Private Incentives versus Class Interests: A Theory of Optimal Institutions with An Application to Growth

We build a dynamic political economy model with a two-class society: workers and the elite. A key feature of the model is that the formation of the elite, the rate of innovation, taxes and public spending are endogenous. Differently from most of the literature on institutions and growth which emphasizes the conflict between different classes, we focus on the tension between private incentives of the members of the elite and their class interests. Our model explains the observed differences in colonization strategies by showing how the optimal choice of institutions depends on the initial conditions faced by colonizing powers. The model also creates a mapping between institutions and economic outcomes which is consistent with the observed differences in the patterns of economic growth.