Chapter 3: Legal Capacity

The public good is in nothing more essentially interested, than in the protection of every individual's private rights.

- William Blackstone

William Blackstone. Wikimedia Commons

This chapter adds an important new dimension to the picture - government efforts to improve the operation of private markets, an intervention that we call legal capacity.

This productive role for government can improve the efficiency of resource use and shape the incentives to accumulate capital, issues that tend to surface frequently in academic and policy discussions. Indeed, the need to create a better business climate has been a constant refrain in the development economics literature.

In the process of development, improvements in economic institutions can thus help to endogenously raise the level and growth of income. Understanding the incentives governments may have to undertake such improvements is therefore central to understanding economic prosperity and possible barriers to progress.

To explore these issues, this chapter continues developing our core model by adding in contractual frictions or badly protected property rights associated with low legal capacity. We then consider why governments may or may not try to alleviate these problems. As with fiscal capacity in the last chapter, we allow the government to invest in legal capacity, which we think of as better economic institutions. Throughout, we study these investments jointly with investments in fiscal capacity, so that the model now has two state variables - fiscal capacity and legal capacity. Because higher legal capacity makes the economy work better, this extended framework also serves to endogenize income.

In the core model, fiscal and legal capacity are complements. This makes the model extremely tractable and allows us to generate a number of testable predictions on the coevolution of fiscal and legal capacity. The complementarity also gives us immediate insights into the reasons why fiscal and legal capacity may be clustered in the raw data, as we observed in Chapter 1.

Having extended this reduced-form framework, we explore the microeconomic foundations of legal capacity. Specifically, we build a simple generalequilibrium model with labor and capital and use it to illustrate how the government can build economic institutions. These institutions can help to improve the economy's resource allocation and raise its income by improving the contracting environment for the private sector. Such institution building is a core example of an investment in legal capacity.