UNIVERSITY OF ECONOMICS
HO CHI MINH CITY
VIETNAM

ERASMUS UNVERSITY ROTTERDAM
INSTITUTE OF SOCIAL STUDIE
THE NETHERLANDS

VIETNAM – THE NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE IMPACT OF INSTITUTIONS ON ECONOMIC
GROWTH AND INCOME IN SOUTHEAST ASIAN
COUNTRIES

BY

PHAN CHANH PHONG

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, DECEMBER 2015


UNIVERSITY OF ECONOMICS
STUDIES
HO CHIMINH CITY
VIETNAM

INSTITUTE OF SOCIAL
THE HAGUE

THE NETHERLANDS

VIETNAM - NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE IMPACT OF INSTITUTIONS ON
ECONOMIC GROWTH AND INCOME IN
SOUTHEAST ASIAN COUNTRIES
A thesis submitted in partial fulfilment of the requirements for the degree of
MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

PHAN CHAHH PHONG

Academic Supervisor:
DR. CAO HAO THI

HO CHI MINH CITY, DECEMBER 2015


DECLARATION
I declare that: “The Impact of Institutions on Economic Growth and Income in Southeast
Asian Countries” is my own work; it has not been submitted for 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 2015
Phan Chanh Phong


i


ACKNOWLEDGEMENTS
I would like to express my deepest gratitude to my academic supervisor, Assoc. Prof. PhD.
Cao Hao Thi, for his helpful comments, guidance and regular feedbacks in this thesis.
I am also grateful to Prof. Dr. Nguyen Trong Hoai and Dr. Pham Khanh Nam for their great
advice when this thesis is just in form of ideas.
I would like to thank all lecturers for the knowledge and lessons they gave me and their
support during the time I studied at the programme.
Last but not least, my sincerest thanks are for my family, especially my mom. Without
their frequent encouragement as well as spiritual support, I would not have been able to
complete this thesis.

ii


ABSTRACT
The role of institutions has generated considerable interest among researchers and
practitioners recently, with the various result approaches and proposals. The studies often
investigate the direct impact of institutions on growth; moreover, there are few researches on
this topic in Southeast Asian area and Vietnam. This thesis investigates both direct and indirect
impact of institutions on economic growth and income in the context of Southeast Asian countries
over the period 2000-2013 by using six measures of institutional indicators, all of which are
developed by the World Bank in 2014. The model is estimated using an Ordinary Least Squares, a
Fixed Effect as well as a Random Effect estimation strategy. Estimation results show that the
direct impact of the institutions on growth is insignificant; however, the direct impact on the
income and indirect impact on growth through trade policies are high significant. In addition, the
results also show that the influence of corruption on income is stronger in low-income countries.
From that, respective policies are suggested to stimulate growth and income in Southeast Asian

countries.
Keywords: Institutions, Economic Growth, Income, OLS, Fixed Effect, Random

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Effect.


ABBREVIATIONS
AEC

Asean Economic Community

COC

Control of Corruption

FE

Fixed Effects

GE

Government Effectiveness

ICRG

International Country Risk Institutional Guide

NIE


New Institutional Economics

OLS

Ordinary Least Squares

PCI

Provincial Competitiveness Index

PSNV

Political Stability and Absence of Violence/Terrorism

RE

Random Effects

RL

Rule of Law

RQ

Regulatory Quality

VAA

Voice and Accountability


iv


CONTENTS
DECLARATION

i

ACKNOWLEDGEMENTS ................................................................................................................. ii
ABSTRACT

..................................................................................................................... iii

ABBREVIATIONS

iv

LIST OF TABLES

viii

LIST OF FIGURES

ix

Chapter 1 INTRODUCTION ............................................................................................................. 1
1.1 Problem statement ........................................................................................................................ 1
1.2 Research objectives........................................................................................................................ 3
1.3 Research questions ........................................................................................................................ 3

1.4 Contribution of the research .......................................................................................................... 3
1.5 Structure of the research ............................................................................................................... 3
Chapter 2 LITERATURE REVIEW ..................................................................................................... 4
2.1 Theoretical literature ................................................................................................................... 4
2.1.1 Definition of institutions ......................................................................................................... 4
2.1.2 Informal and formal institutions ............................................................................................. 6
2.1.3 The New Institutional Economics............................................................................................ 7
2.1.4 How do institutions influences economic ............................................................................... 8
2.1.5 Solow model............................................................................................................................ 9
2.1.6 Measuring institution ............................................................................................................ 10
2.2 Empirical review ........................................................................................................................... 11
Chapter 3 RESEARCH METHODOLOGY ......................................................................................... 15
3.1 Analytical framework ................................................................................................................... 15
3.1.1 Model of institutional impact on growth .............................................................................. 15
3.1.2 Model of institutional impact of income .............................................................................. 17
3.1.3 Model of indirect impact of institutions on economic performance.................................... 19
3.2 Data and Variables ....................................................................................................................... 19
3.2.1 Data source ........................................................................................................................... 19

v


3.2.2 Variable measurement.......................................................................................................... 19
3.3 Estimation method and model validation .................................................................................... 29
3.3.1 Heteroscedastic testing ........................................................................................................ 29
3.3.2 White Heteroscedasticity –Consistent Stand Errors or Robust Standard Errors .................. 29
3.3.3 Breusch-Pagan LM test for Random Effects.......................................................................... 29
3.3.4 Hausman test for Fixed versus Random Effects model ........................................................ 29
3.3.5 Omission of relevant variables .............................................................................................. 30
Chapter 4 ANALYSIS RESULTS ...................................................................................................... 32

4.1 Overall explanation and hypothesis testing ................................................................................. 32
4.1.1 Statistical test of model overall significance ........................................................................ 32
4.1.2 Heteroscedastic testing ........................................................................................................ 33
4.1.3 Model Testing ....................................................................................................................... 34
4.2 Impact of institutions on economic growth ................................................................................. 35
4.2.1 Voice and Accountability, Political Stability and Absence
of
Violence/Terrorism ............................................................................................................. 36
4.2.2 Government Effectiveness, Regulation Quality .................................................................... 39
4.2.3 Rule of Law, Control of Corruption ....................................................................................... 41
4.2.4 Summary results of growth ................................................................................................... 45
4.3 Impact of institutions on income ................................................................................................. 46
4.3.1 Voice and Accountability, Political Stability and Absence of Violence/Terrorism ................ 46
4.3.2 Government Effectiveness, Regulation Quality .................................................................... 50
4.3.3 Rule of Law, Control of Corruption ....................................................................................... 53
4.3.4 Summary results of income .................................................................................................. 56
Chapter 5 CONCLUSIONS ............................................................................................................. 58
5.1 Conclusions .................................................................................................................................. 58
5.2 Policy implications ........................................................................................................................ 59
5.2.1 Policies for economic growth ................................................................................................ 59
5.2.2 Policies for income ................................................................................................................ 59
5.3 Limitations and further researches .............................................................................................. 60

vi


REFERENCES

.................................................................................................................... 61


APPENDIX A

HETEROSCEDASTIC TEST ............................................................................... 65

APPENDIX B

BREUSCH-PAGAN LM TEST FOR RANDOM EFFECTS ........................................ 71

APPENDIX C

HAUSMAN TEST FOR FIXED VERSUS RANDOM EFFECTS MODEL ..................... 75

vii


LIST OF TABLES
Table 3.1 Explaining the variables in growth model ...........................................................................16
Table 3.2 Explaining the variables in income model ..........................................................................18
Table 3.3 Institutional variables from World Bank .............................................................................21
Table 3.4 Summary statistics of key variables ....................................................................................21
Table 3.5 Between and within variations of key variables .................................................................23
Table 3.6 Average of the institutional indicators of Southeast Asian countries in 2000-2013 ..........27
Table 4.1 Hypothesis testing of the overall significance of regression..............................................32
Table 4.2 Heteroscedasticity test .......................................................................................................33
Table 4.3 Breusch-Pagan LM test for Random Effects........................................................................35
Table 4.4 Hausman test for Fixed versus Random Effects model ......................................................35
Table 4.5 Impact of institutions on growth - Voice and Accountability .............................................37
Table 4.6 Impact of institutions on growth- Political Stability and Absence of Violence/Terrorism.37
Table 4.7 Impact of institutions on growth - Government Effectiveness ...........................................39
Table 4.8 Impact of institutions on growth - Regulation Quality .......................................................41

Table 4.9 Impact of institutions on growth - Rule of Law...................................................................42
Table 4.10 Impact of institutions on growth - Control of Corruption ................................................43
Table 4.11 Summary of impact of institutions on growth ..................................................................45
Table 4.12 Effect of institutions on income - Voice and Accountability .............................................48
Table 4.13 Effect of institutions on income - Political Stability and Absence of Violence/Terrorism49
Table 4.14 Effect of institutions on income - Government Effectiveness ..........................................51
Table 4.15 Effect of institutions on income - Regulation Quality .......................................................52
Table 4.16 Effect of institutions on income - Rule of Law ..................................................................54
Table 4.17 Effect of institutions on income - Control of Corruption ..................................................55
Table 4.18 Summary of impact of institutions on income..................................................................56

viii


LIST OF FIGURES
Figure 1.1 Income against years of Southeast Asian countries ............................................................2
Figure 1.2 List of the countries in ASEAN Economic Community .........................................................2
Figure 3.1 The impact mechanism of factors on economic performance ..........................................17
Figure 3.2 Income against years of Southeast Asian countries ..........................................................25
Figure 3.3 Income against years of low-income Southeast Asian countries ......................................26
Figure 3.4 Growth rate against years of Southeast Asian countries ..................................................26
Figure 3.5 Government Effectiveness against years of Southeast Asian countries............................26
Figure 3.6 Average of the institutional indicators of Southeast Asian countries in 2000-2013 .........28
Figure 3.7 Average income of Southeast Asian countries against average institution index. ............28

ix


CHAPTER 1


INTRODUCTION

1.1 Problem statement
Southeast Asian countries have common points of geography, climate and cultural traits.
Due to the geographical location situated on the maritime road connecting the Indian Ocean and
the Pacific Ocean, Southeast Asian has long been regarded as a bridge between China, Japan and
India, West Asia and the Mediterranean. However, economic growths of Southeast Asian
countries differ greatly. Singapore led the average annual income per capita which is 55,980 USD.
Meanwhile, countries such as Cambodia, Laos, and Myanmar and Vietnam have average annual
income just under 2,000 USD. Figure 1.1 shows average annual income per capita of Southeast
Asian countries in period 2000-2013. In this context, an important question was raised about the
contribution of institutions in explaining the tremendous changes in economic activities between
countries in regions of Southeast Asian. Explaining the huge difference in average incomes
between the richest countries and the poorest is one of the most fundamental problems in
economic development. To explain the difference, economists may seek guidance from three
strands of thought that are climate and natural resources, international trade, and institutions
(Rodrik and Subramanian, 2003).
Participation AEC (ASEAN Economic Community) will also be a great opportunity for
Vietnam to promote institutional reform and modernization of the economy, raising the level of
development. List of the countries in AEC is provided in Figure 1.2. However, in the coming years,
Vietnam also faces a huge pressure on institutional reform, economic restructuring, improving
science, technology, and competitiveness, in the context of ASEAN jumped from AFTA (Asia Free
Trade Area) to AEC. Currently, the level of development of Vietnam is far behind many countries
in ASEAN such as Singapore, Malaysia, and Thailand ... therefore, reform pressures pose with
Vietnam is huge. This context raises the question whether the urgent institutional improvements
have actually led to the better economic performance in Vietnam.
Although the question of the effect of regulation on economic growth seems to be the
most appropriate in a context where there are significant weaknesses in the institutional setting
(i.e. the developing economies), we focus on Southeast Asian countries that also differ markedly
in quality of institutions.

When concepts of institutions are different for different scholars and vary from study to
study (Nelson & Sampat, 2001), the foremost requirement is how to measure such a
multidimensional concept. In fact, no single variable can capture the multidimensional aspects of
the institutional structure of a country; as a result, there are many potential methods of studying
the impact of the institutions. Our research will change the Solow growth model to check the
quality of the institution’s framework plays a prominent role in explaining differences in growth
rate and income in these countries. We use measures of institutional quality that were drawn
from the governance indicators developed by the World Bank, on a scale from -2.5 (worst) to 2.5
(best). Our analysis covers the period 2000-2013 for the Southeast Asian countries, and we
estimate our models using OLS, Fixed Effects and Random Effects.

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60.000
Brunei Darussalam

50.000

Indonesia

40.000

Lao P.D.R.
30.000

Malaysia

Myanmar


20.000

Philippines
Singapore

10.000

Thailand
0

2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014

GDP Percapita USD)

Cambodia


Timor-Leste
Vietnam

Years

Figure 1.1 Income against years of Southeast Asian countries

Figure 1.2 List of the countries in ASEAN Economic Community

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1.2 Research objectives
The main objective of this research is to consider the impact of institutions on economic
growth and income of Southeast Asian countries in period 2000-2013.
In an attempt to explain the impact of institutions on economic, the research explores the
contribution of six institutional indicators, which are developed by the World Bank, including
Voice and Accountability, Political Stability and Absence of Violence/Terrorism, Government
Effectiveness, Rule of Law, Regulatory Quality and Control of Corruption.
The research also recommends policies to improve the impact of institutions on economic
performance.
1.3 Research questions
This research is expected to answer these questions:
-

Do institutions impact directly on economic growth?
Do institutions impact indirectly on economic growth through export trade?
Do institutions impact directly on income per capita?
Do institutions impact indirectly on income per capita through export trade?


1.4 Contribution of the research
Currently, there are few researches in Vietnam and Southeast Asian area. Some
researches consider Provincial Competitiveness Index (PCI) as a proxy for institutions to assess the
impact of institutions on economic development of the provinces, therefore not assess the impact
of institutions on a whole country. Moreover, researches often investigate the direct effect; this
research will assess the direct and indirect impact of the institutions on economic growth and
income in Southeast Asian Countries from 2000 to 2013.

1.5 Structure of the research
This research consists of five chapters as followings:
Chapter 1, which is about the importance, the reason of conducting the research, is
clearly presented as above.
Chapter 2 presents the concept of different institutions, institutional classifications,
institutional impact on the economy, how to measure institutional variables, and reviews the
empirical researches of the relationship between the institutions and economic performance.
Chapter 3 describes the data, the statistical characteristics of the data, research
methodology and empirical models for considering the effects of the institutions on economic.
Chapter 4 reports and considers the results of regression the economic performance on
institutional indicators.
Final chapter gives the conclusions, policy implications, limitations and further research.

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CHAPTER 2

LITERATURE REVIEW

This chapter presents the concept of different institutions, institutional classifications,
institutional impact on the economy and how to measure institutional variables. In addition,

present the Solow model which is widely used to examine the factors that effect on economic
performance. Finally, the chapter reviews the research results on the impact of the quality of
institutions on economics issued, along with analysis and evaluation.
2.1

Theoretical literature

2.1.1 Definition of institutions
Until now, Adam Smith has been usually remembered as the founder of neoclassical
economics with “invisible hand” theory (Smith, 1976). This theory confirms the significance of
exchange and trading in the market, in which he pointed out that economic growth depends on
“the rules” or institutional constraints of production relation, business in society. However, until
1914, the first definition of institution has been issued by Veblen. Accordingly, institution is the
standard of behavior or regulation that determines behavior in specific situations and be accepted
and complied by members of social group. Basically, compliance with this regulation is controlled
by itself or by external power.
After Veblen, many new definitions of institution have been issued by economists.
Example, Schmid (1972) gave that institution is a collection of relations between people. These
relations determine right and responsibility of one person in correspond with other‘s right, and
determine right and responsibility in general. Similarly, North (1990) gave that institution is “the
social rule,” or limitations in capacity and knowledge of human, establish the relationship
between people. Therefore, they create stimulation in polity, society and economy. Institution
includes informal constraints (something be accepted or forbidden according to customs, habits,
traditions and morals) and formal regulation (law, or other regulations…) and mechanisms
ensuring their effective enforcement. According to North, the main role of institution in a society
is to reduce uncertainty by creating a solid structure for interaction of persons. Institutions are
created, developed and revised by human. So, theories of institution have to begin from
individuals. According to Nugent and Lin (1995), institution is a system of rules created by human
to manage and shape interaction of human, thereby helping them to form the expectation about
what others would do.

Obviously, though there are differences between these descriptions, but the concepts
mentioned above are unified in considering that institution is a set of rules or norms of human
behavior, effective regulation of relations between human beings.
In 2000, Sokoloff gave a more extended definition of institution. He said that institution is
a political and law framework, creating legal principles and basic rules for activities of individuals
and companies. The voluntary organization or collaboration among entities that affect the nature
and organization of the exchange: cultural values and beliefs effect on economic behavior through
their impact on the willingness to participate and adhere to the principles of market and to
content of goods and services. Thus, in this definition, specific connotation of the rule is a

4


somewhat better format: the institutional actors are not only “human”, but also organizations,
the human collective.
In the report of the World Bank in 2003, a concept of institution is introduced as “the
rules and organizations, including informal norms associated with human behavior”. The informal
norms system includes beliefs and social values (also oldest norms governing social behavior), the
mechanisms and informal coordination network. Meanwhile, formal institutional system includes
law, other legal documents, procedures as well as the subjects responsible for building, modifying,
enforcement the laws and regulations. Because institution controls human behavior, so that if it
works well, it will allow persons to work together efficiently, cooperate in planning for yourself,
family, and community in general. Conversely, if it works ineffective, it will cause distrust and
instability in many fields.
Although there are certain differences, but generally, the definitions of institution until
now are unified in some important factors. Specifically, the concepts gave that institution include
the following:
-

The set of rules, or the "rules of the game" (law, the rules of society, the rules of a

community ...);
The actors "play" or "players" (state authorities, social organizations, nongovernmental organizations, businesses, communities, ...);
Mechanisms to enforce the rules, or is the "how to play" (policies, support
mechanisms ...).

In reality, economic development has shown that successful economies have very
different institutions, and the development levels of countries with similar institutions are also
highly diverse. For example, most developed countries have already reached the productivity and
general welfare (such as the UK, France, Germany, Japan and the US), but hard to say that these
countries have similar institutions, review all aspects of the history and the present.
When talking about the institutional system as a whole, some of the following
characteristics often had been the researchers note:
First, the institutional system can fairly be divided into two categories: institutional
environment and institutional management. Institutional environment determines the
institutional constraints on management. Institutional environment focused on the overall level of
activities while the institutional management related to the interactions and individual
transactions.
Secondly, it is necessary to distinguish the institutional environment (including rules,
general social norms) with the separate organizational form (the sort of organization) as an entity
in the institutional environment. Although organizations can also be viewed as a set of rules,
these rules are primarily for internal application. Organizations were created for individual groups
with the functional purpose. Organizations can be classified into: political organizations (political
parties, parliaments, city councils, the executing agency ...); economy organizations (companies,
cooperatives, family farms ...); social organizations (associations, clubs, churches ...). Although
these organizations are separate entities, they are bound together by some common purpose to
achieve certain goals. Creation of a model for the organization (organization will launch and

5



operate like) basically is influenced by the institutional framework. In turn, these organizations
will again affect the evolution of the institutional framework. Thus, there is a relationship
between institutional environments and organizations. The organization was created by a
deliberate series of opportunities arising from the current limit (there are institutional limitations
and media limitations of economy theory). In the process of implementing its goals, the
organization is the major factor leading to institutional changes.
Third, state institutions and non-state institutions are the two types of institutions most
discussed now. Along with the legal provisions, apparatus and tools implemented by the
legislature, execution and judiciary, state institutions have the most profound impact on
economic and social change. However, non-state institutions are diverse and growing in
importance. What is noteworthy here is that the state does not merely set out the rules (laws and
legal - which is an integral part of the institutional environment of a country) and enforce the
rules that all other organizations must comply, but the state, as an institution, must also comply
with these rules. Every day, the state agencies invest resources, allocate of credit, purchase goods
and negotiate contracts… these actions have a huge influence on the transaction costs, the
activities and economy results. Clearly, the state simultaneously performs two functions: (i) held
the main role in creating the institutional framework and (ii) execute those institutions.
Fourth, laws, rules can be enforced under the influence of stakeholders within or under
the influence of external third parties. The action mechanism of external third party (such as the
court system or arbitration) plays a very important role in the development of links between
actors in the market. Enforcement mechanisms facilitate market participation groups to access to
market opportunities.

2.1.2 Informal and formal institutions
The institutions are usually divided into two categories as formal institutions and informal
institutions.
Informal institutions often operate outside the formal legal system, reflecting the
unspoken code of social behavior (such as customs, traditions, and norms of social conduct). The
informal institution is not illegal institution. They have an important role in the development of
the country and should be supported to become official institutions (with registration). Rodrik

(2008) criticized neoclassical economics for undervaluing the informal institutions.
Formal institutions include regulations and laws of the government and rules of private
organizations operating under the public law. Helmke and Levitsky (2004) gave that “formal
institutions are openly codified, in the sense that they are established and communicated through
channels that are widely accepted as official”.
While the formal institutional characteristics and its enforcement can partly be measured
and evaluated, then informal institutions dependent on the researcher's perception.
The importance of formal and informal institutions is seemingly different around the
world. The informal institutions are more important in developing countries, where the formal
institutions are underdeveloped.

6


Ideally, these formal and informal institutions must complement each other. Together,
they can reduce transactions costs than either could alone. For example, the Court formally
prevents disputes and facilitates informal settlement simply by providing the threat of
enforcement.
2.1.3 The New Institutional Economics
Because there are different aspects of institutions that have been concerned, researched
by economists, so the institution economics has been formed. The institution economics includes
two main fields: Old Institutional Economics and New Institutional Economics (NIE).
Old Institutional Economics focuses on researching on a role of law, ownership, the
formation and impact of organization on the economic power, the economy transaction,
and the allocation of income. According to opinion of old institutional economics,
institution is formal or informal process to solve conflicts and contradictions.
- New Institutional Economics focuses on researching on human behavior associated with
ownership theory, transaction costs and information asymmetries. According to opinion
of New Institutional Economics, institution is a tool to reduce chance costs and
information costs. This tool is set of rule, law that is formed in formal or informal types.

Although these economics fields have two different research perspectives, but basically,
there is no opposition when considering nature of the institutional concept.
-

From a theoretical point, the researches of institutions in NIE are divided into three
categories of theory approaches: the Historical Perspective Approach, the Comparative
Institutional Approach and the Theory of Imperfect Information.
The Historical Perspective Approach proposed by North (1990) to the study of institutions
represents an attempt to construct an analytical framework that integrates institutional analysis
into economics and economic history in order to explain the factors that account for the different
patterns of economic performance experienced by diverse societies. Previous research on this
issue has been carried out, among others, by Alchian (1950) with his evolutionary hypothesis, and
North and Thomas (1973) that have offered an efficient explanation later confuted by North
(1981) himself. Since much of the developmental path of societies is conditioned by their past,
institutions are historically specific. For this reason, it is necessary to be sensitive to the historical
context, especially when dealing with the issue of institutional change (Alston, 1996).
The comparative institutional approach has recently been developed to investigate issues
regarding institutions and institutional change. Of particular relevance are questions related to
the emergence of particular types of institutions and their impact on the diverse spheres that
contribute to build up a society (Greif, 1998b). In this analytical framework, institutions are
conceptualized as the endogenously emerging equilibrium outcome of a game; thus, the
prominent interest is in investigating how the rules of the game are generated and become selfenforcing through the strategic interaction of the agents, whose behavior is in turn influenced by
the self-enforcing constraints determined within the existing set of rules. Therefore, institutions
are regarded as non-technological constraints that guide social interaction and provide incentives
to maintain certain regularities of behavior (Greif, 1998b).

7


Besides the historical and comparative approaches, another influential recent strand of

new institutional economics is the one associated with the theory of imperfect information. In this
line of study the underlying rational of institutional arrangements and contracts (formal or
informal) are explained in terms of strategic behavior under asymmetric information among the
different parties involved (Bardhan, 2000). More in detail, this conceptual framework stresses
that due to information and enforcement costs some markets will not exist and other markets will
be largely uncompetitive, so that, in this context, institutions have at least two major roles: firstly,
they are a response to missing markets; secondly, they may help to overcome the information
problems that preclude complete markets (Arnott and Stiglitz, 1991; Hoff et al, 1993).
The basic difference of three approaches lies in analysis tools to perform studies. While
the Historical Perspective Approach efforts to integrate economic theory and economic history in,
the Comparative Institutional Approach uses of game theory and history information, the
Imperfect Information Theory is most mathematically – oriented (Nabli & Nugent, 1989).
2.1.4 How do institutions influences economic
Institutional factors have a direct impact on growth, called direct influence channel. Also
through interaction with the standard production factors, they can also indirectly influence on
growth by replacing the marginal effect of these factors, called the indirect influence channel.
Among the institutional determinations significantly influencing economic performance are a
property right, contract enforcement, a transaction cost, democracy, and corruption.
Romer (1990) demonstrated that knowledge is not a commodity because patents allocate
monopoly power to innovators. Therefore, patents serve as tools of knowledge creation; they
provide the appropriate incentives for those engaged in R & D to make the investment that will
eventually lead to the creation of knowledge. This process heavily depends on the quality of the
institutions. Institutions provide security of property ownership right and lead to tremendous
support for the process of registration of copyrights, ideas, creative activities of individuals. In this
case, good institutions promote innovation of the economy (Tebdaldi & Elmslie, 2008), thus
promote economic growth.
References to contract enforcement, institutions stimulate rules and laws to prevent
market failures and agency issues. Institutions impact operational efficiency and reduce the risk of
anti-competitive behavior and rent-seeking by corporate actors. Only with proper institutions,
operational issues are resolved and selective scope of rent-seeking is minimal.

Other sources of institutional advantages contribute to economic growth is associated
transaction cost. In this case the institution in conjunction with other production factors, to
determine the structure of exchange that influence the cost of production and distribution, they
influence the feasibility and profitability of economic activities. Through this mechanism,
institutions are considered "underlying determinant of long-run Economic performance" (North,
1990).
North (1990) studied the economic reality of democracy, has come to the conclusion that
democratic institutions play an important role in maintaining good government, limiting
corruption, promoting effective economic development and ensuring economic environment
more freely. The 2002 U.N. Human Development Report considers democracy as an important
8


feature of good governance. It reports, “For politics and political institutions to promote human
development and safeguard the freedom and dignity of all people, democracy must widen and
deepen” (UNDP 2002). So far, there have been different ways to recognize the role of institutions
for development, such as recognize the role of each institutional type for development
(administrative institutions, political institutions, economic institutions ...) or recognize the role of
each field of development (economic growth, social stability ...).
Although some authors suggest that the specific type of corruption impacts positively on
economic development (Nye, 1967; Khan, 1996), most studies show the negative consequences of
corruption (Mauro, 1995; Akỗay, 2006; Gupta et al., 2002). The mechanism here is that a
corruption acts as illegal taxes distort decision-making and economic processes. Akỗay (2006, p.
33) reviewed the impact of corruption on human development and found that "corruption may
indirectly affect the development of the people by lowering economic growth and incentives to
invest.” Moreover, as Rose-Ackerman (1996) has argued that corruption also tends to distort the
distribution of economic benefits and contribute to inequality in wealth. Therefore, corruption
often impacts negatively on human development because it decreases economic growth and
redirects money from social services.
The 2000 United Nations Millennium Declaration gave that good governance is a

requirement for countries to promote economic development and poverty reduction.
Report of the World Bank in 2002 confirmed how institutions support market and affects
the lives of people by affecting economic growth and how people participate in markets. Further
over, if institutions weakly support market, they would hurt poor people disproportionately.
However, critics have argued that the effects of institutions have been exaggerated.
In the indirect influence channel, there is some evidence that the institutions concern
with policy variables, especially trade policy. Aghion et al. (2005) showed impact of policies
depends on a country's distance from the technological frontier. Because the institution is
considered a determinant of the technological position of a country (Parente and Prescott, 2000),
meaning that the institutions could alter the marginal effect of policies on economic growth.
Minier (2007) showed the institutions do affect the relationship between trade openess and
growth. Therefore, in this research, in addition to direct effects, we analyze indirect effects of
institutions on economic growth and income through a trade policy, namely export trade.
2.1.5 Solow model
In recent years, there are a growing number of experimental projects on cross-countries
growth and convergence. In the theory and empirical growth literature, the Solow model (Solow,
1956) is summarized as the foundation of the exogenous growth model fundamentally. Since, this
research would use the Solow model to investigate impact of institutions on growth and income.
Considering a set of assumptions, the Solow model asserts that long run growth rate is
determined exogenously. More obviously, the economy converges to a steady state level of
growth, which primarily depends on the rate of technological progress and labor force growth.
The production function in Cobb-Douglas framework at time t is given by:

Y (t )  K (t ) ( A(t ) L(t ))1
9

0   1

(2.1)



K is capital and L is labor.
A is noted as the level of technology.
α is capital share.
L is assumed to grow at an exogenous population growth rate (n) and A is assumed to
grow at g which implies advancement of knowledge. Also it holds,

L(t )  L(0)e nt

(2.2)

A(t )  A(0)e gt

(2.3)

Defining y=Y/AL and  = K/AL. The transformation of  takes the following form:

 (t )  sy(t )  (n  g   ) (t )

(2.4)

 s (t )  (n  g   ) (t )
Where:
s is a portion of output that is saved and reinvested.
δ is the rate of depreciation.
Equation (2.4) clearly converges to steady state level  *

s *  (n  g   ) *

(2.5)

1


 (1 )
s
 

 (n  g   ) 
*

(2.6)

Substituting equation (2.6) into (2.1) and solving for the equation, we have:

 Y (t ) 


ln 
 ln A(0)  g (t ) 
ln( s) 
ln( n  g   )

1
1
 L(t ) 

(2.7)

At steady state level, income per capita depends on the initial technology A(0), technical
advancement g, rate of savings s, rate of working-age population growth n, depreciation rate δ

and capital share α. This research would use the equation (2.7) to consider impact of institution
on income.
2.1.6 Measuring institution
Here we discuss three main measures that are used commonly.
The first set, initially used by Knack and Keefer (1995), Hall and Jones (1999), and more
recently by Acemoglu et al. (2001), as indicators of the quality survey from the International
Country Risk Institutional Guide (ICRG), collected in 1980 and 1990. The data include subjective
assessment of risks for international investments of the same size as the law and order, the

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quality of government, corruption, the risk of rejection of government contracts and
expropriation. From 1982 to 1997, the risk of expropriation in Iran moves from point 1 (highest
expropriation risk) to 9 (near the highest point of the 10), while the risks in Libya and Syria move
from 1.5 to 9.
The second set is a composite index of surveys and assessments of different aspects of
governance, collected by Kaufmann et al. (2003). Rodrik, Subramanian, and Trebbi (2004) also
used this dataset. These categories include six indicators and combine the views of a large
number of enterprise, citizen and expert survey respondents in industrial and developing
countries. Due to their popular and available, this dataset would be used in this research.
The final set, collected by political scientists (Jaggers and Marshall, 2000) from the polity
IV project, measures the limits of executive power. Polity IV makes the attempt to measure the
political environment, not choices of dictators. Constraints on the issue refer to “the extent of
institutionalized constraints on the decision-making powers of chief executives, whether
individuals or collectivities.” Polity IV provides a rapidly consideration results of election over
time, certainly not a measure of actual political constraints on bureaucracy, and not a measure of
anything permanent or durable.
2.2 Empirical review
Barro (1989) included two variables from Banks's [1979] data set to measure political

instability. The variable REV is the number of revolutions and coups per year, and the variable
ASSASS is the number per million population of political assassinations per year. Findings reported
that measures of political instability (proxied by revolutions, coups, and political assassinations)
are inversely related to growth and investment. These relations could involve the adverse effects
of political instability on property rights and the linkage between property rights and private
investment. The correlation could, however, also reflect a political response to bad economic
outcomes.
Hasan, Wachtel, and Zhou (2009) investigated the relationship between institutions and
economic growth in China. Rule of law and awareness of property rights are used as proxy
variables, which are measured by ratio of private sector total fixed investment to overall fixed
invetsment, number of lawyers per 10,000 people and ratio of number of domestic trademark
applications to number of firms. The results show that institutional development contributes to
explain for provincial economic growth differentials.
Dias and Tebaldi (2012) analyzed the relationship between human capital, institutions and
economic growth. This paper used panel data 61 countries in 1965-2005 and employs OLS and
GMM dynamic panel estimation technique. Regarding institution variables, democracy and
autocracy were used as proxies for political institution while share of educated labor in the
economy presents structural institution, human capital variable is generated based in Hall and
Jones (1999). Piecewise function and the capital stock were calculated following perpetual
inventory method proposed by Easterly and Levince (2001). The authors concluded that structural
institutions completely affect long-term economic growth, however, political institutions were
found to not be correlated with productivity and long-term economic performance.

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Phan (2013) analyzed the impact of institutional factors on provincial economic
performance in Vietnam. Regarding institution variables, PCI and its nine sub-indices were used as
proxies for institutional quality. The author used two most popular production functions, CobbDouglas and Translog, in the research. The paper employed the Stochastic Frontier Analysis (SFA)
model for the sample of 58 provinces over the 2007-2011 interval, making use of the component

error terms to account for both statistical noise and data overstatement. The author found that
although the effect for PCI on provincial GDP is significant but just some of 9 sub-indices impact
the economic performance of Vietnam's provinces for the 2007-2011.
Siddiqui and Ahmed (2013) investigated the effect of institutions on economic growth in
84 countries in 2002-2006. In order to capture the multi-dimensionality of institution, the
aggregate index of institutionalized Social Technologies (IIST) was used together with its subindices of institutional and policy Rents, Political Rent and Risk-Reducing Technologies with the
application of OLS and GMM methods. Estimation results gave that institutions positively affect
economic outcomes.
Dar and Amirkhalkhali (2012) investigated 23 OECD (Organization for Economic Cooperation and Development) countries in 2002-2008. The authors use Fixed Method and Random
Method estimation technique in the research that employs the Solow growth model. The authors
concluded that higher quality of regulation leads to higher growth and strongest impact does not
appear to be in those countries which are at the lower end of the Regulatory Quality spectrum.
Jalilian, Kirkpatrick & Parker (2007) analyzed 117 countries in 1989-1999 and 96 countries
in 1980-2000. This paper used Regulatory Quality and Government Effectiveness as institution
indicators and relied on cross-section regression, panel regression (Fixed Effects). Estimation
results gave that a strong causal link exists for the institution - growth nexus in developing
countries.
Kaufmann and Kraay (2002) investigated effect running from better governance to higher
income per capita. They rely on 194 different measures gathered from 17 different sources of
subjective governance data built by 15 different organizations (international organizations,
political and business risk rating agencies, think tanks, and non-governmental organizations). The
authors used OLS and IV estimation technique in the research. Estimation results suggested that a
one standard deviation improvement in the governance measure raises per capita incomes nearly
four-fold in the long run.
Olson et al. (2000) analyzed to explain why a subset of developing countries is growing
quickly, but other developing countries are growing slowly. They argued that this difference is due
to differences in the quality of institution and found that productivity growth is correlated with
the quality of institution strongly.
While most of the research has focused on the direct effect of institutions on economic
growth, Minier (2007) investigated indirect effect of institutions on economic growth through

parameter heterogeneity. The author used panel data of 70 countries from 1960 to 2000 and
considered whether the quality of a country’s institutions could affect the relationship between
growth and its other determinants, such as human and physical capital accumulation, geography,
and government policies Applying exogenous and endogenous sample splitting technique, the

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author attempted to measure the varied parameters of growth determinants in recognition of
such a threshold. Findings reported that there is not much evidence that institutions affect
growth indirectly, in the sense of affecting the parameters of the aggregate production function.
However, institutions influence the marginal effect of policy variables such as export trade, import
on growth. In particular, countries with weak institutions appear to suffer from trade openness in
ways that countries with better institutions do not. Although the correlation between “openness”
(measured by the quantity of trade) and growth is close to zero in countries with strong
institutions, this correlation is negative among countries with weaker institutions. Papageorgiou
(2002) employed the data-sorting method which allows the data to endogenously select regimes
using different variables. It is shown that openness, as measured by the trade share to GDP, is a
threshold variable that can cluster middle-income countries into two distinct regimes that obey
different statistical models. Their result suggests that openness may not be as crucial in the
growth process of low and high-income countries but it is instrumental in identifying middleincome countries into high and low-growth groups.
Converse, there were some studies that do not support the proposition that institution
causes growth. Glaeser et al. (2004) reviewed the proposition that institutions cause growth using
cross-country data from 1960 to 2000. Their results did not support the proposition. They also
found that it is challenging to establish a causal link between institutions and economic growth
due to problems in institutional measurements and limitations in econometric techniques. By
analyzing the history of the economic development and specific governance reforms of the United
States, Mauritius, Argentina and Jamaica, Goldsmith (2007) showed that economic growth of the
United States and Argentina gone up before major governance reforms had been adopted.
Holmberg, Rothstein & Nasiritousi (2009) reviewed the importance of good governance and

offered a benchmark statistical analysis. The authors showed that three QoG variables such as
Rule of Law, Corruption Perception, and Government Effectiveness have positive but weak
correlations with economic growth, but their correlation with income per capita is so strong.

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Summarily, this chapter presented the different concepts of institutions, in generally, the
definitions of institution until now are unified in some important factors, including the set of rules
(law, the rules of society, the rules of a community), players (state authorities, social
organizations, non-governmental organizations, businesses, communities) and mechanisms to
enforce the rules (policies, support mechanisms).
Among the institutional determinations significantly influencing economic performance
are a property right, contract enforcement, a transaction cost and corruption. Institutions provide
security of property ownership right that leads to tremendous support for the process of
registration of copyrights, creative activities of individuals, promoting innovation of the economy
thus promotes economic growth. References to contract enforcement, institutions stimulate rules
and laws to prevent market failures and agency issues and reduce the risk of anti-competitive
behavior and rent-seeking by corporate actors. Additionally, institutions determine the structure
of exchange that influences the cost of production and distribution. They influence the feasibility
and profitability of economic activities. Besides, some studies show the negative consequences of
corruption such as an illegal tax that distorts process of decision-making or economic processes.
In this chapter, we discussed three main measures that are used commonly. The first set,
indicators of the quality survey from the International Country Risk Institutional Guide (ICRG)
includes subjective assessment of risks for international investments of the same size as the law
and order, the quality of bureaucracy, corruption, risk of rejection of government contracts and
the risk of expropriation by the government. In all three sets of data, this is probably most
problematic. The second set is a composite index of surveys and assessments of Government
Effectiveness that be collected by Kaufmann et al. (2003) and is a clear outcome measure. The
final set, coming from the polity IV dataset, collected by political scientists (Jaggers and Marshall,

2000), measures the limits of executive power directly.
While considering the research relate to impact of institutions on economic performance,
we see that most of the research has focused on the direct effect of institutions on economic
growth. The study uses many different concepts of institutions, since the results are divergent.
Kaufmann and Kraay (2002) suggested a one standard deviation improvement in the governance
measure raises income per capita nearly four-fold in the long run. Dias and Tebaldi (2012)
concluded structural institutions completely affect long-term economic growth; however, political
institutions were found to not be correlated with productivity and long-term economic
performance. Moreover, Minier (2007) investigated the indirect effect of institutions on economic
growth through parameter heterogeneity. Converse, there were some studies that do not support
the proposition that institution causes growth.

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