Legal Institutions, Sectoral Heterogeneity, and Economic Development
by Rui Castro, Gian Luca Clementi and Glenn MacDonald
Abstract
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.