Development Economics (Fall 2023)

Prof. Iwan Jaya Azis

Vetry Yoel Halomoan

Homework #2
1. Institutional Factors in Development

a. Explain what is ‘local capture’ under a decentralization system and how it plays a role in
the “Institutional Model of Decentralization” (IMD); use as much as possible the example
of cases in Indonesia

Answer:
Local capture (L) is a phenomenon that occurs when local elites or interest
groups (Q, P) capture the decision-making process in a decentralized system (D),
leading to the subversion of the public interest. In the context of the Institutional Model of
Decentralization (IMD), local capture is a potential danger that can undermine the
effectiveness of decentralization. The IMD is a framework that outlines the components
and principles of a successful decentralization process. It emphasizes the importance of
institutional design, political incentives, and fiscal arrangements in achieving the goals of
decentralization.
Indonesia is a country that has undergone a significant decentralization process
since the late 1990s. The decentralization policy aimed to transfer authority and
 responsibility for public functions from the central government to local governments. The
decentralization process in Indonesia has been accompanied by challenges, including
the issue of local capture. Studies have shown that local elites have captured the
decision-making process in some regions, leading to the subversion of the public
interest.
The IMD identifies several components and principles that are essential for a
successful decentralization process. These include:
● Institutional design: The design of institutions at the central, regional, and local
levels should be aligned with the goals of decentralization. This includes the
establishment of clear and legally recognized geographical boundaries for local
governments, the creation of effective intergovernmental relations, and the provision of
adequate resources to local governments.
● Political incentives: The decentralization process should create incentives for
local leaders to act in the public interest. This includes the establishment of democratic
processes for the selection of local leaders, the provision of accountability mechanisms,
and the promotion of citizen participation in decision-making.
● Fiscal arrangements: The decentralization process should provide adequate
fiscal resources to local governments to enable them to carry out their functions
effectively. This includes the establishment of revenue-sharing mechanisms, the
provision of grants, and the creation of a system of intergovernmental transfers.
Local capture can undermine the effectiveness of decentralization by creating a
situation where local elites capture the decision-making process and act in their own
interests rather than the public interest. This can lead to the misallocation of resources,
the subversion of democratic processes, and the perpetuation of inequality in welfare
(W).

b. What are the ‘quantity’ and ‘quality’ parts of the welfare equation in the IMD, and explain
the mechanism through which each of them will determines the regional welfare under a
decentralization system with local capture.
Answer:

1.) Quantity Equation

The quantity and quality parts of the welfare equation in the IMD refer to the two
components that determine the level of welfare in a region. The quantity part refers to
the amount of budgets and resources available in a region, while the quality part refers
to initial welfare, participation (P), and local capture (L), it measures the level of
efficiency and effectiveness of local government. Under a decentralization system with
local capture, the mechanism through which each of these components determines
regional welfare is affected by the actions of local elites who may capture resources and
use them for their own benefit, rather than for the benefit of the wider population. An
example of this can be seen in Indonesia, local capture is a concern in public good
provision. People's participation is the most important factor that determines whether the
system produces positive or negative local capture. The size of the local budget and
initial welfare condition also matter. To achieve a low degree of local capture, it is
essential to improve the initial welfare condition and increase people's participation. The
IMD identifies three essential components and principles for a successful
decentralization process: institutional design, political incentives, and fiscal
arrangements. Local capture can undermine the effectiveness of decentralization by
creating a situation where local elites capture the decision-making process and act in
their own interests rather than the public interest.
In a democratic system like Indonesia, decentralization is so far
welfare-enhancing only for more developed regions, not for all, suggesting that a serious
institutional reform is needed (Iwan J. Azis, 2010).
2. Inequality and Development

a. What is the difference between the classical approach and modern approach of the link
between inequality and growth, and give some examples to clarify your answers
Answer:
Poverty and inequality have been linked to economic growth in several ways.
Classical economic theory suggests that income inequality is good for growth because
the rich will save, leading to investment, which in turn leads to growth. This approach
emphasizes the role of incentives and the potential for benefits to "trickle down" to all
members of society, including the less affluent. In contrast, modern economic theory
suggests that excessive inequality can reduce overall consumer demand, leading to
decreased demand for goods and services, which negatively affects economic growth.
High levels of inequality can also result in social unrest and instability, which can disrupt
economic growth.
Empirical research has challenged the belief that income inequality has a
negative effect on growth and confirmed the validity of the Kuznets curve, which
suggests that inequality initially increases with economic growth but eventually
decreases. The relationship between economic growth and income distribution is critical
for poverty reduction. While growth has been the dominant force in poverty reduction,
reductions in inequality have great potential to reduce poverty.
Both classical and modern approaches have influenced economic policy in
different ways, and the approach taken often varies depending on a country's economic
and political context.

b. Of several factors explaining the growing income inequality in many countries around the
world, including Indonesia, the fast growing financial sector is considered one of them.
By using some examples, explain why this is so.
Answer:
The fast-growing financial sector is considered one of the factors explaining the
growing income inequality in many countries, including Indonesia, due to the following
reasons;
First, financial sector size relative to the economy. A study by the International
Monetary Fund (IMF) found that the financial sector can play a role in reducing inequality
by expanding the provision of financial services to low-income households and small
businesses, helping create a more inclusive society. However, if not well managed, it can
amplify inequalities. This suggests that as the financial sector grows, it can contribute to
both reducing and increasing income inequality, depending on how it is managed.
Second, access to and use of financial services by individuals and firms. The
expansion of the financial sector can lead to increased access to financial services,
which can benefit individuals and firms in terms of investment, credit, and risk
management. However, if this expansion is not accompanied by policies that ensure
equal access to financial services for all segments of the population, it can exacerbate
income inequality.
Third, Financial structure and type of financing (bank lending vs. market-based
financing). A study by the Bank for International Settlements (BIS) found that the
relationship between financial structure and income inequality is not monotonic. Up to a
point, more finance (both bank- and market-based) reduces income inequality. Beyond
that point, inequality rises if finance is expanded via market-based financing, while it
does not when finance grows via bank lending. This suggests that the type of financing
can influence the impact of the financial sector on income inequality.
Lastly, Financial sector pay and labour income inequality. The level of earnings in
the financial sector and the implications for labour income inequality have been a subject
of analysis. A paper by the OECD found that financial sector workers make up a
significant share among the top 1% earners, although the overall employment share of
finance is relatively small. The contribution of financial sector pay to income inequality is
limited but noticeable, with most of it explained by financial institutions paying salaries
and bonuses that are above what employees with similar profiles get in other sectors.
This wage premium is more than twice as high for financial sector workers at the top of
the distribution than at the bottom, indicating a high level of wage inequality within the
sector.
EXAMPLE → According to the World Bank, Indonesia's level of inequality is now
considered to be relatively high and climbing faster than most of its East Asian
neighbors. Between 2003 and 2010, consumption per person for the richest 10% of
Indonesians grew at over 6% per year after adjusting for inflation. But for the poorest
40%, consumption grew by less than 2% per year. This has resulted in a sharp increase
in the Gini coefficient over the past 15 years, increasing from 30 in 2000 to 41 in 2013. A
2014 survey on public perceptions of inequality report that most Indonesians consider
income distribution in Indonesia to be "very unequal" or "not equal at all"
The sources of income inequality in Indonesia have been investigated by the Asian
Development Bank (ADB) using household-level data. The results show that education,
wealth, and the employment sector are significant contributors to income inequality in
Indonesia[5]. In addition, a paper by the OECD found that financial sector workers make
up a significant share among the top 1% earners, although the overall employment
share of finance is relatively small. The contribution of financial sector pay to income
inequality is limited but noticeable, with most of it explained by financial institutions
paying salaries and bonuses that are above what employees with similar profiles get in
other sectors.
Therefore, the fast-growing financial sector in Indonesia could contribute to
income inequality through the following ways:
● Unequal access to financial services: If the expansion of the financial
sector is not accompanied by policies that ensure equal access to
financial services for all segments of the population, it can exacerbate
income inequality.
 ● Financial sector pay and labour income inequality: The high level of wage
inequality within the financial sector could contribute to income inequality
in Indonesia.
● Financial structure and type of financing: The type of financing can
influence the impact of the financial sector on income inequality.
Overall, the fast-growing financial sector in Indonesia could contribute to income
inequality if not well managed. Policies that ensure equal access to financial services
and address wage inequality within the financial sector could help mitigate the impact of
the financial sector on income inequality.
References:

[1] Azis, I. J. (2011). Institutional Model of Decentralization in Action. SSRN Electronic

Journal. https://doi.org/10.2139/ssrn.2009114

[2] Green, K. (2005, February 28). Decentralization and good governance: The case of

Indonesia. Munich Personal RePEc Archive. https://mpra.ub.uni-muenchen.de/18097/

[3] Azis, I. J. (2010). INSTITUTION MATTERS: Local Capture in Decentralization.

[4] Hill, H. (2021). What’s happened to poverty and inequality in Indonesia over half a century?

Asian Development Review, 38(1), 68–97. https://doi.org/10.1162/adev_a_00158

[5] Indonesia’s rising divide. World Bank. (n.d.).

https://www.worldbank.org/en/news/feature/2015/12/08/indonesia-rising-divide