Political Economy: Why the Rules Decide Who Gets Rich

Stand at the border fence in Nogales. On the Arizona side, household incomes are far higher, children finish school, and the roads and electricity work. A few metres away in Sonora, Mexico, people share the same desert, much of the same ancestry and food, and many of the same relatives. Daron Acemoglu and James Robinson open their 2012 book Why Nations Fail with this pair of towns. Their answer: it is not geography or culture, it is the rules each side lives under, and who made them.

Not everyone accepts that answer, and the story of why is the story of this subject. Political economy sits where economics and politics meet. Economics asks how people respond to incentives; politics asks who sets the incentives, and for whom. Put them together and you can ask why some governments tax heavily and others lightly, why some oil states are rich and stable and others are neither, and why a few countries in East Asia grew from poverty to wealth in a generation.

Institutions and growth: the rules of the game

The economic historian Douglass North defined institutions as "the rules of the game" in a society: formal ones (a constitution, property law, a court) and informal ones (norms, expectations). North, who shared the 1993 economics Nobel prize, argued that what separates rich from poor countries is less the resources they hold than the rules that tell people whether effort will be rewarded. If a farmer expects the harvest to be seized, she plants less. If an inventor expects a copy to be sold on the next street, he invents less.

The rival explanations are worth stating fairly. Geography: tropical disease, poor soil and distance from trade routes (Jeffrey Sachs, Jared Diamond). Culture: beliefs about trust and work, in a tradition that runs back to Max Weber. Policy: whether a government's choices on trade, spending and money encourage growth. The institutions view says these other things matter, but mostly through the rules people live under. The debate is about how much, and whether institutions are the deep cause or one link in a longer chain.

Extractive and inclusive institutions, and the critics

Acemoglu and Robinson's version is bold. Inclusive economic institutions protect property for ordinary people, enforce contracts, and let anyone start a business; they rest on inclusive political institutions that spread power widely. Extractive institutions let a narrow elite take what others produce, and the elite resists change, because new technology or fair competition could threaten it. Their historical argument includes colonial settlement: where European settlers died quickly of disease, colonisers set up systems to extract wealth rather than settle, and those systems persisted after independence. In 2024 Acemoglu, Simon Johnson and Robinson shared the economics Nobel prize for this line of work.

The criticism comes from several directions, and it is serious. Jeffrey Sachs argues that the book underplays geography, technology and international politics, and notes that Singapore and South Korea grew fast without being democracies. Jared Diamond argues geography matters more and asks where good institutions come from in the first place. Francis Fukuyama says the inclusive/extractive binary is too crude and that China's growth sits awkwardly with the theory. William Easterly says the case studies lack statistical support; Arvind Subramanian raises reverse causation, since rich countries can afford better institutions. A fair summary: most economists accept that institutions matter; there is real disagreement about whether the inclusive/extractive split explains as much as the book claims.

Without JavaScript: in the toy, a 40 percent take leaves income per person after 100 years at about 82 percent of the level under a 10 percent take, and an 80 percent take leaves the economy with no growth at all.

Notice two things. Output after 100 years falls as the take rises, because people keep less to invest. But the elite's own long-run take is largest at a share of roughly two-thirds, not at 100 percent: a ruler who takes everything starves the thing he lives on. That is Mancur Olson's point about the "stationary bandit": even a self-interested ruler wants a tax base that lasts, and what restrains him is his need for a future. What the toy cannot show is what changes a ruler's incentive, which is exactly what the book, and its critics, argue about.

The resource curse

It seems natural that oil, gas or diamonds should make a country rich. Yet in 1995 Jeffrey Sachs and Andrew Warner reported that countries with more natural-resource exports tended to grow more slowly. Political scientists added a political story: Michael Ross argued in 2001 that oil in particular is associated with less democracy, because a government funded by oil rent does not need to tax its citizens, and citizens who are not taxed demand less say. Economists point to "Dutch disease", named after the effects of the Groningen gas field found in 1959: a resource boom lifts the exchange rate and hurts other exports like factories and farms. Resource prices also swing wildly, which makes budgets whipsaw.

It is a tendency, not a law. A 2008 study by Brunnschweiler and Bulte argued that resource abundance, as opposed to export dependence, is not bad for growth, and a later study suggested price volatility rather than abundance drives the problems. Norway founded its petroleum fund in 1990, and its rule lets the government spend only up to about 3 percent of the fund each year. Botswana, a diamond exporter, is often cited as another success. Institutions again: both had working rules before the money came.

With nothing saved, spending follows the price: boom, then bust, and projects half-built when the price falls. With everything above average saved, spending is flat. But the fund then depends on a good estimate of "average", and a long run of low prices drains it. That is why real rules, Norway's included, are debated constantly.

Redistribution and the median voter

In a democracy, if the poor outnumber the rich, why do they not vote to take more from the rich? The classic model comes from Allan Meltzer and Scott Richard (1981), building on Duncan Black (1948) and Anthony Downs (1957). Put voters on a line by income. If everyone votes on a single question, the winning position is that of the median voter, the one with exactly half the voters on each side. In a society where average income is above the median (a few very rich people pull the average up), the median voter gains from taxing everyone and paying out equally. So more inequality, the model says, should mean more redistribution.

Without JavaScript: with the default settings the decisive voter earns about 0.73 of the average and prefers a tax of about 27 percent; if the poorest 40 percent cannot vote, the preferred rate falls to zero.

Raise inequality and the decisive voter's preferred tax rises; exclude poor voters and it falls. Real data are harder on the model. Studies find some support (one found more aggressive redistribution where the median citizen would gain, across 79 countries) and some contradictions: the decisive voter in some referendums was not the median one, and many unequal democracies redistribute little. Explanations on offer include turnout and money that favour the rich, voters' beliefs about fairness and mobility, and the way parties package issues. The model is a clear starting point rather than a verdict.

Varieties of capitalism

Not all market economies work alike. In Varieties of Capitalism (2001), Peter Hall and David Soskice divided rich countries into liberal market economies (the United States, Britain, Ireland, Australia, Canada and New Zealand) and coordinated market economies (Germany, Japan, Sweden, Austria and others). In the first, firms coordinate mainly through markets and contracts. In the second, they rely more on negotiation, industry bodies and long relationships. Their claim is about complementarities: a feature in one area works best alongside matching features in the others. Patient bank finance suits long job tenure; firm-specific skills suit firms that will not poach each other's workers. Flexible hiring and stock markets suit general skills that move between employers.

Hall and Soskice predicted that liberal economies lean to radical innovation (software, biotech) and coordinated economies to incremental improvement (machine tools, cars). Critics reply that the framework underplays change (Germany has reformed its labour market since the 1990s), treats actors as locked into institutions, and rests partly on the United States as an outlier. It remains a standard way to see that "capitalism" has several designs. It connects to the library's The Mixed Economy (31/05).

State-led development in East Asia

In the 1960s South Korea was poor; a standard economics textbook says its output per person then grew about 7 percent a year for more than thirty years, and one working paper puts income per head in 1962 at under a hundred US dollars. The state did not leave this to the market alone. In Korea, Japan and Taiwan, governments steered credit to chosen industries, pushed firms to export, and protected infant industries. Chalmers Johnson's study of Japan's trade ministry (1982), Alice Amsden on Korea (1989) and Robert Wade on Taiwan (1990) described a "developmental state". The World Bank's East Asian Miracle (1993) credited mostly market-friendly policies with a smaller role for intervention, an interpretation its critics disputed.

The same tools failed elsewhere: many governments that picked winners picked losers. What differed, scholars argue, is that East Asian states tied support to performance (exports, not just promises) and had capable bureaucracies. The free-market view holds that the countries succeeded in spite of intervention, or that the lesson is openness to trade and high investment. This is not settled. What is not in dispute is the arithmetic of compounding, which explains why decades of fast growth transform a country.

At 7 percent a year, income per head doubles about every ten years and is about 7.6 times larger after thirty. At 2 percent it is 1.8 times larger. A country at 2 percent for a generation looks much the same to its citizens; at 7 percent it looks like a different country.

What a graduate just sees

• Rules matter at least as much as resources: ask who set them and who benefits.
• Even a selfish ruler needs a tax base. What restrains plunder is the ruler's need for a future, or others' power to check him.
• Institutions are a strong explanation with strong critics. Say which claim you mean: "matters" or "matters most".
• Resource wealth is a risk, not a curse: price swings, an exchange rate that squeezes other industries, and a state that does not need its citizens' taxes.
• In a democracy, the median voter's preference is a force. When it fails to predict policy, ask who actually votes and who actually gets heard.
• Capitalism has several designs, and features tend to come in matching bundles.
• Industrial policy has a record of both successes and failures: look for what made the successes accountable.
• Small differences in growth rates compound into different worlds.

Where it shows up next

• Development Economics (34/48): the same questions about poor countries, from the economist's side.
• International Trade & Finance (34/47): tariffs, exchange rates and industrial policy in the world economy.
• Public Economics (34/49): taxes and the welfare state, where the median voter model gets used.
• Research Methods in Political Science (35/18): how scholars try to test claims like "institutions cause growth".
• In the world: sovereign-wealth-fund rules, debates on industrial policy in Europe, the US and China, and why governments in unequal democracies do or do not redistribute.

If you want to go deeper

• 📘 Textbook. Torsten Persson and Guido Tabellini, Political Economics: Explaining Economic Policy (MIT Press, 2000): the standard formal treatment; demanding.
• 📘 Textbook. Peter Hall and David Soskice (eds.), Varieties of Capitalism (Oxford University Press, 2001): the book behind one idea, with the case chapters.
• 📘 Gentler. Daron Acemoglu and James Robinson, Why Nations Fail (Crown, 2012). Read it alongside a critic, such as Jared Diamond's or Francis Fukuyama's review.
• 🌐 Free course. MIT OpenCourseWare 14.75, Political Economy and Economic Development (Benjamin Olken, Fall 2012).