Institutional Arrangements, Property Rights, and the Endogenity of Comparative Advantage

• Author: Nita Ghei
• Position: Cato Institute, Washington D.C.
• Pages: 04

Cato Institute, Washington D.C. A significant part of the work on this article was completed when I was a Visiting Assistant Professor at George Mason University School of Law, and the support I received is gratefully acknowledged. I would like to thank Lloyd Cohen, Peter Van Doren, Dan Griswold, D. Bruce Johnsen, Bruce Kobayashi, Michelle Boardman, Tom Hazlett, Oliver Goodenough, participants at the Levy Workshop at George Mason University School of Law, and participants at a faculty workshop at the Vermont Law School for helpful comments. All opinions expressed are mine, and are not to be attributed to either the Cato Institute or George Mason University. Any remaining errors are solely my responsibility.

To produce the wine in Portugal, might require only the labour of 80 men for one year, and to produce the cloth in the same country, might require the labour of 90 men for the same time. It would therefore be advantageous for her to export wine in exchange for cloth. This exchange might even take place, notwithstanding that the commodity imported by Portugal could be produced there with less labour than in England. Though she could make the cloth with the labour of 90 men, she would import it from a country where it required the labour of 100 men to produce it, because it would be advantageous to her rather to employ her capital in the production of wine, for which she would obtain more cloth from England, than she could produce by diverting a portion of her capital from the cultivation of vines to the manufacture of cloth.¹

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I Introduction

It is practically axiomatic for economists to describe comparative advantage as the basis of international trade. Gains from international trade arise from the difference between the opportunity costs of production for different countries. In Ricardos wine production example, the opportunity cost of wine production, in terms of cloth production forgone, is lower in Portugal than in England. Thus, it "would be advantageous" for Portugal to import cloth from England and export wine to England, even if Portugal has an absolute advantage in the production of both goods.²

In Ricardos simple one-factor model, there is little, if any, exploration of the source of comparative advantage. The Ricardian comparative advantage model explains the gains from trade that accrue to nations, and consequently, why freeing trade can be beneficial. It does not explain what determines comparative advantage. That is, it does not explain why Portugal has a comparative advantage over England in the production of wine. The simple two-goods/one-factor model does not explain the pattern of trade-why countries export and import the goods that they do. The Heckscher-ohlin model, or factor proportions model, addresses that question; this model has remained the general equilibrium mainstay in the area, despite a lack of empirical support. ³

One distinguishing feature of the literature based on the Heckscher-Ohlin model is a focus on treating factor endowments, and therefore comparative advantage, as exogenous. ⁴ Some of the literature briefly acknowledges that differences in institutional arrangements can influence factor productivity, but fails to explore the issue any further.⁵ There is some Page 619 empirical work that suggests property rights regimes and political and economic liberty can have significant effects on investment and growth. ⁶ This Article argues that institutional arrangements and security of property rights can have an impact not just on investment and growth, but on comparative advantage and the pattern of trade as well.

Section I considers the empirical evidence on the relationship between property rights regimes and investment. This section also briefly examines some of the empirical literature from the "new" growth theory. section II considers the implications of the factor proportions model for patterns of production and factor endowments and examines the model's poor empirical performance. section III examines recent work suggesting that all exports are not necessarily the same in terms of their impacts on economic growth. Section IV examines how institutional arrangements can vitiate or enhance comparative advantage. This Section presents two case studies, as well as one shorter illustration, that examine the link between institutional arrangements and trade patterns. This Section first analyzes a case that looks to real property rights. Specifically, the case discusses how changing property rights affected the evolution of the wheat trade in Russia/U.S.S.R., from the emancipation of the serfs in 1861 through collectivization in the Soviet Era, to the changes in post-Soviet Russia, and how institutional arrangements can overwhelm "natural" comparative advantage. The second case study examines patents, intellectual property rights created by statute, and the way in which governments can and do influence the evolution of comparative advantage in goods that use intellectual property rights intensively. The case study focuses on the pharmaceutical industry and examines the impact of institutional arrangements-particularly intellectual property rights regimes-in the European Union and the United States. The Section's short illustration addresses how macroeconomic institutional arrangements can impact "natural" comparative advantage, as Cote d'Ivoire discovered with its fixed exchange rate regime. The final section examines the policy implications of these findings, particularly for the allocation of scarce institutional capital in developing countries.

II Growth, Investment, and Property Rights

The long-recognized relationship between security of property rights, on one hand, and investment and growth, on the other, can shed some light on the relationship between property rights regimes and trade. There are three major theoretical arguments for a positive relationship between security of property rights and investment, all with some empirical support. Page 620

The first argument is a security argument, originally articulated by Harold Demsetz.⁷ The main premise of the security argument is that when property rights are not secure, there is a non-zero, positive probability of expropriation. ⁸ This positive probability of expropriation acts as a random tax on the property and reduces the expected return on any investment that enhances the value of the property, thus acting as a disincentive to invest.⁹The second argument is collateral-based and holds that property can function as collateral in obtaining credit. ¹⁰ The more secure the property right, the easier and less costly it is for a property-holder to obtain credit using the property as collateral. Cheaper credit, in turn, encourages investment.¹¹ The third argument rests on the basis of gains from trade.¹² Better-defined and more secure property rights will expand the set of trading opportunities and permit easier transfer of land to higher-valued uses.¹³ This, in turn, improves investment incentives.¹⁴

Empirical work in this area tests these hypotheses largely in the context of either land or natural resources. Timothy Besley analyzes property rights data from two separate regions in Ghana.¹⁵ The results, based on data from Ghana, should be interpreted with caution because Ghana's legal and economic systems are in the midst of evolving from a subsistence economy to an exchange economy.¹⁶ Specifically, Ghana's system of property rights is gradually changing, from a system based in communal rights to land to a system based on individualistic rights.¹⁷ Besley's results suggest that, in the case of Ghana, at least, investment and property rights evolve symbiotically. Page 621 Thus, some endogenity exists in the process. The very act of investing in a piece of land reinforces the property rights.¹⁸ This feature of the traditional system of property rights is still extant; seeing it reflected in the data is not surprising.

Besley analyzes data from two regions: Wassa, which is primarily a cocoa-producing area, and Anloga, where shallots are the primary crop and agriculture is not the primary source of income.¹⁹ One striking feature of Besley's results is that property rights are more robust for the region where the investment is longer-term. Cocoa trees require several years to come to maturity, unlike shallots. This delayed maturity makes cocoa trees a longer term investment than shallots; and as a result, security of property rights should matter more in Wassa. The econometric results for Wassa are, in fact, more robust than for Anloga.²⁰

Lee Alston, Gary Libecap, and Robert Schneider found results that were consistent with this in their study of property rights of land in Brazil.²¹ Using census and micro-level data, Alston et al. studied the relationship between the value of land and investment in specific property and the security of property rights in the form of title. ²² The data supported the hypothesis that title encouraged farm-specific investment. ²³ Thus, secure title contributed positively to the value of the land. Further, the expected change in the value from having title appears to increase with the incidence of...