Most economists concur that four factors—human resources, physical capital, natural resources, and technology—have an impact on economic development and growth. Governments in highly developed nations prioritize these issues. Even nations with abundant natural resources that are less developed will fall behind if they do not advance technological innovation and raise the level of education and competence of their workforce.
It is difficult to assess the role of political institutions in economic performance. Long-standing, deep-seated political and social difficulties have shaped today’s national institutions and economies. Similar political institutions in two distinct countries can have differing effects on their respective economies.
At the same time, institutions in two separate countries that differ politically might lead to identical economic performance. What can explain these disparate and conflicting results? What impact do political institutions have on economic performance?
The Impact of Human Resources
The skills, education, and training of the labor force have a direct effect on the growth of an economy. A skilled, well-trained workforce is more productive and will produce a high-quality output that adds efficiency to an economy. A shortage of skilled labor can be a deterrent to economic growth. An under-utilized, illiterate, and unskilled workforce will become a drag on an economy and may possibly lead to higher unemployment.
Investment in Physical Capital
Improvements and increased investment in physical capital – such as roadways, machinery, and factories – will reduce the cost and increase the efficiency of economic output. Factories and equipment that are modern and well-maintained are more productive than physical labor. Higher productivity leads to increased output.
Labor becomes more productive as the ratio of capital expenditures per worker increases. An improvement in labor productivity increases the growth rate of the economy.
Quantity and Availability of Natural Resources
The quantity and availability of natural resources affect the rate of economic growth. The discovery of more natural resources, such as oil or mineral deposits, will give a boost to the economy by increasing a country’s production capacity.
The effectiveness of a country at utilizing and exploiting its natural resources is a function of the skills of the labor force, the type of technology, and the availability of capital. Skilled and educated workers are able to use this natural resource to spur the growth of the economy.
Improvements in Technology
Improvements in technology have a high impact on economic growth. As the scientific community makes more discoveries, managers find ways to apply these innovations as more sophisticated production techniques. The application of better technology means the same amount of labor will be more productive, and economic growth will advance at a lower cost.
Countries that recognize the importance of the four factors that affect economic growth will have higher growth rates and improved standards of living for their people. Technological innovation and more education for workers will improve economic output which lead to a better living environment for everyone. Increases in labor productivity are much easier to achieve when investments are made in better equipment that requires less physical work from the labor force.
How do Economic Institutions Affect Economic Growth?
It has been already demonstrated that economic institutions (such as property rights, regulatory institutions, institutions for macroeconomic stabilization, institutions for social insurance, institutions for conflict management, etc.) are the major source of economic growth across countries.
Among other things, economic institutions have a decisive influence on investments in physical and human capital, technology, and industrial production. It is also well-understood that in addition to having a critical role in economic growth, economic institutions are also important for resource distribution.
As a consequence, some groups or individuals will be able to gain more benefits than others given the set of preexisting economic conditions and resource allocation. In other words, economic institutions are endogenous and reflect a continuous conflict of interests among various groups and individuals over the choice of economic institutions and the distribution of resources.
The prevailing institutional design of economic institutions thus depends mostly on the allocation of political power among elite groups. Political institutions, formal and informal, determine both the constraints and incentives faced by key players in a given society.
Given the endogenous feature of political institutions and the strategic allocation of powers they provide, appropriately chosen institutions can help the development of credible mechanisms capable of decreasing risks of opportunistic behavior of political and economic players. In other words, political institutions have to provide incentives for politicians to abide by them repeatedly over time.
What form or combination of political institutions is required to enhance economic growth? Do political institutions affect economic performance regardless of any preconditions or stages of economic development? In other words, does a new democracy tend to perform as well as a consolidated, or well-established, democracy if their political institutions run similarly?
To assess the importance of political institutions on economic growth Pereira and Teles developed an econometric model (a system GMM estimator with autoregressive distributed lags) using yearly data in a large sample of 109 countries covering a maximum time span from 1975 to 2004. The key dependent variable is GDP per capita.
We took into account several political institutions as explanatory variables such as electoral rules (plurality rule vs. proportional representation—open and closed lists—and district magnitude); a form of government (parliamentary vs. presidential systems); political regime (dictatorship vs. democracy measured in terms of years under democracy); government fractionalization; the size of the executive’s political party or coalition in Congress (number of seats held by the executive’s party or coalition); federalism and robustness of federal structure (the degree to which states/provinces have authority over taxing, spending or regulating); and years that the same elite group is in office or government durability.
Controlling for other economic variables, our main findings indicate that political institutions fundamentally matter only for incipient democracies, and not for consolidated democracies. Political institutions demonstrate that consolidated democracies and political institutions are substitutes for determining economic growth. Consolidated democracies have already internalized the effect of political institutions.
New democracies, on the other hand, need the effective and ostensive presence of political institutions. As a consequence, their impact on economic performance is more visible and necessary. The consolidation of democracy, therefore, downplays the importance of political institutions in relation to economic performance: once democracy is consolidated, and favorable institutional conditions for investments are provided, the importance of the political variable loses intensity.
The econometric results also suggest that the adoption of a democratic regime positively affects economic growth once it is controlled by the variables that measure political institutions. As expected, in rich countries, the effects of political institutions on growth are small or negligible as opposed to poor countries.
These findings support the results for “old democracies” since there is a strong correlation between income and democracy. Przeworski (1999) shows that “the expected life of democracy in a country with per capita income under $1,000 is about eight years. Between $1,001 and $2,000, an average democracy can expect to endure 18 years. But above $6,000, democracy lasts forever.”
On the other hand, political institutions are extremely important for economic growth in low-income countries. Specifically, the longer the same elite is in power, the more fragmented the party system is; the greater the number of parties in the governing coalition, and the more party-centered the electoral system is, the smaller economic growth will be for low-income countries. On the other hand, the greater the district magnitude and the more pluralitarian the electoral system is, political polarization and federalism help poor countries to achieve better economic performance.
In addition, the results show that the effects of political institutional variables are different for autocracies and democracies. In democratic regimes, the longer political power is held by a particular political leader, the greater economic growth will be; however, when dealing with autocracies such effect is reversed. Political polarization also has an opposing effect under democratic and authoritarian regimes. While this variable does not help authoritarian governments achieve good economic performance, it does provide a positive impact on democratic governments.
Given that political institution variables often suggest a certain degree of political rights, the results suggest that even autocratic regimes can have a satisfactory economic performance as long as some political rights are granted to society. It also might suggest that political institutions work as a substitute for democracy in authoritarian regimes, generating economic growth.
In other words, autocracies can differentiate from one another in terms of political institutions. That corroborates the claim of Przeworski et al. (2000), who have not found considerable differences between economic growth as a function of political regimes, either in democracies or autocracies.
Therefore, this preliminary investigation suggests that instead of just considering the different types of regimes as a single “package” (democracy versus authoritarianism), it is imperative to determine which type of democracy and/or autocracy is considered within the analysis controlling for its respective specific political institutions.
As suggested by Acemoglu, to understand how different political institutions affect economic decisions and economic growth, we will need to go beyond the distinction between democracy and non-democracy. Although the adoption of a democratic regime is not sufficient to achieve greater economic growth, democracy with good institutions might be.
Why is the Economic System Important?
An economic system is a regulatory structure that governs several components of production and distribution, such as capital, labour, land, and other physical resources. There are numerous crucial entities, agencies, and decision-making powers in an economic system. Furthermore, economic systems often follow patterns of use and consumption that form the foundation of society and communities.
There are five distinct types of economic systems, including the following:
1. Traditional economic system
In a traditional economic system, each member of a community or society has a specific role that contributes to the whole progress of the community. Traditional economic systems represent the oldest model, where societies are more physically connected and socially satisfied through labor, farming and other simple processes. While traditional economic systems can have several benefits, their antiquated model can also present several potential drawbacks.
Some advantages include:
- Rarely any surplus in goods or resources
- Community members are generally more satisfied in social roles
- Absence of total economic hierarchy results in a lack of economic competition
Some potential drawbacks include:
- Antiquated methods of distribution
- Lack of growth and technology development
- Reliance on localized resources and services inhibits globalization
- Less focus on industrialized production and more focus on agricultural processes
2. Command economic system
In command economic systems, governments and centralized powers control much of the economic processes, including allocating and distributing resources, goods and services. In a command economy, the government plays a key role in directing and intervening in business processes that provide essential goods and services to the community. Many command economies consist of governments that have total control over the distribution and use of valuable resources, like oil and gas.
Additionally, these types of systems may operate under governing entities that have ownership of essential industries like transportation, utilities and energy, and technology. Command economies can be beneficial for creating sustainability, however, there are a few potential drawbacks to this type of system.
Some advantages include:
- Creates potential for mass mobilization of necessary resources due to government control
- Creates additional jobs for community members and citizens due to increased mobility of resources
- Focuses on benefits to society over individual interests
- Encourages more efficient use of valuable resources
Some disadvantages could include:
- Creates scarcity due to an inability to plan for individual needs
- Forces government rationing due to the inability to calculate demand on set prices
- Eliminates market competition, resulting in a lack of innovation and advancement
- Inhibits employees’ freedom to pursue creative jobs and careers
3. Centrally planned economic system
In a centrally planned economy, the society creates and dictates economic plans to drive the production, investments and allocation of goods, services and resources.
The government only intervenes in production processes to regulate fair trade agreements and ensure compliance with international policy. Additionally, governments in a centrally planned economy take part in coordination efforts to provide public services. This type of economic system is an offshoot of the command economy, where governments still maintain a level of control over the allocation and distribution of resources.
Advantages of this system include:
- Better able to meet national and social objectives by addressing issues like environmentalism and anti-corruption
- Gives governing powers the ability to make decisions regarding the production and distribution of goods and resources when private industries cannot raise enough investment capital
- Allows input from community members on government plans for setting product prices, determining production quantity and opening up job sectors
Some disadvantages could include:
- Can create a lack of government resources to respond efficiently to shortages and surpluses
- Potential for corrupt actions within governing bodies and established powers
- Creates a potential loss of freedom for citizens wanting to start their own enterprises
- Institutes governing powers that sometimes develop into repressive political systems
4. Market economic system
In a market economic system, or a “free-market system,” communities, firms and proprietors act in self-interest to decide how to allocate and distribute resources, what to produce and who to sell to. Governments in market systems typically have little intervention in how businesses operate and generate income, however, can regulate factors like fair trade, policy development and honest business operations.
While market economic systems can benefit emerging businesses and sole proprietorships, there are some potential disadvantages to using a free-market economic system.
Advantages may include the following:
- Provides incentive for innovative entrepreneurship
- Gives consumers a choice in goods, services and purchase prices
- Creates market competition for resources, resulting in quality offerings and efficient use of resources to produce goods
- Inspires research, development and advances in goods and production of goods
Some disadvantages could be:
- Highly competitive markets can cause a scarcity in resources for disadvantaged individuals
- Potential for monopolizing of industries and niches, such as technology, health care and pharmaceuticals
- Can increase income disparity by placing focus on economic needs over societal, community and human needs