• We have benefited from comments at seminars at Tel Aviv University and at the Hebrew University of Jerusalem. We received especially helpful suggestions from Ephraim Kleiman. The views expressed are those of the authors and are not necessarily those of the Federal Reserve or its staff.


This paper develops a model for studying colonial investment in which the metropolitan government restricts the amount of investment in the colony in order to maximize the net profits earned in the colony. The model explicitly includes the threat of subversive activity by the indigenous colonial population. The analysis suggests why historically some countries but not others became colonies and why many colonies that were initially profitable subsequently become unprofitable and were abandoned. The model also has implications for the amount of investment in colonies, the allocation of indigenous colonial labor between production and subversive activity, and the distribution of income between colonial firms and the indigenous population.