The Institutional Determinants of Bilateral Trade Patterns

Provided by Research Papers in Economics

The Institutional Determinants OfBilateral Trade Patterns

paper to be presented at the ERSA 2003 Congress
in Jyvaskyla, Finland

Henri L.F. de Groot^a, Gert-Jan Linders^a, Piet Rietveld^a and Uma Subramanian^bl
a Department of Spatial Economics, Vrije Universiteit, The Netherlands
^b World Bank, Washington, United States

Abstract

This paper studies the effect of institutions on trade flows, using a gravity model approach. We start from a
standard gravity equation that incorporates geographical proximity, language, trade policy and common
history. These factors reflect the costs of trade across geographical and cultural distances. The quality of
governance and the extent of familiarity with the resulting framework of rules and norms also affect the costs
of doing business between any pair of countries. This paper extends the gravity equation to include proxies
for institutional quality and institutional homogeneity between trade partners. For this, we use indicators on
political stability, regulatory quality, and other proxies that reflect the quality of governance. We test whether
institutional homogeneity and institutional quality have an independent impact on trade volume between pairs
of countries. We find that having a similar law or regulatory framework promotes bilateral trade by 12% to
18%. Furthermore, a better quality of formal institutions on average coincides with higher trade. An increase
in regulatory quality of one standard deviation from the mean leads to an estimated increase of 20 to 24% in
bilateral trade. Lower corruption similarly accounts for 17 to 27% extra trade.

JEL codes: F14

Keywords: bilateral trade flows, gravity model, institutions

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