variables reflecting the institutional framework in pairs of countries. We prefer including
the natural log of distance in the model, because it slightly improves the overall explanatory
power of the model. The alternative specification choices of Table 2 receive specific
attention in Appendix B.
5. The Role of Institutions
In this section we discuss the explanatory role of institutional quality and institutional
homogeneity for the intensity of bilateral trade.
A better quality of the institutional framework reduces uncertainty about contract
enforcement and general economic governance. This reduces transaction costs directly, by
increasing the security of property, as well as indirectly, by increasing the level of trust in
the process of economic transactions. Interpersonal trust has a complex origin in both
culture, economic behaviour and governance, and may not be perfectly correlated to the
actual quality of formal institutions (e.g., Linders et al., 2002; Den Butter and Mosch,
2002). However, Knack and Keefer (1997) provide evidence for mutual dependence
between formal rules, informal norms and trust. They show that perceived quality of formal
institutions is positively related to informal institutions, such as civic norms, and trust. The
lower trade costs that result from a better quality of governance increase trade from or with
the country in question.
Homogeneity in the perceived quality of institutions (cf. Beugelsdijk and Van Schaik,
2001) may both reflect and give rise to similar norms of behaviour (conventions, business
practices) and similar trust in doing business (Linders et al., 2002). Familiarity with and
sharing of informal habits and procedures of business reduces uncertainty in bilateral
transactions, and adjustment costs between trading partners, independent of whether formal
rules are effective or not. This may increase interpersonal trust in doing business together,
and positively affects international trade.9
Table 3 presents the results for a gravity model as before, which is supplemented with
variables for institutional quality and homogeneity. The respective specifications each
include an indicator that reflects the perceived quality of a country’s institutional
framework. The variable relevant for each specification is given in the first row. The
indicator is included in the regression as a variable for the country of origin and the country
10
Bilateral Trade Flows and Institutions