We construct a dynamic general equilibrium model with incomplete contracts to examine the interaction between factor accumulation, institutions of contract enforcement, and political-economy frictions. In the cross-country data, an economy’s exposure to enforcement frictions is correlated with the degree of industrialization. Theoretically, we find the incompleteness of contracts leads to underinvestment in relation-specific capital and causes production inefficiency due to misallocation. Misallocation occurs through two channels: unbalanced inputs for each product and unbalanced production across products. In addition to production inefficiency, the imperfect contract enforcement leads to distortions in factor supplies. We analyze the dynamic patterns of enforcement institutions by allowing the government to invest in the improvement in the contractual environment (“institutional capital”). We analyze how different types of governments choose different patterns of institutional investment over time. A higher level of institutional capital can enhance industrialization through directly improving production efficiency and indirectly encouraging physical capital accumulation. As institutional capital is accumulated, the economy shifts production toward industries that are more vulnerable to contractual enforcement. We highlight the role of government commitment in the equilibrium accumulation of institutional capital.
- Incomplete contract