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Legal Institutions, Sectoral Heterogeneity, and Economic Development

  • Rui Castro

    (Universy of Montreal, Canada)

  • Gian Luca Clementi

    (New York University, USA and Rimini Centre for Economic Analysis, Rimini, Italy)

  • Glenn McDonald

    (Washington University in St.Louis, USA)

Poor countries have lower PPP–adjusted investment rates and face higher relative prices of investment goods. It has been suggested that this happens either because these countries have a relatively lower TFP in industries producing capital goods, or because they are subject to greater investment distortions. This paper provides a micro–foundation for the cross–country dispersion in investment distortions. We first document that firms producing capital goods face a higher level of idiosyncratic risk than their counterparts producing consumption goods. In a model of capital accumulation where the protection of investors’ rights is incomplete, this difference in risk induces a wedge between the returns on investment in the two sectors. The wedge is bigger, the poorer the investor protection. In turn, this implies that countries endowed with weaker institutions face higher relative prices of investment goods, invest a lower fraction of their income, and end up being poorer. We find that our mechanism may be quantitatively important.

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Paper provided by The Rimini Centre for Economic Analysis in its series Working Paper Series with number 05-07.

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Date of creation: Jul 2007
Date of revision: Jul 2007
Handle: RePEc:rim:rimwps:05-07
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