Legal Institutions, Sectoral Heterogeneity, and Economic Development

A large body of evidence suggests that poor countries tend to invest less (have lower PPP-adjusted investment rates) and to face higher relative prices of in- vestment goods. It has been suggested that this happens either because these countries have lower TFP in the investment-good producing sectors, or because they are subject to greater investment distortions. What is still to be understood, however, is what are the causes of these shortcomings. In this paper we address this question by providing a micro-foundation for the cross-country dispersion in investment distortions. Our analysis rests on two premises: 1) countries differ with respect to the rights enjoyed by outside investors (such as bondholders andminority shareholders) and 2) firms producing capital goods face a higher level of idiosyncratic risk than their counterparts producing consumption goods. In a model of capital accumulation where the protection of investors rights is incom-plete, this difference in risk induces a wedge between the returns on investment in the two sectors. The wedge is bigger, the lower the investor protection. In turn, this implies that countries endowed with weaker institutions are poorer, face higher relative prices of investment goods, and invest a lower fraction of their income. Our analysis also suggests that the mechanism we study may bequantitatively important