Legal Institutions, Sectoral Heterogeneity, and Economic Development

The impact of imperfections in financial markets on firm-level investment varies greatly across industries. In particular, it appears that the choices of firms producing capital goods are more likely to be constrained by financial factors. We argue that this is the case because the intrinsic nature of their operations tends to worsen the moral hazard that characterizes the relationships with their investors. For example, their cash-flows are typically more volatile than it is the case for the average firm in consumption goods sectors. In this paper we focus on the macroeconomic consequences of such cross-sectoral variation. We consider a simple two-sector overlapping generations capital accumulation model, where firms have private information about the outcome of their operations. Legal institutions are able to eliminate only part of the contractual inefficiency induced by such informational asymmetry. Furthermore, cross-sectoral technological heterogeneity implies that the effectiveness of such institutions also varies across industries. We investigate the relationship between the quality of institutions and various features of economic development. Consistently with the available evidence, we find that countries with better institutions tend to (i) exhibit higher growth rates and higher levels of output, (ii) have a lower relative price of capital goods with respect to consumption goods, (iii) have a larger output share of capital goods production, and (iv) display a larger capital/labor ratio. We therefore argue that cross-country differences in legal institutions may explain a large fraction of the actual cross-country differences in economic development