Significance of Institutional Environment for Agricultural Production Pavol Minárik Department of Institutional Economics University of Economics in Prague

Abstract The paper examines significance of institutional environment for agricultural production. It adds to the extensive research of agricultural production functions. First, it reviews relevant theory of institutional economics that explains how institutions contribute to productivity in general, especially if interpreted as economic freedom. Then, a model of agricultural production is presented, which explains aggregate agricultural production using various inputs, as well as variables representing institutional environment. Results concerning elasticities of material inputs (land, labor, capital) are consistent with previous research. The paper proves some significance of institutional variables. Finally, it suggests some directions for further research.

Keywords: agricultural productivity, institutions, economic freedom, development, international comparison JEL classification: O13, O43, Q11

Acknowledgement This research has also been supported by a grant from University of Economics in Prague, project no. IGA 33/08.

"When wars or revolutions cut us off from cows, the industrialists discovered that milk does not come originally from cans." G. K. Chesterton1

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Chesterton, G. K. (1928). The Outline of Sanity. London: Methuen & Co., p. 108.

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Introduction The new institutional economics is based on the assumption that institutions predominantly determine economic and human development. This assumption is subject to a test in this paper. However, in order to justify this research, we have to answer two addition questions – first, why deal with agriculture, and second, why deal with production functions. To the first question, we have to acknowledge the role of agriculture for human subsistence. It provides food and resources for manufacturing. From a different perspective, agriculture employs many people, especially in the developing countries, and their well-being is closely tied to development of this sector. Any analysis of poor countries' development would be incomplete, fi it ignored rural population and agriculture as it main occupation. Regarding the second question, why deal with production function, we have to acknowledge the role of this topic in contemporary economics. Rather than establishing a brand new system of economic, the new institutional economics is able to contribute to mainstream concepts. Introduction of institutional variables to standard production functions, as we attempt to do in this paper, shall both prove the positive role of institutions in economic development and improve the standard analysis of production. Agricultural production functions have been researched for some time. The most recent studies in this field have employed institutional variables to some extent, notably the research supported by the World Bank (e.g., Mundlak, Larson, & Butzer, 1997, 2008). However, the institutional variables used in this research are often inadequate, insufficient, or used in an inappropriate manner. For example, Vollrath (2007) uses a relevant measure for institutions, denoted as "institutional quality index"; however, he extends the rating constructed for specific time period to data representing a time span of 35 years. Thus, this index does not reflect institutional change that has occurred through the time. For this reason, the present paper focuses specifically on the institutional variables to evaluate their role. This paper aims to examine the significance of institutional environment for agricultural production. First, it reviews relevant theory that explains how institutions contribute to productivity in general, especially if interpreted as economic freedom. Then, a model of agricultural production is presented. The model allows us to estimate the contribution of various inputs to aggregate agricultural production. To this model, the variable representing institutional environment is introduced. Results are compared to findings of previous research. Finally, the paper suggests some directions for further research.

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Institutional Environment and Productivity The impact of institutional environment on other economic variables is now widely recognized among economist. Limitations that individuals face in their choices are not only of physical nature but also include various humanly devised constraints. Thus the framework for economic activity is formed by a combination of scarce productive resources and institutions that limit their use in different ways. In this chapter, we define institutions and describe in general their impact on productivity and examine some specifics of agriculture. Definition of Institutions Following Aoki (2001), we may distinguish three different views of institutions that are based on game-theoretic perspective. First, institutions may be viewed, as they are in daily conversation, as prominent organizations, i.e. as players of the game. Second, following North (1990), institutions are viewed as the rules of the game that are distinct from the players. As put by North: "Institutions are the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction."(North, 1990, p. 3) There are two types of rules of the game: formal ones (constitutional, property rights, contracts) and informal ones (norms and customs). The key issue connected with the institutions as the rules of the game is their enforceability. While the formal rules may be transferable from country to country, the informal rules are more persistent and thus borrowed institutions may be neither enforceable nor functional. Including the issue of enforcement and enforcer’s motivation to the analysis leads to the third view of institutions. As put by Aoki (2001, p. 2), "[t]he most reasonable way of approaching institutions from this perspective is then to conceptualize an institution as an equilibrium outcome of the game." In the end, however, "[a] proper formulation of a concept, such as that of institutions, may depend on the purpose of the analysis." (ibid.) For our purpose, we understand institutions as the rules of the game. Enforcement of these rules is viewed as of their characteristics (qualities).2 Defining institutions as the rules of the game still leaves us with great choice of different measures. There are many different rules that govern life in a society. As mention above, there are formal rules, best represented by constitutions and statutory laws, but also binding court decisions (precedents) and such. Further, there are different informal rules, ranging from well-known and well-described conventions to obscure customs having nature of Hayekian tacit knowledge. As for the enforcement, different forms range from self-enforcement to enforcement by power of state.3 In the following analysis, we focus on two broad categories of institutions, namely the rules effecting property rights and contracts. These seem to have the most direct effect on economic activity. Property rights generally define who has the authority to make decisions about use of particular assets. Limits of contractual freedom put restriction on what property rights and under what conditions can be traded among individuals. We examine impact of various setting on economic performance bellow. Finally, we shall mention the importance of process law. It determines the quality (especially the cost) of enforcement. As we have defined enforcement of particular rules as one of the characteristics of those rules, we will not

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Following another definition by North (1986, p. 4): "Institutions are rules, enforcement characteristics of rules, and norms of behaviour that structure repeated human interaction." 3 For details see Voigt (2008, chapter 1).

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deal with process law further, and we consider it subsumed in the quality of property-rights and contract rules. Institutions and Economic Development The term property rights stand for a complex of rights; each of them represents a different aspect of property ownership. Among these rights is the right to use an asset, the right to exclude others from using it, and the right to transfer the asset to others. Property rights allow the owner to determine the uses of the asset and to derive value from the asset. (Anderson & Huggins, 2003) Such notion of property rights allows us to better interpret property and government intervention. Nominal ownership may be incomplete, i.e. the owner may not have all the property rights. For example, if there is a requirement to obtain a license for particular use of an asset, part of the property rights is in hands of the government (which can decide whether the asset can be used in particular way). Importance of property rights lies in their ability to reduce conflicts in society. Generally, there are four sources of conflicts between people and four ways to eliminate them. According to van Dun (2007), conflicts stem from plurality, i.e. existence of multiple persons, diversity of their preferences, scarcity of resources and free access to scarce means. "Given that each of the causes is necessary, it is sufficient to eliminate only one of them to eliminate the possibility of interpersonal conflict between A and B. Let us assume that we can tackle each of the four causes independently. Then there are four pure strategies for eliminating the possibility of interpersonal conflict. The first involves replacing plurality with its opposite, unity; the second replaces diversity with uniformity or consensus; the third eliminates scarcity and gets us into a condition of abundance; finally, the fourth introduces property, thereby getting rid of free access." (van Dun, 2007, p. 62)

First two solutions are "political"; they require elimination of people as autonomous beings4 or elimination of natural differences in human preferences respectively. As for the "economic" solutions, abundance can be achieved either by modification of people's wants or the environment. Assuming such modification is unlikely, definition of property rights seems the only feasible way to restrain conflicts among people. Well-defined property rights effect economic activity in two ways. First, they are a solution for a problem called the tragedy of commons, and second, they provide, or rather promote, incentives for savings and investment. Both these outcomes come from the fact that clearly defined and protected property rights precisely establish who has the right to use an asset and derive benefits from it, or – otherwise stated – to exclude others from using it. Open access combined with scarcity results in conflict or destruction of the scarce resource. The latter option is usually referred to as the "tragedy of commons". It does not necessarily concern all commons.5 However, if a society fails to develop a solution, either by establishing private property or some form of communal property governance, the effects are grave. Open access often leads to inefficient use of resources and eventually to its depletion. 6

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Either by physical elimination or subjection to one person's will. It is important to distinguish between open access and communal property (Eggertsson, 2003). 6 More on this subject can be found in Eggertsson (2003), or the introduction to chapter 2 in Anderson and McChesney (2003). 5

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Furthermore, well-defined and enforced property rights encourage investments. In a free access setting, everyone is motivated to maximize present use of a resource. However, if the future revenue from investment is guaranteed to the owner, he has incentives to maximize present value of future returns. Therefore, he is willing not only to economize on scarce natural resources but also to make improvements to enhance their productivity. Overall benefit to economic welfare is thus enhanced. Several empirical results on the benefits of private property are summarized by de Alessi (2003), many of them concerning land rights. A study of land use in Libya cited there showed that maximum returns per hectare were 5 to 80 higher for privately owned land compared to open access land. Private land was typically cultivated more intensively. Efficiency of communal property is documented by the example of Swiss villages – some of the land has been kept in communal ownership there due to the nature of their use (forests, alpine grazing meadows, irrigation, waste land, etc.). Government regulation and government ownership is proved to be inefficient, at least in case Mexican land reform, which severely limited transfers of land rights, and with federal government’s ownership of land in the west of the USA. After the rather lengthy discussion of property rights, let us add a short remark on contractual freedom. It is generally assumed in economic theory that voluntary exchange increases welfare of both trading parties.7 Therefore, it is the role of institutions to facilitate exchange by decreasing transaction cost. However, some rules are specifically designed to increase transaction cost and to limit contractual freedom. These rules may follow some social purpose other than maximization of welfare to contractual parties, e.g. elimination of some kind of externalities or enforcement of some moral principles.8 Generally, high transaction costs, caused either by government regulation or insufficient contract enforcement, discourage specialization and division of labor, and thus slow down economic development. Our hypotheses are based on the assumption that economic growth and development is significantly dependent on institutional environment. Generally, institutions work to reduce strategic uncertainty naturally involved in all interactions among people. In terms of transaction cost economics, institutions do reduce transaction costs. In effect, the number of transactions increases, allowing division of labor and greater specialization in society. As pointed by Adam Smith (1776), division of labor is the key to economic growth. Further, this analysis focuses mainly on formal institutions, i.e. institutions enforced by the state. North (1988, p. 7) points out "a critical and neglected aspect of economic history: the essential role of third party enforcement of contracts for human economic progress." As opposed to personal exchange that solves the problems of contract fulfillment by repeat dealings and a network of social interaction, modern societies must rely on different institutional settings. "[I]ncreasing specialization and division of labour necessitates the development of institutional structures that permit individuals to take actions involving complex relationships with other individuals far removed from personal knowledge and extending over long periods of time. […] The establishment and enforcement of property rights conducive to the creation of [efficient factor and product] markets would then allow individuals in highly complex, interdependent situations to have confidence in their 7

Abstracting from various discussions on rationality, ex-ante and ex-post utility and exchange between persons with limited capacity. 8 Examples may include drug prohibition, occupational safety and health regulation, prohibition or regulation of Sunday shopping, production and sale of pornography, etc.

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dealings with individuals with whom they have no reciprocal and ongoing exchange relationships. This is only possible as a result of a third party to exchange, government, which specifies property rights and enforces contracts." (North, 1988, p. 7, italics added)

Formal institutions and government performance in general are therefore important elements of economic development. As noted further by North "while third party enforcement is far from perfect, there are vast differences in the relative certainty and effectiveness of contract enforcement, temporally over the past five centuries in the Western world, and more currently between modern Western and third world countries." (ibid.) It is precisely these differences and their impact on productivity that is the subject of present research. Further, we focus on economic freedom as a representation of institutional quality and its effects on economies. Economic Freedom as Measure of Institutional Environment The key problem of institutional analysis is measurement and quantification. In this paper, two indices are used to reflect quality of institutional environment in different countries. First, to represent institution with direct impact on economic activity, we use economic freedom index as reported in the Economic Freedom of the World reports published by Fraser Institute in Canada. Second, to measure quality of political institutions, we use indices for political rights and civil liberties as reported by the Freedom House in its Freedom in the World reports. The definition of freedom is not straightforward. There are various concepts of freedom, some of them fundamentally different (see Berlin, 1958). Bruno Leoni (1991 [1961]) discusses notions freedom in depth (and his analysis is not too different from that of Berlin) to advocate "freedom as the absence of constraint". Of course, he does not promote absence of constraint under any circumstances: "There are cases in which people have to be constrained if one wants to preserve the freedom of other people."9 (Leoni, 1991 [1961], p. 10) In the same way Douglass North (1988, p. 4) asserts that "freedoms […] are uniformly applied rules with respect to the security of persons and property over a range of civil, political, religious, and economic activities. […] None of these freedoms is absolute; nor are they ever perfectly enforced." Let us focus on economic freedom as it understood by the authors of the Economic Freedom of the World (EFW) reports. Gwartney and Lawson (2008, p. 3) describe the basic characteristics of freedom that underlie their index as follows: "The EFW index is designed to measure the consistency of a nation’s institutions and policies with economic freedom. The key ingredients of economic freedom are * personal choice * voluntary exchange coordinated by markets * freedom to enter and compete in markets * protection of persons and their property from aggression by others."

Consequently, "[i]nstitutions and policies are consistent with economic freedom when they provide an infrastructure for voluntary exchange and protect individuals and their property from aggressors. Personal ownership of self is an underlying postulate of economic 9

To make the case more complicated, he adds that "[t]his is only too obvious when people have to be protected against murderers or robbers, although it is not so obvious when this protection relates to constraints and, concomitantly, freedoms that are not so easy to define." (Leoni, 1991 [1961], p. 10)

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freedom." (Gwartney & Lawson, 2008, p. 3) This view of freedom is consistent with those of Leoni and North mentioned above. The construction of EFW index is based on three methodological principles (see Gwartney & Lawson, 2008). First, authors prefer objective data to surveys or value judgments.10 Second, the data used to construct the index come from external sources, mostly renowned international organizations such as the International Monetary Fund and World Bank. Third, to maintain transparency, the report provides information about the data sources and the methodology used. The EFW index is comprised of 42 distinct variables which measures the degree of economic freedom in five major areas: 1. 2. 3. 4. 5.

size of government: expenditures, taxes, and enterprises, legal structure and security of property rights, access to sound money, freedom to trade internationally, regulation of credit, labor, and business.

The first component measures the degree to which a country relies on personal choice and markets rather than government budgets and political decision-making. The second one reflects the security of property rights, protected by the rule of law, provides the foundation for both economic freedom and the efficient operation of markets. Major importance of property rights and contractual freedom is described above.11 Access to sound money is required to protect property rights and, thus, economic freedom. Inflation erodes the value of property held in monetary instruments, so when governments use money creation to finance their expenditures, they are effectively expropriating the property. The fourth component actually reflects the contractual freedom of citizens and their foreign partners. It measures a variety of restraints that affect international exchange, such as tariffs, quotas, hidden administrative restraints, exchange rate and capital controls. Finally, the fifth component measures the contractual freedom among citizens with regard to credit market, labor market and entrepreneurship. (see Gwartney & Lawson, 2008, p. 4-7) Let us now briefly consider the link between institutional environment as reflected in the EFW index and economic development. Douglass North (1988, p. 4) asserts that the "connection [of various freedoms] to economic growth is straightforward. The more secure are these freedoms, the lower the costs of transacting; and declining transaction costs are (given relatively non-controversial behavioural assumptions) a critical historical source of economic growth." Indeed, empirical research supports such assertions. Norton and Gwartney (2008) provide several exhibits to prove the connection between economic freedom and economic and human development. They find correlation between the EFW index and multiple variables reflecting living conditions of people, besides income it is life expectancy at birth, infant survival rate, access to water and health-care, etc. It is evident that the freer the country is the better off its people are. Also positive changes in living conditions (i.e. development) are connected to improvement of institutions and policies as measured by the EFW index. Following charts taken from the Economic Freedom of the

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Although they admit that due to the nature of economic freedom and the importance of legal and regulatory elements it is sometimes necessary to use data based on surveys, expert panels, and generic case studies. 11 Gwartney and Lawson (2008, p. 6) note that "more than any other area, this area is essential for the efficient allocation of resources. Countries with major deficiencies in this area are unlikely to prosper regardless of their policies in the other four areas."

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World 2008 Annual Report document the connection between economic freedom and human well-being (see Figure 1). Figure 1. Economic Freedom and Economic and Human Development

Source: Gwartney and Lawson (2008, p. 18-20)

Political Freedom and Stability of Institutions While the importance of economic freedom for economic growth and development is fairly obvious, impact of political institutions is much more uncertain. On one hand, Douglass North claims that political and civil liberties were essential for modern economic growth in the West: "This growth was inextricably involved with the emergence not only of secure property rights but of political, religious, and "civil" freedoms." (North, 1988, p. 3) On the other hand, Przeworski and Limongi conclude their research on the relation of political regimes and economic growth with a statement that "we do not know whether democracy fosters or hinders economic growth." (Przeworski & Limongi, 1993, p. 64) Authors of the Economic Freedom of the World report note how important it is to recognize the difference between economic freedom and democracy: "Democracy has to do with how political choices are made, while economic freedom is about the consistency of those choices with voluntary exchange and the protection of people and their property from aggressors." (Gwartney & Lawson, 2008, p. 3) It is obvious from empirical evidence that democratic political decision-making will not guarantee economic freedom. This has been well-proven in countries like Venezuela or Zimbabwe. On the other hand, economic freedom can obviously co-exist with little democracy, as it is in Hong Kong.

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Przeworski and Limongi (1993) summarize three main arguments concerning democracy12 and economic growth. They focus on property rights, investment, and the behavior of dictators. It has been shown above that secure property rights foster growth, however, it is not certain whether democracies or dictatorships better secure these rights. The argument against democracy is that democracy hinders growth by undermining investment, as it pressures for immediate consumption. It is said that only dictatorship can insulate the state from such pressures. On the other hand, the main argument in favor of democracy is that autonomous rulers are predatory and may have no interest in maximizing total output. However unclear the connection between political institutions and economy is, it seems reasonable to include politics into the analysis. Following North further, he states that "while falling production costs are a result of technological change or economies of scale, reduced transaction costs are a consequence of the development of more efficient institutions; and since political institutions are the source of the specification and enforcement of property rights, our examination must encompass both political and economic institutions." (North, 1988, p. 9-10) Nevertheless, we may find political institutions, as reflected by indices used in this paper, statistically insignificant. Specifics of Agriculture Conclusions about the relation between institutional environment and economic welfare presented above are based on general theories and aggregate views of economy. However, do they apply also for all particular sectors of economy? Especially, for our purpose, do they hold for agriculture in different countries? This section outlines some specifics of agricultural production that may suggest why results of particular policies may be different in the agriculture.13 Agriculture has undergone enormous change in the last century. As reported in literature, global agricultural output has grown faster than food demand for this period, the population deriving a livelihood from agriculture has declined, real food prices have fallen, and in many countries the proportion of rural households living in poverty has fallen. However, this vast development has not been uniform across different nations. According to Binswanger and Deininger (1997, p. 1961), "there has been great variation among countries and regions in output, productivity, and rural welfare, with some experiencing large improvements and others experiencing stagnating or even declining output, productivity, and rural living standards." These authors also note that "[a]gricultural policies in developing countries are often highly distorted." (ibid.) Many particular features of agriculture arise from and can be explained by the material conditions of agricultural production and the specific imperfections of financial, insurance, and factor markets in rural areas. Regarding the material conditions of agricultural production and their impact, Binswanger and Deininger observe following: "Agricultural production is characterized by heterogeneity, seasonality, and spatial dispersion, and by large variations in weather and prices that affect similar producers within a region in the same way – implying that their incomes are covariant. These characteristics aggravate the problems caused by well-known 12

Democracy is discussed here because it is often regarded as a benchmark. It is definitely true for the indices used in this paper to assess political institutions – the best score is given to liberal democracies, other regimes are rated with respect to them. 13 This section relies heavily on survey of literature published by Binswanger and Deininger (1997).

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informational asymmetries which characterize contracts for insurance, credit, and labor. Covariance and informational asymmetries, have major consequences for financial and insurance markets: crops usually cannot be insured against loss and rural financial intermediation and credit markets develop slowly and with great difficulty. Spatial dispersion, heterogeneity, and seasonality imply that hired labor, which does not share in profits, must be closely supervised – and supervision costs are exceptionally high." (Binswanger & Deininger, 1997, p. 1963-4, inner citations omitted)

As a result, many of the institutions in rural areas have developed in response to specific material conditions and the imperfections in respective markets. Authors claim that fully privatized land rights may not be the most efficient arrangement for rural economies in the situation of highly incomplete markets. Communal types of land ownership may be preferable. Also the way in which rights to productive assets, especially land, are allocated affects not only the distribution of income in rural areas, but also the overall efficiency of the rural economy. There are some other specifics of agriculture. As a result of the absence, or poor development of markets for products, much of the production is subsistence oriented. Missing labor markets often force productive units to rely on family labor. Productive assets, such as land and cattle (or other assets), are used as savings instruments. It can be explained as the consequence of undeveloped markets for finance and risk diffusion. According to literature, there are few economies of scale in agriculture that might provide advantages to farms larger than what a family could operate using its own labor. This feature comes together with the high cost of supervising wage labor. Therefore, the family farm seems to be the most efficient unit of production. However, the nature of agriculture often prevents land to be allocated in such way. As noted above, productive assets – such as land or cattle – are used as savings instruments and risk insurance. To smooth the consumption in the years of lower production (e.g. in periods of drought), distress sales of assets at very low prices occur. This can lead to the concentration of land holdings even if large holdings are less efficient than family farms. After the prices return to normal level, original owners are unable to purchase their asset back as they lack sufficient resources. On the other hand, social institutions may come up to reduce risk caused by physical environment. As reported, "[s]patially diversified social networks, created and maintained through migration and marriage, help insure against covariate risks and prevail as long as less costly mechanisms to insure against such risks are unavailable." (Binswanger & Deininger, 1997, p. 1965) Following the general knowledge about importance of property rights and notes on the nature of agricultural production, it seems that allocating land rights to farm operators would increase the efficiency of agricultural production. However, agriculture operates in a specific environment of high information costs and imperfect markets for finance and insurance, as outlined above. Therefore, "[a]bandoning communal land rights for fully tradable property rights may lead to the loss of safety nets for the poor, the use of economies of scale in herding, or measures to diversify risk." (ibid., p. 1966) Moreover, various institutional setting may develop with regard to land rights that are not reflected in official policies or legal

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documents. These may provide environments that are actually better or worse for economic activity than those suggested by general institutional evaluations. 14 Regarding public investment, the effect on agricultural production is ambiguous. On one hand, high public expenditures reduce economic freedom. On the other hand, literature on agriculture suggests that potential rates of return to public investments in agricultural sectors are above those in other sectors, i.e. countries underinvest. However, public investments are often ill-allocated, focusing on state-owned enterprises and large-scale agriculture. Such investments may have actually even reduced growth. Efficient public expenditures are those focusing on education and also those facilitating consumption smoothing in risky environments. (see ibid., p. 1970-1) As we have mentioned above, ownership settings with regard to land are relevant. Empirical results (de Alessi, 2003) on different arrangements favor private property and limited communal property to government ownership and open access. Ownership of land traditionally has very diverse legal limits compared to other factors of production. And clearly, the importance of land as a factor of production is relatively high compared to other sectors. Due to diversity of institutional settings, and often significant difference between official and actual rules (de Soto, 1989), any aggregate measures reflect the institutional environment in this field quite imprecisely.

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On informal institutional setting with regard the land rights, see de Soto (1989).

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Significance of Various Inputs and Environment for Agricultural Production The first part of this paper describes theoretical grounds that make us believe that institutional environment and specifically economic freedom have influence on agricultural productivity. Below, we attempt to verify this hypothesis through empirical analysis. This second part is an econometric analysis of agricultural production function including institutional factors represented by indices of economic freedom and political rights and civil liberties. This analysis extends the ongoing research of agricultural production function. Importance of such research is summarized by Mundlak, Larson, and Butzer (1997, p. 1): "Knowledge of the production structure, as reflected in the production elasticities, is essential in the discussion of several key topics such as: 1. The contribution of inputs to output and, in a dynamic context, to growth. 2. The existence of returns to scale. 3. The sensitivity of the cost of production to changes in factor prices. 4. The relationships between factor prices and their productivity."

Empirical studies conducted so far have utilized various data collected at different levels, from micro data at the firm level to macro data at the national level. Cross-country studies – such as this one – utilize national data. Their advantage lies in the large spread in inputs and other important variables which helps to increase the precision of estimates. Previous research in agricultural production functions is reviewed in Mundlak, Larson, and Butzer (1997) and Mundlak (2000). Empirical studies suggest that the assumption of homogeneous technology represented by a production function applicable to all observations in the sample is not realistic and it is not supported by the data. We thus follow the suggestion of Mundlak, Larson and Butzer (1997) to differentiate between functions estimated from observations within country and time and those obtained from variability across countries and over time. Previous results with regard to different inputs can be briefly summarized as follows. Estimates of land elasticity from the between-country regressions are low in absolute terms and also relative to estimates obtained from the within regression. Two measures of capital have been used in most studies, i.e. machinery and livestock, and they are also used in the present paper. The elasticity of machinery varies around 0.1 (a little higher for the betweencountry regression) and elasticity of livestock range from 0.2 to 0.35. The estimates for the labor elasticity are less stable, but generally between 0.2 and 0.4. (Mundlak, 2000, p. 378-9) Model Specification For the purpose of econometric evaluation of hypothesis about the significance of institutional environment we use simplified model based on the model used in Mundlak, Butzer, and Larson (2008). This model is built on assumption that at any time there are multiple techniques of production and that producers choose one technique together with the choice of inputs and outputs. The production function is therefore a function of output, state

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variables and inputs. The choice of technology depends on state variables, as well as the choice of inputs.15 For the purpose of econometric analysis, the production function may be approximated by a Cobb-Douglas-like production function. The production function implemented under state s is: Y = Γ(s) X β(s)eu where Γ(s) represents the technology function and X is an array of inputs. As follows from the assumption about simultaneous choice of technology and inputs, both the vector of elasticities of different inputs β and the technology function are functions of state variables. After logarithmic transformation (y = ln Y, γ(s) = ln Γ(s), x = ln X) we come to: y = γ(s) + β(s) x + u To simplify the analysis we assume further that elasticities of different inputs do not depend on state variables, so that β(s) = β. Moreover, we linearize γ(s), i.e. γ(s) = s γ. Applying these assumptions, we obtain the equation of production function to be estimated by OLS in the following form: yit = β0 + γ sit + β xit + uit where β0 is the intercept and uit is the error term. First, we estimate the function for pooled data. Then, to obtain results cleaned of variability over time and between countries (and of both), we employ time and country dummies respectively. Description of data and variables To estimate the production function we use data from different sources. The data on agricultural inputs and output come from the database of the Food and Agriculture Organization (FAO), the index of economic freedom is taken from Fraser Institute’s Economic Freedom of the World reports, the human development index comes from United Nations Development Programme's Human Development Report and the data on political and civil institutions are from the Freedom in the World reports published by the Freedom House. The choice of countries in the sample is based on data availability and it includes countries of great diversity with regard to different characteristics. Regarding the time span, complete data are available from 1975 to 2000 in five year intervals. Variables used in the analysis are described in more detail below.

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For detail on the microeconomic model and more advanced econometric analysis of production function see Mundlak, Butzer, and Larson (2008). Extensive discussion on econometric estimates of agricultural production function is provided in Mundlak, Larson, and Butzer (1999).

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The sample includes data from 104 countries.16 These countries are chosen from different regions, they have various area, population and living standards. Europe is represented by 29 countries (including Russia), 23 of them are current members of EU. Equally 29 countries are located in Africa, four in the north Africa, five in Sahel region, 18 belong to sub-Saharan Africa and two of them are islands. Two countries are from North America, eight from Central America, five countries are Caribbean islands and 10 countries are located in South America. Asian continent is represented by 17 countries, seven from Near East, five from South Asia, two from Southeast Asia and three from East Asia. Region of Australia and Pacific is represented by four countries. Output and inputs.17 Output is measured as "gross production" reported by FAO. These data are calculated using FAO indices of agricultural production that are based on the sum of price-weighted quantities of different agricultural commodities. Production quantities of each commodity are weighted by 1999-2001 average international commodity prices and summed for each year. "Gross" means that the production is calculated without any deductions for feed and seed. Output is expressed in 1000 intl. $. The "international commodity prices" are used to facilitate international comparison of productivity at the national level. International prices are expressed in so-called "international dollars". The method (labeled Geary-Khamis formula for the agricultural sector) assigns a single price to each commodity, so that, e.g., one metric ton of wheat has the same price regardless of the country where it was produced. Land is measured as "agricultural area" reported by FAO (ResourceSTAT). This category is the sum of areas of arable land, land under permanent crops and permanent meadows and pastures. Arable land is that under temporary agricultural crops, temporary meadows for mowing or pasture and gardens. Permanent crops are long-term crops which do not have to be replanted for several years (e.g. cocoa, coffee), trees and shrubs producing flowers (e.g. roses, jasmine); and nurseries (except those for forest trees). Permanent meadows and pastures are those used permanently, i.e. five years or more, to grow forage crops. Data are expressed in 1000 hectares. Labor is measured as agricultural labor force or "economically active population in agriculture" reported by FAO (PopSTAT). It is the part of the economically active population engaged in or seeking work in agriculture, hunting, fishing or forestry. Tractors are "agricultural tractors" reported by FAO (ResourceSTAT). The term as defined by FAO refer to wheel and crawler or track-laying type tractors (excluding garden tractors) used in agriculture. Fertilizers stand for fertilizer consumption. It is the sum of nitrogenous fertilizers,

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Albania, Algeria, Argentina, Australia, Austria, Bahamas, Bahrain, Bangladesh, Belize, Bolivia, Botswana, Brazil, Bulgaria, Burundi, Cameroon, Canada, Central African Republic, Chad, Chile, China, Colombia, Congo, Democratic Republic of Congo, Costa Rica, Côte d'Ivoire, Croatia, Cyprus, Czech Republic, Denmark, Dominican Republic, Ecuador, Egypt, El Salvador, Estonia, Fiji, Finland, France, Germany, Ghana, Greece, Guatemala, Guinea-Bissau, Guyana, Haiti, Honduras, Hungary, India, Indonesia, Iran, Israel, Italy, Jamaica, Japan, Kenya, South Korea, Latvia, Lithuania, Madagascar, Malawi, Mali, Malta, Mauritius, Mexico, Morocco, Nepal, Netherlands, New Zealand, Nicaragua, Niger, Nigeria, Norway, Oman, Pakistan, Panama, Peru, Philippines, Poland, Portugal, Romania, Russia, Rwanda, Senegal, Slovenia, South Africa, Spain, Sri Lanka, Sweden, Switzerland, Syria, Tanzania, Thailand, Togo, Trinidad and Tobago, Tunisia, Turkey, Uganda, Ukraine, United Arab Emirates, United Kingdom, United States of America, Uruguay, Venezuela, Zambia, Zimbabwe. 17 Unless otherwise stated, following descriptions are based on FAOSTAT web site: http://faostat.fao.org/.

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phosphate fertilizers and potash consumption18 reported by FAO (ResourceSTAT). Data are expressed in metric tons. Livestock is measured as number of different animals kept for agricultural production expressed in cow equivalents. The original data come from FAO database (ResourceSTAT). To calculate the aggregate numbers, following weights are used: 1 horse = 1 mule = 1 buffalo = 1.25 cattle = 1.25 asses = 0.9 camels = 5 pigs = 10 sheep= 10 goats = 100 chickens = 100 ducks = 100 geese = 100 turkeys (Hayami & Ruttan, 1985, cited in Vollrath, 2007, p. 214). An alternative method of weighting livestock is suggested by Craig, Pardey, and Roseboom (1997). They divide animals into those used primarily for traction and those that provide breeding services.19 Vollrath states that, in case of his analysis, "using the Craig, Pardey, and Roseboom (1997) livestock measures does not materially impact the results of the regressions." (Vollrath 2007, p. 214) We assume that this holds for the present analysis as well, and thus, we do not use these alternative weights. Permanent crops and land equipped for irrigation are used as further measures (or rather proxies) of capital. "Permanent crops" reported by FAO (ResourceSTAT) is the land cultivated with long-term crops which do not have to be replanted for several years (e.g. cocoa, coffee), trees and shrubs producing flowers (e.g. roses, jasmine); and nurseries (except those for forest trees). The land equipped for irrigation is the "Total area equipped for irrigation" reported by FAO (ResourceSTAT). It is the area equipped to provide water to the crops via irrigation. It includes areas equipped for full and partial control irrigation, equipped lowland areas, pastures, and areas equipped for spate irrigation. Data for both variables are expressed in 1000 hectares. Note on output and capital measures: There is an alternative approach to measuring output and capital used in papers by Mundlak, Larson, and Butzer (1997, 2008). These authors use agricultural GDP in 1990 US dollars for output. They prefer GDP to frequently used agricultural production because it comes from national accounts which they have also used for the construction of the fixed capital variable. These authors have constructed their own series of capital in agriculture (Crego, Larson, Butzer, & Mundlak, 1998) based on national accounts data on investment for fixed capital (also denoted as "structures and equipment"). They also use their own series of capital in livestock and in trees; livestock being priced by regional trade prices and the value of an orchard is assumed to be the discounted stream of future net revenues. Environment and technology. This paper uses the Human development Index (HDI) as the main technology shifter. The HDI is published by United Nations Development Program in its Human Development Reports. The HDI is a composite index that measures average achievements in three basic aspects of human development: health, knowledge and a "decent standard of living". Health is 18

These are the main types of fertilizers used in agriculture. They account for more than 50 % of fertilizers consumption in the world. The same measure is used in Mundlak, Larson, and Butzer (1997) and Vollrath (2007). 19 "Livestock serve many different purposes in agriculture, and so care must be taken in measuring and interpreting stocks of animals as inputs in agriculture. Animals on farms provide traction, fertilizer, breeding, recreation, and banking services (as stores of wealth) as well as representing part of output. We have no reliable information on agricultural use of animal manure, but we have partitioned animals into those used primarily for traction and those that provide breeding services. Any livestock that serve neither function are properly treated as part of output but not inputs." (Craig, Pardey, & Roseboom, 1997, p. 1067)

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measured by life expectancy at birth; knowledge is measured by a combination of the adult literacy rate and the combined primary, secondary and tertiary enrolment ratio; and standard of living by GDP per capita.20 In this paper, we use data from Human Development Report 2007/2008 (Table 2, p. 234-7) that were calculated using a consistent methodology and data series. As mention above, the most important measure of institutional environment used here is the Economic Freedom Index (EFI) that comes from Fraser Institute’s Economic Freedom of the World reports. Economic freedom is rated on scale from 0 to 10; the higher the score is the freer the country is. Construction of the EFW index is described above. Here we only pause for a comment on comparability of this index over time. The EFW index has evolved over time and it has become more comprehensive and the available data more complete. Therefore, authors have chain-linked the data to assure comparability across time. The base year for the chain-link index is 2004. The chain-linked methodology guarantees that a country’s rating will change across time periods only when there is a change in ratings for components present during adjacent years. This allows us to use the index for comparisons across time periods. (Gwartney & Lawson, 2008, p. 13) The chain-link index is also used in this analysis. 21 To measure political and civil society institutions this paper employs the Freedom in the World (FIW) – Political Rights (PR) rating and Civil Liberties (CL) rating published by the Freedom House.22 Political rights and civil liberties are defined by the authors as follows: "Political rights enable people to participate freely in the political process, including the right to vote freely for distinct alternatives in legitimate elections, compete for public office, join political parties and organizations, and elect representatives who have a decisive impact on public policies and are accountable to the electorate. Civil liberties allow for the freedoms of expression and belief, associational and organizational rights, rule of law, and personal autonomy without interference from the state." (Freedom House, 2008)

The ratings process is based on a 10 questions on political rights (concerning electoral process, political pluralism and participation and functioning of government) and 15 questions on civil liberties (concerning freedom of expression and belief, associational and organizational rights, rule of law and personal autonomy and individual rights). Points produced from these questions are compared to previous survey and a change in points is made only if there has been a real world development. Also changes to the methodology are introduced incrementally in order to ensure the comparability of the ratings from year to year. The final rating ranges from 1 for the most free to 7 for the least free. Other possibly relevant variables not included. There are many other state variables that could (and maybe should) have been included in the present analysis. Let us briefly mention some of those used in literature. As a technology measure, it is possible to use peak yield and schooling23 (Mundlak, Larson, & Butzer 1997, 2008), research and development expenditures (Vollrath, 2007), and land distribution (as 20

For details on index construction see Human Development Report 2007/2008, or information on the HDI available online at: http://hdr.undp.org/. 21 The chain-link index is available from the latest Economic Freedom of the World report (Gwartney & Lawson, 2008, p. 14-16) and online at http://www.freetheworld.org/. 22 These ratings are available online at http://www.freedomhouse.org/. 23 This measure is reflected in the present analysis in the Human Development Index.

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shown in Vollrath, 2004, 2007). Physical environment measures may include potential dry matter and water availability variables (Mundlak, Larson, & Butzer, 1997, 2008) or some measures of land quality (used e.g. in Vollrath, 2007; extensive analysis in Wiebe, 2003). Economic environment, or motivation, can be introduced using relative prices in agricultural and non-agricultural sectors (i.e. trading terms of agriculture), price variability and inflation (Mundlak, Larson, & Butzer, 1997, 2008). It is also possible to employ variable for wealth or income distribution, such as Gini coefficient (Allcott, Lederman, & Lopez, 2006). There are some alternative, or additional, institutional measures as well. They include variables for democracy, different forms of government (measures of political competition, presidential or parliamentary regime, federal or unitary government), and government expenditures (Allcott, Lederman, & Lopez, 2006). Quality of institutional environment may also by represented by legal origin (Vollrath, 2007) or presence of armed conflict (Wiebe, 2003). Empirical Results We test our hypotheses using the data described in previous section. The sample used has total of 509 observations. It is an unbalanced panel with 104 countries, each with data for two to six time periods.24 This section starts with the summary statistics for productivity of land, followed by examination of scatter plots of land productivity against institutional variables. After that we estimate the model specified above. The summary statistics for the productivity of land are given in the Table 1. The inputs are calculated per units of land. This form of presentation is chosen to demonstrate the extensive variation among individual observations.25 It is clear that different countries employ very different amounts resources in agricultural production. It is also obvious that human development and institutional environment is very diverse. Table 1. Summary Statistics for Output and Inputs per Ha and Institutional Variables Variable Production per ha (intl. $) Labor per 1000 ha (number) Tractors per 1000 ha (number) Fertilizers per 1000 ha (tons) Livestock per 1000 ha (cow equivalents) % Permanent Crops % Land Equipped for Irrigation Human Development Index Economic Freedom Index FIW Political Rights FIW Civil Liberties

Mean 687.44 397.30 19.92 59.95 909.74 8.03 9.46 0.69 5.70 3.30 3.46

SD 913.10 630.99 44.47 84.02 889.87 9.75 15.57 0.18 1.22 2.13 1.78

Min 5.83 0.91