Description

This paper tests a specific channel through which institutions affect output per capita: the role of institutions in firm-level division of production. We argue that weak er institutions increase transaction costs, including those incurred by a firm when de aling with suppliers of intermediate goods. Firms respond to these higher costs by substituting interm ediate goods produced within the firm for those externally supplied, which in turn discourages spec ialization and consequently decreases productivity. To test this channel, we rely on differences across sectors in their capacity to substitute internal goods for intermediate goods. We first create an inde x that measures the 'complexity' of a sector's intermediate structure using data from the United Stat es. Using this index, we find that industries with a more complex intermediate goods structure suffer a relatively larger loss of productivity in countries with poorer institutions.