The Institutional Determinants of Bilateral Trade Patterns

theory of comparative advantage can provide a theoretical rationale for the gravity model of
bilateral trade.

In general, the gravity model considers trade between a pair of countries as an
increasing function of their combined economic size and a decreasing function of their
geographical distance (Frankel and Rose, 2002). Also, other variables that relate to either of
the two countries may enter into the equation (Frankel et al., 1997; Smith, 2002). From the
set of possible other variables that could enter into the gravity equation, this paper
especially emphasizes variables that reflect institutional quality and institutional similarity.
Both institutional quality and cultural or institutional heterogeneity influence the costs of
trading, though these costs are different in nature than the transport costs associated with
physical distance. Property uncertainty, doubts concerning the quality of governance, and
lack of common norms result in relatively high transaction costs associated with trade
relations.

This paper is organised as follows. Section 2 illustrates the motivations for studying the
impact of institutional performance on international trade flows. Subsequently, the paper
discusses the indicators of institutional quality that have been used in the analysis. In
sections 4 and 5, we present and discuss the regression results for alternative specifications
of a basic and extended gravity model, respectively. In the last section, the conclusions are
presented, and some further extensions for research on the role of institutions for trade are
proposed.

2. Institutions, Economic Performance and Trade

The impact of institutions on transaction costs has received a lot of attention in the
literature on economic growth and development (e.g., Olson, 1982). Institutions and policy
mechanisms, labelled social infrastructure, are recognized as background variables for
productivity and growth (Hall and Jones, 1999; Olson, 1996; Knack and Keefer, 1995).
Transaction costs arise fundamentally due to opportunistic behaviour in the market and
because of uncertainty in the general economic environment. Hence, security of property
rights and enforcement of private contracts are central objectives in a sound framework of
formal institutions (see North, 1990). But good governance also requires sound and neutral
economic policies, which demands independence and autonomy for government structures.

Bilateral Trade Flows and Institutions

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