The Demand for Production Inputs as the Reflection of the Level of Property Rights Protection

Abstract

In this paper, we discuss a mechanism linking the quality of institutions and the composition of demand for production inputs. We construct a simple theoretical model when a company can either produce a capital-intensive, or a labour-intensive good. In the former case, it uses physical and human capital as inputs while in the latter case, it employs human capital and labour to produce output. If property rights are wellprotected the company has higher incentives to start a capital-intensive production, as with a reliable enforcement of the property rights it can acquire a higher return from investing into physical capital. On the contrary, a less reliable protection of the property rights creates a potential threat to the firm as physical capital can be expropriated or arrested to urge the company to share its profits with rent-seekers. Thus, by not investing into physical capital, the company increases its bargaining power vis-a-vis the rentseekers. But in this case, it also needs less human capital, as the latter is in high demand when it complements physical capital. As a result, the insufficiently protected property rights reduce the demand for physical and human capital. And due to the fact that alongside the imperfectly protected property rights the company prefers to produce a labour-intensive product, it demands more labour. We illustrate this result with the case of Venezuela under the presidency of Hugo Chavez where an exogenous institutional shock resulted in sharp deterioration of business environment and led to withdrawal of capital from the country followed by exodus of entrepreneurs, scientists, physicians, journalists, etc. A lot of capital-intensive companies were shut down while the retail and wholesale sectors started playing a more prominent role.