Given the complexity of effects that changes in the business climate elicit, different firms, industries, and regions will be affected in different ways. Moreover, business climate–fueled growth is not simply a shift toward some technological frontier. Developing countries must overcome or reduce all kinds of obstacles to efficiency, dynamic and otherwise, without any illusions that the economy will soon arrive at a frontier. Indeed, changes in the investment climate may have their most crucial impact far from the technological frontier.

A weak business climate, on the other hand, may not only discourage investment, it can also lead businesses to take costly or counterproductive steps to defend themselves from the consequences of its weaknesses. If social order and control are weak, firms typically have to invest heavily in defensive measures such as private security (as in parts of Latin America or the former Soviet Union). If the power supply is unreliable, firms will invest in their own generating capacity (as in many parts of South Asia). If it is difficult to get goods through or to ports, trade is discouraged (as in many countries in Sub-Saharan Africa) and larger, more costly inventories are held. Many such constraints on development are not quickly or easily reversed.

To formalize the idea of an economy in which the business climate significantly impacts output and productivity – the key hypothesis in the recent literature – it makes sense to present a simple aggregate model that explicitly includes the business climate, using an approach that is standard in endogenous growth theory.<sup>2</sup> It should be noted that aggregate growth models inevitably involve production possibility frontiers, and as discussed, in developing economies crucial economic gains may take place far from some hypothetical technological or efficiency frontier. Moreover, more specific questions may have to appeal to different and more disaggregated models – each with its own insights – rather than shoehorning all interesting phenomena into one particular model. The following aggregate model, however, does provide a broad sense of the main economic relationships investigated by the literature surveyed below. Even microeconomic studies that focus exclusively on firm level variations in productivity and growth implicitly hypothesize a macro relationship of this type in the aggregate.

Suppose that output, Y, is a function of the capital stock, K, labor, L, and the business climate, as measured by a single variable M. We write this function, where t is time, as: Note that we implicitly distinguish between the non-infrastructure aggregate capital stock, K, and the infrastructure capital stock KI, which is a determinant of M.<sup>3</sup> As the output function is written here, the business climate affects both output and productivity levels, through the function F( ), and the rate of change of output, through the function α( ). To keep things simple, we can portray the rate of change of the business climate in the model as being governed by: • (2) _M_ = g (μ, M(μ, x), Y),

> 2  See Aghion and Howitt, 1998. Also Stern, Dethier and Rogers, 2005: 207. 3 Straub, S. 2008: 6-8

3