The Institutional Determinants of Bilateral Trade Patterns

government effectiveness to familiarity with actual formal procedures, and with informal
solutions, need not be so strong. The effect of homogeneity is indeed clearest for the
indicators that directly relate to government output, regulatory quality and rule of law. A
common extent of corruption may reduce adjustment costs between trading partners, but
does not necessarily reduce uncertainty and increase trust in bilateral transactions. The
arbitrary and external nature of corruption affecting transactions does not generally lead to
informal norms, conventions and procedures of business to surround the problem posed by
this aspect of bad governance. On the contrary, corruption is an informal procedure
following from bad governance: if one encounters corruption in a transaction, one generally
must comply in order to successfully complete the transaction. Corruption poses external
transaction costs to bilateral transactions. Consequently, common experience in the extent
of corruption need not have a definite positive impact on trade.

6. Conclusions

Although the world economy has further integrated towards one global market,
international trade is not nearly as large as it should be, on the basis of purely objective
differences in resource endowments, and taking into account objective resistances to trade
caused by transport costs and formal barriers to trade. Economists have come to refer to this
as the ‘mystery of the missing trade’.

Several observers have drawn the conclusion that subjective resistance exists towards
international trade, caused by intangible factors (e.g. Deardorff, 2001 and Rauch, 2001).
Often, they refer to the institutional framework for explanations. This paper has therefore
intended to explicitly investigate the effect of institutions on the patterns of trade. It starts
from the argument that the quality of formal rules that govern economic interaction is an
important determinant of the uncertainty and opportunism in market exchange. A low
quality of governance increases the transaction costs that are incurred in exchange.

The impact of institutions on private trade and investment is argued to be at least as
important in international exchange as in domestic transactions. Moreover, the quality of
formal rules affects the informal norms and procedures of doing business that are devised to
cope with transactional uncertainty. This creates the possibility that countries with similar

Bilateral Trade Flows and Institutions

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