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Journal ArticleDOI

The Institutional Determinants of Bilateral Trade Patterns

01 Feb 2004-Kyklos (Tinbergen Instituut)-Vol. 57, Iss: 1, pp 103-123

Abstract: The intensity of international transactions remains lower than could be potentially justified on the basis of transportation costs alone. This has become known as the ‘mystery of the missing trade’. Transaction costs may be responsible for ‘under-trading’ across national borders. More specifically, the relatively low intensity of foreign trade may reflect the importance of institutions for cross-border transactions. This paper studies the effect of institutions on trade flows, using a gravity model approach. According to the gravity model, trade between any two countries is a function of each country's gross domestic product, the distance between them, and possibly other variables that reflect the costs of trade between them. We start from a standard gravity equation that incorporates variables for geographical proximity, common language, trade policy and common history. These factors reflect costs of trade across geographical and cultural distances. The quality of governance and the extent of familiarity with the resulting framework of rules and norms also affect the costs of doing business between any pair of countries. The effects of institutional quality and similarity on transaction costs may be substantial in international markets. Because of the greater extent of competition and higher uncertainty in international markets, the impact of quality and similarity of institutions on cross-border trade may be relatively pronounced. Therefore, this paper extends the gravity equation to include proxies for institutional quality and institutional homogeneity between trade partners. We use indicators on political stability, regulatory quality, corruption and other proxies that reflect the quality of governance, available from the comparative data set constructed by Kaufmann and others (World Bank, 2002). Variables that capture similarity in the quality of institutions are then constructed from these indicators. We test whether institutional homogeneity and institutional quality have an independent impact on trade volume between pairs of countries. The results indicate that, for example, having a similar law or regulatory framework promotes bilateral trade. Furthermore, a better quality of formal institutions on average coincides with higher trade. JEL codes: F14 Keywords: bilateral trade flows, gravity model, institutions
Topics: Bilateral trade (67%), Gravity model of trade (66%), Commercial policy (63%), Transaction cost (53%), Quality (business) (50%)

Summary (2 min read)


  • Recent research in international economics points at the likely relevance of barriers to trade other than tariffs and quotas.
  • The impact of institutions on transaction costs has received a lot of attention in the literature on economic growth and development (e.g., Hall and Jones 1999 , Olson 1996 , Knack and Keefer 1995) .
  • The authors therefore investigate the hypothesis that institutions matter for international trade 1 .
  • Interpreting trade between two countries as the economic analogue of the mutual gravitational force between two bodies, with their respective GDPs reflecting mass, the authors see the intuitive rationale for a gravity model of bilateral trade 2 .
  • Indicators from 17 different sources, constructed by 15 organisations have been combined, including the sources used by Anderson and Marcouiller (World Economic Forum's Global Competitiveness Report) and Koukhartchouk and Maurel (Heritage Foundation, Economic Freedom Index) .


  • In the empirical analysis that follows, the authors make use of both country-specific and bilateral data from various sources.
  • Since these variables are more or less standard in the literature, the authors do not extensively discuss them here.
  • It reflects whether citizens and business can prevent arbitrariness in the behaviour of government and enforce good governance when needed.
  • It presents the sample means and standard deviations for each of these indicators, together with some tentative illustration of the corresponding cross-country differences in institutional quality.
  • The independent variables are, respectively: national income (Y), income per capita (y), the distance between i and j (D ij ), dummies reflecting whether i and j share: a land border (Adj), their primary language (Lang), membership in a regional Preferential Trade Agreement (PTA), their main religion , and whether they were part of a common colonial empire (Col).


  • Before investigating the effects of institutions, the authors first discuss a set of specifications of the gravity equation that take into account standard variables often applied in the literature.
  • Distance negatively affects the intensity of trade.
  • The result supports the importance of trade costs for explaining the patterns of trade.
  • Standard gravity models also control for other country-specific and bilateral characteristics that may affect trade.
  • Following the introduction of country-specific dummies, the coefficients on the bilateral dummy variables rise, and they become statistically more significant.


  • In this section the authors extend the analysis in the previous section and focus on the explanatory role of institutional quality and institutional homogeneity for the intensity of bilateral trade.
  • 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.
  • If traders in both countries experience similar levels of institutional effectiveness, they are better equipped to use each other's institutions, to operate in each other's institutional environment.
  • This price markup depends on two factors.
  • Anderson and Marcouiller refer to the instrumental roles that can be played in this matter by language commonality and contiguity.

4.1 The effects of institutional quality

  • 8. This confirms the finding by Tamirisa and Wei (2002) that corruption is an important informal barrier to trade.
  • A possible solution for the missing theoretical explanation why rich countries trade more has been found.

4.2 The effects of institutional homogeneity

  • Alternatively, differences in institutional quality only start to have independent negative effects on trade, when the difference becomes really large.
  • Then, unfamiliarity adds an extra dimension to the transaction costs of bilateral trade.
  • Adjustment costs, and additional lack of trust and confidence in the security of transactions begin to accumulate when differences in the institutional environment between exporters and importers increase.


  • Recent research draws attention to the importance of informal barriers to international trade, caused by intangible factors.
  • An important implication emerges from their separate focus on country-specific quality of institutions and bilateral homogeneity of governance.
  • This reflects the adjustment costs and extra uncertainty involved when traders do not share a sufficiently effective institutional framework.
  • Institutional dissimilarity affects trade between countries with the best institutional quality and those that have the lowest effectiveness.
  • Potential trade between these countries is diverted to partners closer in terms of institutional effectiveness.

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The Institutional Determinants of Bilateral Trade Patterns
de Groot, H.L.F.; Linders, G.J.M.; Rietveld, P.; Subramanian, U.
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de Groot, H. L. F., Linders, G. J. M., Rietveld, P., & Subramanian, U. (2004). The Institutional Determinants of
Bilateral Trade Patterns. Kyklos, 57(1), 103-123.
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Download date: 09. Aug. 2022

KYKLOS, Vol. 57 - 2004 - Fasc. 1, 103–124
G4_HS:Aufträge:HEL002:15174_SB_Kyklos_2004-01:15174-A03:Kyklos_2004-01_S-003-146 29.11.96 28. Januar 2004 09:12
The Institutional Determinants
of Bilateral Trade Patterns
Henri L. F. de Groot, Gert-Jan Linders,
Piet Rietveld and Uma Subramanian*
Recent research in international economics points at the likely relevance of bar-
riers to trade other than tariffs and quotas. Rauch (2001) focuses on the impor-
tance of information costs that are related to physical (and cultural) distances.
Deardorff (2001) argues that international trade patterns to a large extent de-
pend on largely unobservable trading costs, instead of factor endowments and
technology. On the same note, Anderson (2001) states that informal trade bar-
riers appear to be very large even between similar countries, such as the US and
Canada. Thus, informal trade barriers may help explain the home bias or border
effect in trade (McCallum 1995). Also Obstfeld and Rogoff (2000) highlight
the possible role of unobserved trade costs in sorting out some of the apparent
puzzles in international economics.
The unobserved barriers to trade are often related to incomplete or asymmet-
ric information and uncertainty in exchange. North (1990, 1995) argues that,
because of imperfect insight and incomplete information, people form institu-
tions. He defines institutions as ‘humanly devised constraints that shape human
interaction’ (1990, p. 3). These rules of the game are intended to reduce the un-
certainty in exchange, and lower transaction costs. The impact of institutions on
transaction costs has received a lot of attention in the literature on economic
growth and development (e.g., Hall and Jones 1999, Olson 1996, Knack and
Keefer 1995). This literature builds on the notion that poor governance entails
negative externalities for private transactions, and consequently raises transac-
* Corresponding author: Henri L. F. de Groot, Department of Spatial Economics, Vrije Univer-
siteit, De Boelelaan 1105, 1081 HV Amsterdam, The Netherlands, Tel: +31 20 444 6168 (6090),
Fax: +31 20 444 6004, Email: Gert-Jan Linders and Piet Rietveld: Dept of
Spatial Economics, Vrije Universiteit and Tinbergen Institute. Uma Subramanian: World Bank,
Washington. We are grateful to an anonymous referee of this journal for useful and stimulating
comments on an earlier version of this paper. Furthermore, we thank Silvia Stiller and partici-
pants of the ERSA 2003 conference for comments on an earlier draft. Seite 103 Mittwoch, 28. Januar 2004 9:15 09

G4_HS:Aufträge:HEL002:15174_SB_Kyklos_2004-01:15174-A03:Kyklos_2004-01_S-003-146 29.11.96 28. Januar 2004 09:12
tion costs with negative effects on growth and development. We can neatly ex-
tend these arguments to international trade (see Wei 2000). Because interna-
tional transactions involve multiple governance systems, the effectiveness of
domestic institutions in securing and enforcing property rights in economic ex-
change is an important determinant of trade costs. Furthermore, formal rules af-
fect informal norms of behaviour and inter-personal trust, which influence the
mores and conventions of doing business. These, in turn, may also impact on
risk perceptions and preferences in international transactions. We therefore in-
vestigate the hypothesis that institutions matter for international trade
In order to identify the effects of institutions on bilateral trade, we estimate
gravity equations. 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 in-
versely to the square of their distance. Interpreting trade between two countries
as the economic analogue of the mutual gravitational force between two bodies,
with their respective GDPs reflecting mass, we see the intuitive rationale for a
gravity model of bilateral trade
. In general, the gravity model considers trade
between a pair of countries as an increasing function of their national incomes
and a decreasing function of their geographical distance (Frankel and Rose
2002). Other variables that relate to both countries, or either of the two coun-
tries separately, may also enter into the equation (population size, land area,
contiguity, etc.). The model has performed well empirically. Amongst others,
studies by Helpman and Krugman (1985) and Deardorff (1998) show that both
new trade theories of product differentiation as well as the classical Heckscher-
Ohlin theory of comparative advantage can provide a theoretical rationale for
the gravity model of bilateral trade.
Compared to the literature on institutions and growth, the impact of institu-
tions on international trade flows has received relatively little attention
. Two
1. Evidently, the growth and trade lines of research are closely related. Many studies have identi-
fied openness to international trade as an important determinant of economic growth (e.g., Fran-
kel and Romer 1999). Thus, even if institutions are shown to be of less direct importance for
economic performance than trade (cf. Dollar and Kraay 2002), a strong link between the quality
of governance and trade reconfirms the importance of good governance for long-run economic
performance. See, for example, Frankel and Rose (2002) who use a gravity model approach to
argue that the main benefits of a currency union for economic performance are related to its pos-
itive effect on trade and openness, which affect performance beneficially.
2. The analogy doesn’t entirely follow suit. While the resulting force with which either of the two
particles attracts the other is equal (irrespective of their individual mass), trade from one country
to the other may in general be different from its counterpart.
3. Anderson (2001) and Den Butter and Mosch (2002) are examples in the literature that focus on
the effects of informal institutions on trade. Seite 104 Mittwoch, 28. Januar 2004 9:15 09

G4_HS:Aufträge:HEL002:15174_SB_Kyklos_2004-01:15174-A03:Kyklos_2004-01_S-003-146 29.11.96 28. Januar 2004 09:12
recent empirical studies have considered the impact of institutions on trade in
a gravity model context (Anderson and Marcouiller 2002, Koukhartchouk and
Maurel 2003). Anderson and Marcouiller have been amongst the main contrib-
utors to extend institutional analysis of the economy explicitly to the field of in-
ternational trade. Their most recent contribution combines the analysis of the
effects of institutions in a theoretical model with empirical estimates of the im-
pact of institutional effectiveness on trade. Koukhartchouk and Maurel (2003)
analyse the effects of joining international institutions such as the WTO and the
EU on trade patterns. They introduce variables reflecting institutional quality
into the analysis of potential trade effects for Central and Eastern European
Our paper intends to contribute to this virgin literature in two ways. First, we
have used the most recent and comprehensive data-set on the quality of govern-
ance available. This database was constructed for the World Bank by Kaufmann
et al. (2002). Indicators from 17 different sources, constructed by 15 organisa-
tions have been combined, including the sources used by Anderson and Mar-
couiller (World Economic Forum’s Global Competitiveness Report) and
Koukhartchouk and Maurel (Heritage Foundation, Economic Freedom Index).
Second, we intend to analyse not only the effect of institutional quality on trade,
but also the effect of similarity in governance quality. In this way, we capture
both the country-specific effect of good governance on trade, and the bilateral
influence of institutional distance on patterns of trade. We expect that institu-
tional homogeneity results in similar, hence familiar, informal business proce-
dures, which may reduce transaction costs.
We proceed as follows. Section II discusses the measures of institutional
quality that we have used in the analysis. In sections III and IV, we present and
discuss the regression results for alternative specifications of a basic and ex-
tended gravity model, respectively. Section V concludes.
In the empirical analysis that follows, we make use of both country-specific and
bilateral data from various sources. Gross domestic product for exporting and
importing countries are examples of country-specific variables that we include
in the analysis. Geographical distance, adjacency, main language and religion,
amongst others, are examples of other characteristics that we take into account
for each pair of countries. We focus on trade patterns in 1998, for a set of more
than 100 countries. We use bilateral exports as dependent variable, such that
each country pair yields two observations, with each country either as exporter Seite 105 Mittwoch, 28. Januar 2004 9:15 09

G4_HS:Aufträge:HEL002:15174_SB_Kyklos_2004-01:15174-A03:Kyklos_2004-01_S-003-146 29.11.96 28. Januar 2004 09:12
or importer. Since these variables are more or less standard in the literature, we
do not extensively discuss them here. Appendix A further describes these data
and their sources.
Since the main emphasis in this paper is on the effects of institutions, we
take a closer look at the institutional variables. We have used the database con-
structed by Kaufmann et al. (2002). They have constructed six indicators of
perceived institutional quality. Each indicator captures some related aspects of
the quality of governance. They either reflect the political process, the quality
of the state apparatus and its policies, or the success of governance. We discuss
these indicators in turn.
1. ‘Voice and Accountability’ reflects the extent to which citizens can partici-
pate in selecting government and hold it accountable for the actions taken.
This score includes various characteristics of the political process as well as
assessments of the independence of the media. It reflects whether citizens
and business can prevent arbitrariness in the behaviour of government and
enforce good governance when needed.
2. ‘Political Stability’ refers to the perceived likelihood of the government be-
ing destabilised or overthrown by unconstitutional interference or excesses
of violence against persons and possessions. These factors are highly detri-
mental for the continuity of policy and the stability of the economic environ-
3. ‘Government Effectiveness’ is a measure for the quality of government in-
puts. It represents, amongst others, the perceived quality and independence
of the bureaucracy. This indicates the ability of government to formulate and
implement good policies.
4. ‘Regulatory Quality’ is directly focused on the quality of implemented pol-
icies. It includes the perceived incidence of policies that inhibit the market
mechanism, and excessive regulation of foreign trade and business develop-
ment, and as such closely reflects the transaction costs that result from pol-
icy intrusion by the state in private trade.
5. ‘Rule of Law’ indicates the quality of the legal system. It indicates society’s
perceived success in upholding fair and predictable rules for social and eco-
nomic interaction. Essentially, it focuses on the quality of the legal system
and the enforceability of contracts.
6. ‘Control of Corruption’ represents the extent of ‘lawless’ or unfair behav-
iour in public-private interactions. It complements regulatory quality and
rule of law indicators, pointing at the impact of bad governance on economic
interaction. Corruption, like regulatory intrusion, affects transaction costs
by adding a ‘third-party’ involvement to private transactions. An added com-
ponent of corruption to trading costs is its arbitrary, uncertain nature. Seite 106 Mittwoch, 28. Januar 2004 9:15 09

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