levels of institutional quality may be familiar with each others business practices. This
reduces transaction costs.
We find that institutional quality has a significant, positive and substantial impact on
bilateral trade flows. The same goes for similar quality of governance, although this
depends a bit on which indicator for governance one applies. These results support the
thesis that intangible factors are important barriers to trade, and help to explain the missing
trade mystery.
An important implication emerges from our separate focus on country-specific quality of
institutions and bilateral homogeneity of governance. Although bad governance
substantially lowers the possibility to benefit from trade, countries that share this feature
may partially offset the negative effects because of a shared history and experience in
developing informal procedures to cope with uncertainty and transaction costs. This
supports an evolutionary view of (informal) institutional development (e.g. North, 1990).
Notably, this effect does not occur when two countries lack a similar experience, pointing
at the importance of adjustment costs and trust in international trade (cf. Den Butter and
Mosch, 2002). Although this informal evolution of norms and business practices has
benefits in partly offsetting negative effects of governance on trade, it also has some
potentially important drawbacks. The ‘homogeneity effect’ creates trade divergence and
path dependence. Countries with poor (or good) formal institutions, all else equal, tend to
trade more with other countries that have a similar experience. Because of other negative
effects of poor governance on long term economic performance, these countries may
become locked into a situation of low economic performance. Since they under-trade with
countries that have good institutional prospects for high economic performance, they may
miss out on beneficial technology spillovers through trade (cf. Lejour and Nahuis, 2000).
This provides an additional argument for serious policy concern with the international
promotion of good governance.
Further research on the influence of institutions on trade patterns can also focus on
sector patterns of trade in merchandize. Tradability differs a lot across different sectors. As
a result, parameter estimates for distance may vary substantially in size and importance.
Some products can easily be transported in large quantities at a time. Here, the costs of
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Bilateral Trade Flows and Institutions