The Impact of Institutions on Innovation

By Alexander Donges, Jean-Marie A. Meier and Rui C. Silva. Donges is from the University of Mannheim; Meier and Silva are from London Business School. Excerpts:

"Abstract 

This paper studies the impact of institutional reforms on innovation. We use the timing and geography of the French occupation of different regions of Germany after the French Revolution of 1789 as an exogenous shock to the institutions of those regions. Combining novel county- level data on Imperial Germany with data on patents per capita, we show that counties whose institutions are more inclusive as a result of the French occupation become more innovative. The institutional reforms that are associated with comparing a county with no occupation to a county with the longest occupation, result in a 129% increase in the number of patents per capita. This result is robust to alternative explanations, such as reverse causality, human capital and financial development. Our findings point to institutions as a first order determinant of innovation and highlight the role of innovation as a key mechanism through which institutions may lead to economic growth."

"Conclusion

In this paper, we empirically investigate the impact of institutions on innovation. We use the French
occupation of parts of Germany in the early 19th century as a source of exogenous variation in the
inclusiveness of local institutions. Regions that were occupied longer were early adopters of reforms
that led to more inclusive institutions, creating an economy with fewer barriers to entry and fewer
distortions in local labor and product markets.

These improvements in the quality of institutions in turn affected innovation in the long-run.
Our results show that counties that were occupied the longest (19 years), and as a consequence
put in place better institutions earlier on, had 129% more patents per capita than counties with
worse institutions due to zero years of French occupation. We provide evidence that our results
are unlikely to be driven by other potential confounding effects that could have been affected by
the French occupation. These alternative explanations include reverse causality through economic
growth, French influence beyond institutions such as culture or knowledge transfers, trade and market
integration, differences in the level of human capital across regions, and financial development.
Our results thus point to institutions as a first order determinant of innovation. The findings
in our paper are also relevant to understand the channel by which institutions may affect growth.
Our results support the view that a way through which better institutions may lead to economic
growth is by promoting a free market system and creating an economic environment more conducive to innovation.

An open question for future research is the identification of 'mediators' between more inclusive
institutions and innovation, or, to put it differently, to identify micro-economic channels through
which institutions affect innovation. For example, shorter and fairer trials that reduce transactions costs could lead to higher levels of investment in R&D; better institutions could be related to stricter
scrutiny and higher accountability of public officials leading to a more efficient provision of public
goods; and lower frictions in labor markets could lead to a more efficient allocation of talent in the
economy. Exploring the precise mechanisms that link the inclusiveness of institutions to innovation
remains a fruitful avenue for future research."