Institution and economic growth

Small firms are subcontractors either in their direct or indirect relation against large firms. They develop new technologies if doing so is incentive compatible, i.e. if entitled to the rents they generate by putting an extra effort to innovate. Therefore, in the program in which large firms decide the level of small firms’ effort to contract for, they must ensure that small firms enjoy a part of the rents and they remain incentivized to develop new technologies. To the extent that technologies help raise profits, it is rational for managers to do so. They often don’t, however, in reality. Such myopic behavior undermines large-firms’ long-term profits. As a result, both large and small firms are worse off. It is therefore necessary that lawmakers and regulators jump in and restrict large firms’ behavior by legislation (e.g. punitive damages) and enforcement. In so doing, a ground is maintained over which small businesses continue to innovate, grow to hire people and spawn skilled labor and entrepreneurs, and eventually let the economy grow. The contractual relationship between small and large firms highlights why and how the institutional devices of legislation and enforcement are critical for economic growth. Their quality are particularly important for developed economies, which are little aided by population inflation, the strongest booster for growth, and among the main features that distinguish developed economies that continue growing against those that don’t.

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