The impact of institutions on innovation
What determines economic prosperity? In addressing this important question, a large body of research shows that the creation of new products and services as well as the improvement of existing production techniques is one of the most important determinants of economic growth (e.g. Mokyr 1992, Grossman and Helpman 1993, Kogan et al 2017, Wu and Hao 2022). Indeed, many of the products and services we value most today were not available just a few decades ago.
The local socio-economic environment is crucial in determining the ability of individuals and firms to innovate, leading to clustering of innovative activities in regions where local conditions are more conducive to innovation (Chatterji et al. 2014). As a result, local and national governments are devoting substantial efforts and resources to designing and implementing policies to foster innovation. For example, in 2015, the White House strategy for American innovation stated that “[n]Now is the time for the federal government to make the seed investments that will enable the private sector to create the industries and jobs of the future, and ensure that all Americans benefit from the innovation economy” (National Economic Council and OSTP 2015).
In a new article, we explore the role of inclusive institutions in creating an environment conducive to innovation (Donges et al. 2022). We use the term “inclusive institutions” (as opposed to “extractive institutions”) to refer to institutions that provide broad access to economic opportunity, rather than favoring the few at the expense of the many (North 1991 Acemoglu and Robinson 2012 ).
Investigating this question empirically is difficult because some regions may have both better institutions and more innovation, but this does not necessarily mean that the former are at the root of the latter. To test whether the establishment of more inclusive institutions later leads to more innovation, we study a historical context: the early adoption of inclusive institutions in French-occupied parts of Germany after the French Revolution of 1789. Figure 1 shows the geographical dimension of the French occupation and its duration.
Institutional inclusiveness is measured using an index comprising four major reforms that were implemented by the French to reduce the power of local German elites, including the dissolution of guilds, the introduction of Civil Code, the abolition of serfdom and land reforms (Acemoglu et al. 2011). These reforms have created a more level playing field in terms of economic opportunity, by lowering barriers to entry and reducing distortions in labor and product markets. Figure 2 shows regional differences in the inclusiveness of institutions based on the Institution Index, which measures the number of years that the aforementioned institutional reforms have been implemented in each German county. The map shows that in the Rhineland, the region with the longest period of French occupation, the institutions index has the highest values due to the early implementation of reforms.
We test whether locations with more inclusive institutions due to French occupation subsequently produced more high-value patents per capita, which we use as the main indicator of innovation. Figure 3 shows the spatial distribution of patenting activity.
Importantly for our study, the motives of the French occupations were military and geostrategic, not economic. Napoleon wanted to extend the French borders to create a territorial buffer between France and its rivals, Austria-Hungary and Prussia. This means that the French did not simply choose to occupy the German regions with the greatest potential for future innovation. This argument is reinforced by the fact that after the French defeat, Prussia wanted to annex the kingdom of Saxony, then considered one of the most prosperous German regions, with great potential for economic growth. However, the United Kingdom and Austria-Hungary did not want to give such economic power to Prussia. Therefore, it was agreed that Prussia would annex the Rhineland and Westphalia. These regions were perceived by the leaders of the time as economically less promising, but they had set up inclusive institutions early on due to the French occupation.
We show that, in departments with more inclusive institutions due to the French occupation, there were significantly more patents per capita around 1900. The magnitude of the estimated effects is large. In the base specification, we find that counties with the longest period of French occupation, which established better institutions earlier, had more than twice as many patents per capita around 1900 as unoccupied counties with more extractive institutions. To ensure that the results are not due to the fact that the occupied regions are (even by chance) those with the most potential for innovation, we exploit the granularity of our manually collected data to take into account possible alternative explanations. Importantly, we find that the results are not dictated by differences in local economic development.
We also test whether French occupation fostered innovation through channels other than institutions, including culture and knowledge transfer, trade and market integration, presence of intellectual elites, inequality income, access to finance or differences in patent laws. However, even after controlling for a large number of potentially confounding effects, the picture that emerges is one where inclusive institutions play a central role in fostering innovation.
Since our analysis relies on patents to measure innovation, there is concern that better institutions have led to an increase in the number of patents even though there has been no change in the level of innovation. . This could have happened because in places with better institutions, the courts might have worked more efficiently, making the legal protection provided by patents more effective. To show that our results are about innovation and not just about patenting, we collected data on innovative products exhibited at two world’s fairs (1876 and 1893) as a non-patent based proxy for innovation. Using this alternative indicator of innovation, we continue to find a significantly positive effect of institutions on the local production of innovation.
By tracing the implications of our results for economic growth, we show that the effect of inclusive institutions was particularly pronounced for innovation in chemicals and electrical engineering, which were the two high-tech sectors of the second industrial revolution. (Mokyr 1992; Landes 2003). .
We study the determinants of innovation in the German Empire, since this historical framework offers us a variation of institutional quality within the same country. However, the results of our study may have broader implications for understanding the determinants of innovation. Even today, countries might be able to spur innovation by creating a more inclusive and efficient legal system with lower transaction costs. According to the Economist Intelligence Unit’s 2021 Democracy Index report, “less than half (45.7%) of the world’s population now live in some kind of democracy, a significant drop from 2020 (49.4%)” . Our results suggest that the lack of inclusive institutions in much of the world means that much of the global potential for innovation remains untapped (see also Bekkers and Góes 2022 for a discussion of how geopolitical conflict can affect innovation). ‘innovation).
Our results also suggest that reforms and policies aimed at increasing competition and creating a level playing field could be particularly beneficial for innovation, even in developed countries. As with guilds or trade licenses in Imperial Germany, today there are institutions such as trade licenses that restrict competition. Lifting these restrictions can foster innovation.
At the beginning of the 19th century, Germany was economically and technologically backward compared to other Western European countries. However, by the end of the century, Germany had become one of the leading industrial countries with highly innovative and internationally competitive companies, especially in the advanced chemical and electrical engineering industries. In this regard, developing and emerging economies may find it very beneficial to set up the type of inclusive institutions we study in our article, as this could make them more innovative and help them catch up with the technological frontier.
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