Factor Returns, Institutions, and Geography: A View from Trade

Abstract

We examine the importance of institutions and geography for determining workers' wages and the return to capital. These returns to labor and capital are examined through the lens of labor and capital's productivities, which are directly related to the factors' returns. We estimate productivities of labor and capital based on trade flows across countries and present statistical evidence that these productivities are related to total factor productivities which rationalize output differences across countries.

We examine whether these labor and capital productivities are related to countries' political institutions and geography. Protection of property rights is the dominant influence on both labor and capital productivity. There is some evidence that a democratic government affects productivity, but once property rights are included in the analysis, the overall democracy index has little influence on factor productivity.. Geography is only important in terms of distance to a large market. Factors such as the incidence of malaria are relatively unimportant.

The unimportance of geography is not only statistical. For example, if the Philippines kept its geography but had the United Kingdom's institutions, the Philippines' labor productivity would increase from seven percent to 75 percent of the U.S.'s and capital productivity would increase from 25 percent to 58 percent of the U.S.'s. On the other hand, if the Philippines were to keep its institutions and were magically more to the United Kingdom's geographic location, labor productivity would increase only from seven percent to 28 percent and capital productivity would increase from 25 percent to 26 percent.

Keywords: Productivity, institutions, property rights, democracy, geography

JEL Classification: 04