1. Introduction
International trade has grown rapidly over the previous decades, outpacing growth in
world output in both goods and services. Declining costs of transportation and
technological advances in ICT are often quoted as explanatory factors for the recent trend
of international economic integration. Still, Rauch (2001) points out that the intensity of
international transactions remains lower than could be potentially expected on the basis of
physical distance. He refers to intangible costs of transacting that may be responsible for
‘under-trading’ across national borders. Trefler (1995) refers to this as the ‘mystery of the
missing trade’. Specifically, the relatively low intensity of foreign trade may reflect the
importance of institutions for the operation of networks of business in international
markets. For example, domestic formal institutions affect security and enforcement of
property rights, and other aspects of the quality of governance. They influence the
uncertainty that surrounds transactions in both domestic and international trade.
Furthermore, formal rules affect informal norms of behaviour and interpersonal trust, which
influence the mores and conventions of doing business. These, in turn, may also impact on
risk perceptions and preferences in international transactions.
In this paper we investigate the hypothesis that institutions matter for international trade.
For this, we implement gravity equations to analyse bilateral trade patterns empirically.
Statistics that feature both origin and destination of trade allow us specifically to investigate
the influence of institutions on the patterns of cross-border transactions. The “gravity
model” of bilateral trade is inspired by Newton’s equation of gravity in physics, which
relates the gravity force with which two bodies attract each other proportionately to the
product of their masses, and inversely to the square of their distance. How does this
translate into economics? To begin with, geographical distance will be of influence for the
intensity of bilateral economic interaction, since it is related, amongst others, to the costs of
transportation. If we interpret trade between two countries as the economic analogue for the
mutual gravitational force between two bodies, whereas their respective GDPs reflect mass,
we see the intuitive rationale for a gravity model of bilateral trade2. Although the model has
always performed well empirically, its theoretical underpinnings were doubted until
recently. Amongst others, work by Helpman and Krugman (1985) and Deardorff (1998) has
shown that both new trade theories of product differentiation and classical Heckscher-Ohlin
Bilateral Trade Flows and Institutions