Endogenous Institutions and Multiple Equilibria: the Role of Commitment
Abstract: Current empirical work and discussions of the impact of institutions on economic performance either implicitly or explicitly assume that institutions persist and that the quality of such institutions impacts investment. We incorporate these empirical patterns into a dynamic model of institutional choice, wherein the government invests in the legal infrastructure in response to the need for the protection of output from appropriation by households. In modeling the government's choice of policy as a dynamic problem, we must consider whether the government is capable of committing to a sequence of investments in legal infrastructure. When the government is able to commit to policy over the infinite horizon, we find a unique equilibrium. However, discretionary policy permits a lower steady state to exist, under which the government over-responds to appropriation of output, succeeding in the reduction of property theft, but at the cost of lower consumption. These results would suggest that a measure of institutional quality must not only consider the extent to which current policies protect property rights, but also include the ability of the government to commit to reform in the long run.