This piece examines the relation between economic development and the quality of the institutional framework. While the empirical literature often finds a positive impact of good institutions, the direction of causality is controversial and only few theoretical ideas have been development to improve institutional quality.
The model introduced in this work creates a two-way relation between economic activity (measured as capital density) and institutional quality. But this relation is not necessarily steady. There may be situations where better institutions actually reduce the domestic return to capital. This removes the incentive to improve institutions as well as to invest a poverty or development trap emerges. Poverty traps appear to explain quite well the disappointing economic development in some of the poorest countries.
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