Industrialization and the Evolution of Enforcement Institutions∗

We analyze the evolution of economic institutions during the process of industrialization. In particular, we focus on the institution of contract enforcement. Empirically, we show that, during the process of industrialization, countries tend to shift their manufacturing production towards industries that require more relationship-specific investment. Theoretically, we build a dynamic model with incomplete contracts and evolving institutions to account for this pattern. In our model, the incompleteness of contracts leads to two types of misallocations that generate production inefficiency: unbalanced use of inputs and unbalanced production of different goods. In addition to this production inefficiency, the imperfect contract enforcement leads to distortions in factor supplies. The model can replicate the empirical patterns when we allow for the government to invest in enforcement institutions in order to improve the contractual environment. We also analyze how different types of governments, in terms of ability to control physical investment and ability to commit to future policies, choose different patterns of institutional investment over time.