relationship as well as their
corresponding conclusions (Mishra, n.d). In particular, Stigler (1952) noted that the
logarithmic production function was introduced by Malthus while (Humphrey, 1997)
demonstrated how the Cobb-Douglas function was firstly presented in “disguised form”
by Von Then in The Isolated State, vol – II. In this line of investigation, it is noted by
Velupillai (1973) that Wicksell in his work dated 1900-1901 formulated his production
function identical to that of Cobb-Douglas. Specifically, in Wicksell’s 1923 review of
Gustaf Akerman’s doctoral dissertation, his production function was formulated as

P  AL C  , with     1 . Similarly, the well-known Leontief production function
was evidenced to be jointly formulated by Jevons, Menger and Leon Walras. Overall,
certain academic achievements associated with individual scholars are not the sole
accomplishment of such individual; rather they are the “culmination of the research
efforts of an entire epoch” (Russel, 1984).

Arrow, Chenery, Minhas, & Solow (1961) formulated the Constant Elasticity of
Substitution (CES) production function allowing for the elasticity of substitution
between capital and labor to be valued between zero and infinity, which stays fixed
along and across the isoquant regardless the size of output or inputs used in the

production process. In this sense, the Cobb - Douglas, the Leontief and the linear
production functions are only its special cases. In the classical form, these production
functions assume that the technological progress is Hicks-neutral (Hicks, 1932),
whereby the marginal rate of substitution between any two factors of production is
independent of technical progress or level of output. Generalization of the CES

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production function was initialized by Brown and Cani (1963) to allow for nonconstant returns to scale. Fundamental contributions were made by Uzawa (1962) and
Kazuo Sato (1967) concerning the incorporation of more than two factors of
production. Likewise, Nervole (1963) generalized the Cobb-Douglas production
function with variable returns to scale, which was further studied by Ringstad (1967).
Diewert (1971) proposed a functional form for the production process that permits
variable elasticities of substitution. Generalization of the Cobb-Douglas and CES
production functions in their classical form was almost complete by mid 1970’s.

The prominently restless area of research in the economics of production is the
empirical estimate of the aggregate production function, an essential tool of analysis in
macroeconomics. According to Felipe and Fisher (2003), there are two strands of
literatures questioning the notion of an aggregate production function: the so-called
Cambridge (UK)- Cambridge (USA) capital controversy and the aggregation literature.
The former raises questions concerning the unit of measurement for capital goods as a
factor of production in the aggregate production function while the latter explores the
conditions for neoclassical micro production functions to be aggregated into a
neoclassical aggregate one. As there are considerable mismatches between
characteristics possessed by firms and that of industries, or moving upwards, the
economy as a whole, when attempts were made in identifying the recipe for the
production functions at macroeconomic levels, they have to be handled with significant
caution.

As advocates of the aggregate production functions, Knut Wicksell (1923) justified the
application of aggregate linearly homogeneous functions by making substantial
contributions to conclude that non-homogeneous production functions for firms are
perfectly compatible with a linear homogeneous function for the entire industry
(Humphrey, 1997). This line of investigation progressed rapidly with activity analysis
of Koopmans (1979), aggregate linear production function of Georgescu-Roegen
(1951), separation theorems and generalization of Von Neumann’s model (1937) as
well as well-grounded proofs provided by Nikaido (1968), all of which strengthened
the foundation of using the aggregate production function in economic analysis.

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According to Felipe and Adams (2005), the Cobb-Douglas production function is still
today “the most ubiquitous form in theoretical and empirical analyses of growth and
productivity”. Its origin officially dates back to the seminal work of Cobb and Douglas
in 1928, whereby an aggregate production function was, for the first time,
econometrically estimated with the employment of 1899-1922 data for the United
States manufacturing sector and the results were accordingly presented to the
contemporary economists (Cobb & Douglas, 1928).
2.2.2

Properties of the production function

The production function reflects the physical relationship between inputs and outputs,
which can be mathematically defined as

y  f  x   max  y |  y, x   T 

The production function has the following properties.
Firstly, there is no “free-lunch”, that is f (0)  0 . Secondly, the production function is
monotonic. As is well-known with respect to a (single output) production function,
monotonicity requires positive marginal products with respect to all inputs, that is
If x  x, then f  x   f  x 

Thirdly, the production function is quasi-concave. Notably, the monotonicity and quasiconcavity property of the production function cannot be imposed globally.
Finally, for non-negative and finite x, f ( x) is, finite, continuous, non-negative and
single-valued

In brief, a number of different functional forms are used in the literature to model
production functions, of which the most popular ones are the Cobb-Douglas function
and the Translog function. The Cobb-Douglas is linear in logs, easy to estimate and
interpret and based on the assumption of constant proportionate return to scale. In the
Cobb-Douglas production function, the elasticity of substitution between capital and
labor is fixed to unity, which is one percent for one percent. With reference to the
Translog function, which is a generalization of the Cobb-Douglas function, this flexible
functional form provides a second order approximation. With fewer restrictions on
production elasticities and substitution elasticities compared with the Cobb-Douglas
function, the Translog function is more commonly used.

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2.3

Empirical literature

The last decade has witnessed a vast majority of empirical studies employing the
production function of some forms to address the institution-growth issue across

countries. In particular, the production function is mostly applied under the so-called
“extended production function” specification that “combines institutional proxies with
traditional growth factors” (Glaeser, La Porta, Lopez-de-Silanes & Shleifer, 2004).
There is also a wide range of other “extended production function” specification in
which other growth determinants say, trade openness, geography, macroeconomic
policy, to list some, are further included as explanatory variables in modeling the
institutional effects on economic performance (Jacob & Osang, 2007). In addition to
independent variables, other source of heterogeneities among model specifications
arises from the choice of dependent ones, which may be grouped into two broad
categories: output-level related variables and output-growth related ones. According to
Eicher and Leukert (2006), empirical evidences of output levels show more robust
effects than those of output growth. In the same line of investigation, main findings
report that the choice of institutional proxies as well as the (non)treatment of its
potential endogeneity is also a primary source of heterogeneity. Particularly,
institutional factors have been proxied mainly by standardized aggregated indices
and/or survey-based indicators constructed at national level. According to Aidis, Estrin
and Mickiewicz (2009) and Shirley (2008), the multi-dimensionality together with the
disparity among institutional proxies, to a certain extent, poses skepticism on the
validity of an ideal variable highly representative of the concept of institution. In
general, empirical institutional research is characterized by such substantial
heterogeneities that it would be challenging to infer a representative empirical impact
magnitude for the whole literature (Efendic, Pugh & Adnett, 2011).

Dias and Tebaldi (2012) address the importance of interactions between institutions and
human capital accumulation for economic growth process. The paper employs panel
OLS and GMM dynamic panel estimation technique for the sample of 61 countries
over the 1965- 2005 interval. Regarding institution variables, democracy and autocracy
are used as proxies for political institution while share of educated labor in the
economy represents structural institution. These institutional variables enter the formal
growth model together with the human capital variable generated based on Hall and

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