International Trade: Issue 2

A defining feature of developing countries is that they have weak institutions, with weak rule of law perhaps the most obvious manifestation. An abundance of evidence documents differences between the developed and developing world along these dimensions (e.g. La Porta et al. 1998). Almost all transactions across and within borders rely on contracts being honoured—whether they be formal or not—and rules being followed. Thus, weak institutions interact with almost every step between an entrepreneur coming up with an idea for a product in one place, and the final good being purchased by a consumer in another. While, of course, institutions matter for domestic transactions, international transactions typically incur larger monetary and time costs between production and delivery, and require contracting across jurisdictions. These issues matter more than ever given the widespread belief that entering global value chains is now a key pathway to development (World Bank 2020), although see Rodrik (2018a) for a counterpoint. Beyond contracting, the literature has uncovered multiple mechanisms through which international trade interacts with weak institutions and rule of law in ways that modify the predictions of canonical trade models. We relegate discussions of rent seeking and lobbying—which is often facilitated by weak institutional environments—to Section 4 that covers firm-specific distortions.

We first cover how weaknesses in three specific institutions—tariff collection, contract enforcement, and regulation—may constrain trade flows, and how specific solutions such as relational contracting enable firms to overcome institutional weakness. In the last section, we also cover how institutions themselves can change as a country opens to trade.

Tariff evasion in developing countries

The implementation of trade policy is one of the most direct ways in which weak rule of law affects trade. In 2017, customs revenues accounted for 37.2% of tax revenue collected in low-income countries, compared to 12.9% in developed countries (Azcarraga et al. 2022). Despite the importance of these revenues for their tax base, developing countries are prone to tariff evasion, which impacts their economic development in five key ways:

1. Missing revenues alter the calculation of the benefits of tariff policies and are particularly detrimental to low-income countries due to their disproportionate reliance on customs revenues.
2. Evasion shapes the distributional impacts of tariffs, especially when part of the collected revenue is diverted through bribes.
3. Inconsistent application of tariff policy endows some firms with an unfair competitive advantage unrelated to their productivity, distorting competition and leading to misallocation.
4. Uncertainty about de facto tariff rates and customs clearance times may deter trade participation.
5. In the presence of imperfect enforcement, attempts to enact industrial policy by targeting specific sectors through tariff or non-tariff measures may be ineffective.

The most common form of tariff evasion occurs through the under-invoicing of imports. Bhagwati (1964) first noted that evasion can be detected by analysing discrepancies in trade statistics reported by exporting and importing countries on the same transactions, a method often referred to as ‘mirror statistics’. Importers have an incentive to report a lower transaction value to reduce their tariff payments. Exporters, by contrast, do not face this incentive because they are not responsible for paying tariffs. The difference between the reports by exporters and importers, known as  the ‘evasion gap’, is thus a potential proxy for evasion. Examining trade between China and Hong Kong, Fisman and Wei (2004) showed that evasion gaps are strongly correlated with import tariffs. They furthermore show that evasion also occurs by importers changing the product category to one with a lower statutory tariff rate, a practice known as ‘misclassification’. These results have been replicated in other developing countries.  Evasion has been shown to be especially prevalent for differentiated products whose price and quality are difficult to ascertain (Javorcik and Narciso 2008), in contexts of weak institutions and enforcement (Mishra et al. 2008), and to be disproportionately perpetrated by politically connected firms (Rijkers et al. 2017).

One challenge when using mirror statistics to detect evasion is that both importers and exporters might have additional incentives to manipulate their trade records beyond merely reducing tariff payments. For example, exporters may opt to underreport their foreign sales to avoid capital controls or to minimise Value Added Tax (VAT) or Corporate Income Tax payments (see Ferrantino et al. 2012, Bussy 2023). VAT rebate schemes, by contrast, may create incentives to exaggerate export sales (Bussy and Jagil 2023). Kee and Nicita (2022) show that firms may also misclassify their customs transactions to avoid non-tariff measures. Discrepancies may also arise due to genuine errors in reporting, as Almunia et al. (2024) document for Ugandan VAT records, and differences in the way import and export statistics are recorded. For example, the former often include the costs of insurance and freight, whereas the latter do not. Thus, understanding the specific reporting incentives firms face is crucial for inferring evasion from mirror statistics. 

Direct evidence that customs officers work with importers to reduce official tariff payments in exchange for small bribes is provided by Sequeira and Djankov (2014) who track a random sample of shipments going through the ports of Durban (South Africa) and Maputo (Mozambique). Corruption is often cost-reducing and “collusive”, with public officials and private agents sharing the rents. However, officials also regularly hold up importers by demanding additional fees to clear transactions (raising import costs). Firms are willing to double their transport costs to avoid this second “coercive” form of corruption which tends to be more prevalent in Maputo, in part to avoid the uncertainty of bribe payments. 

Corruption in customs is often systemic, with accomplices across the customs administration, but the benefits are unevenly distributed. Chalendard et al. (2023) identify manipulation of assignment of import declarations to inspectors in Madagascar's main port, Toamasina, by detecting deviations from random assignment prescribed by official rules. Deviant declarations were more at risk of tax evasion, yet less likely to be deemed fraudulent by inspectors, who also cleared them faster. An intervention that delegated inspector assignment from the customs IT department to a third party ended this manipulation but soon triggered a new form of manipulation—withholding certain applications from the third party. The tax revenue losses associated with the original evasion scheme were highly concentrated among a select few inspectors and brokers, who were also more likely to be engaged in attempts to circumvent the third party delegation system. 

The finding that attempts to crack down on evasion lead to the displacement of corruption helps explain why evasion remains persistent and difficult to remedy. Such displacement has also been documented in response to other remedial policies. Javorcik and Narciso (2017) argue that the WTO Customs Valuation Agreement, which requires countries to use international rules to assess the price of imports in order to collect duties, reduces underreporting of prices when countries join the WTO. Yet, WTO accession also induces importers to shift towards other methods of tax evasion, such as underreporting of quantities and product misclassification. Yang (2008a) shows that hiring private firms to conduct pre-shipment inspections increases import duty collections. However, Yang (2008b) provides evidence that, in the Philippines, imports were simply re-routed to export-processing zones where duty charges could still be avoided. 

Nonetheless, better record keeping and automation of customs procedures have shown promise in reducing evasion. Lajaaj et al. (2023) document how the staggered introduction of computerisation of import declarations in Colombia led to an increase in both imports and tax collection in reformed ports relative to unreformed ones, partially driven by a reduction in underreporting. Relatedly, Carballo et al. (2022a) find that the adoption of electronic customs facilitation through the Central American International Transit of Goods raised El Salvador's exports by 7.5%. However, the evidence of manipulation of inspector assignment discussed above reminds us that anti-corruption technologies are themselves susceptible to mechanism design problems. 

These findings show that curbing corruption is consequential. Without effective enforcement, trade policy is impotent. Sequeira (2016) argues that tariff evasion may be an important explanation for why estimates of tariff elasticities—by how much trade volumes change with tariffs—appear to be low in developing countries. Using variation due to Mozambique entering a trade agreement with South Africa, she estimates a tariff elasticity of just 0.1, well below developed-country estimates. She documents via audits that prior to the reform, bribes were paid on approximately 80% of shipments in order to avoid paying an onerous tariff rate. The payments were small, covering only 7% of the total tariff duties saved (an example of the Tullock paradox). When Mozambique reduced tariffs, trade volumes hardly changed since firms had previously been evading tariffs through bribes. Thus, estimates of the tariff elasticity are not particularly informative in quantifying the gains from reductions in trade costs. Put another way, Mozambique was already far more liberalised than it appeared based on official tariff schedules, given rampant tariff evasion and cheap bribe prices (and similarly the costs of protection in these contexts would be exaggerated).

Finally, one reason developing countries maintain high tariffs is because duties are relatively easily collected on observable imports at a few major ports of entry by a small number of officials. In contrast, tax collection from domestic firms and individuals is costly, difficult to enforce, and challenging in settings where most businesses are informal and most people are self employed. This raises the concern that in the absence of complementary reforms to broaden and deepen the tax base, trade liberalisations can impose large and negative fiscal consequences in developing countries. Cage and Gadenne (2018) find that in the post-1970 period, 45% of countries that liberalised tariffs were unable to recover the lost revenue five years after the reform, and 20% had yet to regain the lost revenue. However, Bachas et al. (2022) provide reason for greater optimism. Using event study and IV strategies, they study the effect of liberalisation on effective capital and labour tax rates in developing countries. They find that trade openness increases these rates, especially effective capital taxation rates; they provide evidence that this is due to increased concentration of economic activity in the formal sector. Together, these two papers suggest that the net effects of trade liberalisation on government revenues in developing countries depends on how liberalisation impacts the amount of economic activity that is visible and taxable by the government.

To summarise, trade policy evasion in developing countries is widespread and often facilitated by customs officials, resulting in substantial fiscal losses, distorted competition, and altered distributional impacts. Common evasion methods include under-invoicing and misclassification of imports, causing discrepancies in trade statistics between exporting and importing countries. While remedial measures often displace corruption, automation and changing the incentives faced by firms and officials show promise in limiting egregious corruption even if not entirely eliminating it. Key questions remain about which firms evade, which bureaucrats enable it, and which transactions are most at risk. Answering these questions is crucial for identifying reforms that would boost trade policy enforcement at low cost.

Contracts are crucial for international trade

Strong contracts are central to relationships when trade entails substantial lags and physical distance between production and sale. Weak rule of law makes it difficult for suppliers to contract with producers, and producers with buyers. These constraints are especially prevalent in trade involving developing country firms, where the associated risks have the potential to reduce the gains from trade in the absence of strong legal enforcement and other technologies or institutions to support contracting. 

The literature on institutions and trade has shown that weak contract enforcement distorts patterns of trade and comparative advantage beyond standard endowment or technology determinants. For example, Nunn (2007) demonstrates that countries with weak contract enforcement tend to export products that are less reliant on relationship-specific inputs. If these institutional differences mean that absent trade, relative prices differ even more (e.g. by raising relative unit labour requirements for producing complex goods in developing countries), gains from trade will be magnified.

On the contrary, Levchenko (2007) observes that institutions may also influence the extent of transactional impediments to combining factors of production that are owned by different parties in ways that reduce the gains from trade. In his model, relationship-specific investments and imperfect contract enforcement lead to rents being paid to labour. Consequently, liberalisation in a country with weak institutions results in the development of sectors that do not require relationship-specific investments and the enforcement of contracts. Developing countries can thus be worse off under trade if enough of the high-rent jobs are shifted abroad. Krishna and Sheveleva (2017) present a related model in which non-enforceable contracts lead farmers to specialise in low-value crops instead of high-value and export-oriented crops.

Antras and Foley (2015) present direct evidence on how contractual frictions affect the gains from trade for developing countries. They examine cross-border transactions of a US-based poultry exporter and find that only firms in importing countries characterised by weak rule of law are required to pay the poultry exporter cash in advance. These expensive contractual terms reduce trade volumes. As demonstrated by Ahn et al. (2011a), trade flows are sensitive to cross-border payment terms, and the need to pay up front for cash-constrained importers may be a key barrier to international trade for firms in developing countries.

Taken together, the above evidence on contractual frictions and international trade paints a pessimistic picture for developing countries. A closer examination of trading relationships reveals partial solutions to problems stemming from weak contract enforcement—informal self-enforcing agreements sustained by repeated interactions, often referred to as relational contracts (Baker et al. 2002).

Historical studies have documented the prevalence of relational contracts or ‘self-enforcing’ informal agreements that enabled trading parties to mitigate commitment problems. Greif (1993) discusses the role of reputation, information transmission, and collective punishments to motivate cooperation between Maghribi merchants and overseas agents in the 11th century. Kranton and Swamy (2008) examine trade among Indian export procurement agents and producers of cotton textiles and opium in the 18th century, and argue that variation in buyer market power (or outside options) can explain why textiles procurement was rife with enforcement problems despite repeated interactions between local agents and weavers (in contrast, opium procurement was considerably more successful). 

Evidence from more contemporary developing country contexts further corroborates the role of reputation and repeated interactions, rather than a formal legal system, in sustaining cooperation in economic transactions. This literature has focused mainly on intranational transactions, but many of the barriers and contracting problems are similar to those in international trade. McMillan and Woodruff (1999) document that trade credit in Vietnam is more readily extended to firms with a history of purchases with the supplier, firms that have been referred by another manufacturer, and firms with limited options for alternative suppliers. Banerjee and Duflo (2000) study the nature of contracts between Indian software companies and foreign buyers. They find that software firms with stronger reputations—measured, for example, by the age of the firm or whether the client is a repeat customer—are more likely to enter time and materials contracts which stipulate that the client pays for any overruns (rather than fixed price contracts where the supplier does).[1]1. The role of network-led enforcement in enabling informal financial access has been documented in many developing countries, e.g. Townsend (1994), Udry (1994), Greif (2000), Banerjee and Munshi (2004), Kinnan and Townsend (2012), Chandrasekhar et al. (2018).  Macchiavello (2011) documents that new Chilean wine producers who export to the UK initially match with high-cost distributors who specialise in discovering new wines. Over time, the exporter’s reputation improves and it can switch to “better” distributors who pay higher prices and engage in long-term relationships. Paltseva et al. (2022) show that in response to the increasing unwillingness of countries to use military force to enforce contracts affecting their firms in the late 1960s, multinational firms in the gas and oil industry backload their investment and production activities in countries with weak institutions to manage increasing expropriation threats. However, this backloading ceases as the relationship between the firm and government matures.

While they may partially substitute for formal enforcement, informal agreements create new hurdles to trade. To trade today, the (future) relationship must be sufficiently valuable so that there is limited temptation to renege to the next best alternative. Forming such a relationship can be costly. Macchiavello and Morjaria (2015) develop a framework to quantify the value of informal trading relationships and the costs of acquiring them. They focus on the Kenyan rose exporting sector where written contracts are impractical given the perishable nature of the product. The authors leverage the co-existence of a spot market alongside direct supply relationships to compute lower bounds on the value of a relationship. They calculate this by estimating the profits foregone when an exporter chooses to supply a direct buyer at a pre-agreed price when the spot market price spikes. Notably, the paper shows that the quantity of roses supplied in direct relationships drops during spot-market spikes. This implies that trade is indeed constrained by contract enforcement difficulties and the need to satisfy incentive compatibility constraints. In related work studying Rwandan coffee producers, Macchiavello and Morjaria (2020) explore the hypothesis that relational contracting may be harder to sustain in high-competition environments as it increases the temptation to renege on relational contracts. However, Ghani and Reed (2022) show that a history of repeated exchange may also predict the survival and evolution of past relationships that would otherwise unravel in response to changes in market structure.

Hansman et al. (2020) document a different margin for overcoming contractual frictions in the Peruvian fishmeal industry: vertical integration. In response to exogenous changes in demand for high-quality fishmeal from foreign markets, downstream manufacturing firms vertically integrate with upstream suppliers (fishing boats) to ensure the supply of very fresh fish required for high-quality production. Relatedly, Macchiavello and Miquel-Florensa (2017) show that vertically integrated coffee producers in Costa Rica can sustain a larger scale of operations.[2]2. We refer readers to Antras (2016) and Antras and Chor (2022) for in-depth reviews of important (and growing) issues related to production fragmentation across national boundaries.

Consistent with the recent evidence related to vertical integration, a small empirical literature in development economics is now focusing on long-term relationships within firm boundaries. These papers leverage rich micro-level data on firms and their workers to test how cooperation among co-workers affects firm performance and organisation. Atkin et al. (2017) present a case study of how employment contracts (i.e. wage structure) can hinder the adoption of a demonstrably beneficial production technology in Pakistan’s soccer ball industry. Adhvaryu et al. (2024a) study how cooperation across managers in an Indian ready-made garment exporter enables them to adapt to production uncertainty from worker absenteeism shocks. In related work, Adhvaryu et al. (2024b) show that reputation concerns in buyer-supplier relationships affect the allocation of workers to production lines where managers assign high productivity workers to low productivity lines to avoid falling behind on orders from large buyers. The survey by Macchiavello (2022) provides further detail on the role of relational contracts in the process of development and the survey by Macchiavello and Morjaria (2023) discusses advances in taking dynamic enforcement constraints to the data and the relationship between relational contracting and firm performance.

Recent contributions to the study of contracting frictions in trade and production have expanded the frontier by combining granular data on transaction patterns with structural models. Startz (2024), further discussed in Section 3.7 below, combines a retrospective transaction-level panel survey of Nigerian traders with a model of search and moral hazard. She estimates the effects of search and contracting frictions on imports by using variation in traders’ observable choices to travel and resolve these problems in-person and finds that these two frictions reduce welfare by 10%. Ryan (2020) compiles data from power procurement auctions in India to estimate a model of renegotiation following coal price shocks with heterogeneous bidders. He finds that politically-connected firms renegotiate more often, and bid below cost in anticipation of future renegotiation. Brugues (2020) studies relationship dynamics between buyer-supplier pairs using VAT data and financial statements from manufacturing firms in Ecuador, and finds that there is too little trade in the early stages of relationships because of the combination of contracting frictions and market power on behalf of the sellers. Zahur (2022) uses a structural model to study the trade-off between under-investment and contracting rigidity in the liquefied natural gas industry. The analysis shows that switching completely from long-term relationships to spot markets leads to welfare gains, as the loss from under-investment due to the lack of long-term contracts is more than offset by the improved matching. Kelley et al. (2020) experimentally evaluate the impacts of a novel monitoring technology on labour contracting arrangements in Kenya’s informal public transit sector and investigate the technology’s welfare consequences through a structural model of relational contracting between “matatu” owners and their drivers. While the welfare effects of monitoring on employees in their setting is unclear (the owners clearly benefit), the advent of monitoring technologies may help firms to overcome contracting frictions such as moral hazard. Houeix (2024) examines a related setting, principal agent relationships among taxi drivers and taxi owners in Senegal, and shows how the observability inherent in many digital technologies ameliorates moral hazard issues but in doing so can also limit adoption of a more-broadly beneficial digital payments technology.

Lastly, much of the existing work emphasises parties already engaged in established relationships. However, forming and sustaining such relationships presents significant challenges for many parties. A recent paper by Antic et al. (2024) develops a model of building relational contracts—a contract requiring the principal and agent to solve task clarity and credibility problems. Using administrative data from the Ethiopian floriculture industry, they find that task clarity problems are economically relevant and more severe for domestic firms, that exporters with higher task clarity are more likely to defect on relationships, and that differences in task clarity explain the share of sales governed by relational contracts. 

A common thread throughout these recent papers is the analysis of transactions within specific industries or firms, often author-collected datasets via bespoke surveys and/or administrative datasets from regulatory agencies. We believe this is a particularly fruitful path to learn about contractual issues in production chains. The combination of such data with structural methods further helps us understand important counterfactual environments. While external validity is a concern, generalisable patterns can emerge through studies across several industries or several countries.

Does international trade impact the enforcement of regulations?

Read more about this topic in Chapter 7 (MNEs & Labour Markets) of the VoxDevLit on Foreign Direct Investment (Garetto, Pavcnik, Ramondo et al. 2025).

Another characteristic of developing countries is weak enforcement of regulations in areas such as pollution, child labour and working conditions. Trade will likely improve matters if export-oriented firms in developing countries adhere more strongly to regulations and use cleaner technologies than typical domestic firms. Trade agreements, which increasingly go beyond tariffs and quotas, may even drive such improvements if developed-country labour groups lobby to insert strong labour and environmental standards in order to prevent capital from “racing” to the bottom. However, the impacts of trade may be pernicious for developing countries if they lead to reallocations of labour and capital into polluting sectors or those with poor work conditions. Rodrik (2018b) further argues that redistributive gains via profit shifting to developed countries may dwarf any direct gains from tighter regulatory standards in developing countries. In one of the few rigorous studies that examines cross-border regulatory enforcement, Chaudhuri et al. (2006) estimate substantial losses to Indian consumers in the market for quinolones from enforcing intellectual property mandated by the WTO.

Edmonds and Pavcnik (2005) explore the impacts of the liberalisation of Vietnam’s rice trade on child labour. Removing export controls and quotas increased rice exports and domestic prices rose. The authors demonstrate that the income effects from price increases dominate, and child labour declines among net rice producers. In a follow-up paper, Edmonds and Pavcnik (2006) provide cross-country evidence that international trade lowers the overall incidence of child labour. Thus, these two papers suggest that the claims that international trade exacerbates (or even perpetuates) child labour are inconsistent with the evidence. However, given the importance of this issue, and the continued perception that international trade may worsen child labour, we are struck that there has been little recent work on these issues.

Where governments lack the capacity to enforce regulations, multinational firms (MNCs) may privately enforce standards if they believe that the reputational risk from media exposure of poor working conditions or an industrial disaster exceeds the costs of implementing stronger protections to health and safety. A growing body of evidence suggests that trade, through the incentives of MNCs working in the country, can lead to better enforcement of regulation in contexts where government capacity is weak.

Harrison and Scorse (2010) find that export-oriented textile, footwear and apparel firms in Indonesia targeted by anti-sweatshop activists in the 1990s raised wages 10-20% (with no effect on employment). However, profits among these firms declined, potentially foreshadowing job losses in future as MNCs relocate elsewhere. Using a novel survey of working conditions, Tanaka (2019) finds that Myanmar firms that export to high-income countries experience large improvements in both wages and working conditions (e.g. fire safety, health-care and union recognition). In fact, labour standards of domestic firms rise to the levels of MNCs operating in Myanmar. This is in part due to improvements in management practices, but also because foreign buyers demand audits of their foreign suppliers, which serve as an alternative monitoring regime for exporters. Boudreau (2024) implements a randomised trial that allows her to study how effective MNCs are at enforcing local labour laws on their suppliers. Bangladesh requires factories to form worker-manager safety committees, yet few firms comply. By randomising which suppliers were initially targeted, she demonstrates the effectiveness of a new programme to enforce compliance spearheaded by an alliance of MNCs. Encouragingly, compliance with the law increased, at least for well-managed firms, without any detectable impact on productivity, wages or employment.

Alfaro-Ureña et al. (2022) develop a quantitative general equilibrium model to study the incidence of responsible sourcing policies—broadly defined to include policies related to worker compensation, benefits and working conditions—on MNC suppliers and their workers. They show that the welfare implication of these activities are a priori ambiguous: it depends on whether or not MNCs face consumer demand that values responsible sourcing practices, and on the potential monopolistic market power of MNCs vis-a-vis their suppliers (or if suppliers have monopsonistic power over workers). They apply the model to study the impacts of private enforcement in Costa Rica and find that it has negatively affected the sales and employment of exposed suppliers but has positively affected the earnings of their workers. On net, the authors calculate positive but minor effects on domestic welfare. Im and McLaren (2023a) explore related questions in a model that examines whether increasing globalisation strengthens or erodes labour rights. Their findings suggest an ambiguous impact where stronger rights raises worker bargaining power but discourages foreign investment. Im and McLaren(2023b) develop a model that does not feature rents and is focused on the effects of labour standards on firms' decisions about what level of labour standards to provide and where to locate their GVCs; in equilibrium, globalisation actually raises labour standards above optimal due to countries’ ability to pass on some of the cost of increased standards to trading partners. 

In summary, the evidence summarised above suggests trade is potentially a force for improving enforcement of labour regulations as developed-country consumers (and workers) value enforcement more than local agents do. Yet, MNCs still struggle with monitoring and enforcing regulations in markets where the government is a reluctant (or incapable) partner. As the 2013 Rana Plaza building collapse in Bangladesh revealed, MNCs whose suppliers are involved in labour-related scandals can respond by reallocating production chains to countries with stronger regulations (see Koenig and Poncet 2022). That incident underscores how weak enforcement of regulations can have aggregate consequences for developing countries.

Turning to environmental regulation, the regulation of pollution has received the most attention from the trade literature. The central question in this literature is evaluating the pollution haven hypothesis—whether trade exacerbates pollution by moving dirty industries to less regulated locations. Section 4.5 on climate discusses the evidence and open questions. 

The evidence on the impacts of weak enforcement of regulation on trade, and of trade on the enforcement of regulation, is growing but remains an emerging literature with many open questions. The available theoretical and empirical literature on labour standards supports the interpretation that trade does not drive a race to the bottom and likely contributes to increased enforcement of existing regulations. That said, the empirical evidence is limited to short- to medium-run analyses and largely focuses on direct effects on firms in the relevant export sector. More evidence is needed on effects in the longer-run, on economy-wide impacts, and on global impacts that may result from foreign buyers moving their sourcing to locations with weaker standards. On the theoretical side, much work remains to be done on what motivates firms sourcing from developing countries to enforce labour and environmental regulations and on the implications of these motivations for exporters and workers in developing countries. Moreover, governments in wealthier countries are increasingly regulating labour and environmental standards in production that occurs beyond their borders (e.g. the German Supply Chain Act, the European Union Directive on deforestation-free products, the Rapid Response Labor Mechanism of the 2019 US-Mexico-Canada Agreement, the EU Carbon Border Adjustment Mechanism), with a limited evidence base for understanding the potential implications for developing countries. Theoretical and empirical work evaluating the possible impacts of these policies is urgently needed.

Trade, growth and institutional change

For the reasons discussed above, as well as weak property rights and shareholder protections, the gains generated by access to trading opportunities may be very different for developing countries. These differential gains can be exacerbated if trade acts as a force for changing institutions themselves. Indeed, in their review of the trade and institutions literature, Nunn and Trefler (2014) argue that “the impact of international trade on domestic institutions is the single most important source of long-run gains from trade.”

The insight from this literature is that international trade can have very different impacts on institutions depending on initial conditions and comparative advantages. Empirical studies have emphasised three mechanisms through which long-distance trade impacts institutions:

1. An increased demand for the rule of law.
2. A shift in the distribution of income that allows certain groups to capture the local institutions.
3. Changes in shared beliefs and out-group trust that could impact state capacity.

The first strand of literature, mainly focused on European history, has emphasised that long distance trade increased the demand for growth-enhancing institutions aimed at reducing transaction costs. In the Middle Ages, Europe experienced a commercial revolution: long-distance trade re-emerged after an extended period of decline. In order to make this commercial expansion possible, a series of institutions had to be created to mitigate different kinds of commitment problems associated with long-distance trade. Milgrom et al. (1990) focus on the rise of the Lex Mercatoria, a body of customary rules and principles relating to merchants and mercantile transactions, which were administered by private judges drawn from the commercial ranks. This institution, which has been argued to be one of the origins of Western contract-enforcing institutions, created the incentives to gather information, honour agreements, report disputes, and adhere to the judgments of the merchant courts. Greif et al. (1994) focus instead on the ruler-merchant relationship. Specifically, they argue that the merchant guilds provided an institutional framework to enforce agreements between merchants and rulers, thus overcoming difficulties that rulers had commiting to not expropriate merchants and hence enabling trade expansion. Acemoglu et al. (2005) focus on the impact of the Atlantic trade between 1500 and 1800 that they argue strengthened the merchant class in countries where political institutions already placed constraints on the monarchy. The merchant class’ increased political power brought about improvements in property rights that made future growth possible. Jha (2015) provides direct evidence for how a merchant class can steer the institutional choices made by governments. He focuses on the English Parliament’s struggle for supremacy against the monarch during the Civil War (1642-1648). He constructs a dataset of the biographies of Parliament members and shows that ownership of assets in the overseas joint-stock companies significantly increased an individual’s support for constraints on the executive. Widening ownership increased the number of supporters of parliamentary supremacy over dictatorial rule. Levchenko (2013) formalises a related idea by combining his earlier model discussed in Section 2.2 with a political economy game.

The second strand of literature on trade and institutions has emphasised the shifts in the distribution of income produced by a trade expansion. Within this literature, trade could become detrimental to institutional development if it allows a small group of enriched merchants (or rentiers) to capture the local institutions. Puga and Trefler (2014) show that Venetian trading opportunities in 10th–12th centuries led to a broad-based merchant class that pushed for constraints on the executive class and the establishment of well-functioning contracting institutions. In the long run, however, wealth concentrated in a narrower set of merchant families who formed a (growth-inhibiting) oligarchy.

Sokoloff and Engerman (2000) focus on the impact of the expansion of trade in the Americas following European colonisation and seek to understand the different paths of development of the Western offshoots: United States and Canada versus Latin America. Their main argument is that the Latin American colonies enjoyed climate and soil conditions that were well suited for crops with economies of scale in production. These crops were therefore most efficiently produced on large slave plantations that resulted in extremely high levels of land ownership inequality. The concentration of wealth allowed a small European elite to dominate politics, and eventually led to the development of extractive institutions characterised by skewed land-tenure rights, commercial legal codes that favoured incumbents, and abusive labour practices. In contrast, the Western offshoots had soils best suited to the production of grains, which presented few economies of scale. These colonies developed relatively egalitarian societies that were characterised by more inclusive institutions. While the analysis of Engerman and Sokoloff is mainly descriptive, Bruhn and Gallego (2012) provide a formal empirical validation of the argument using an impressive dataset capturing economic activities performed across different regions of the Americas during the colonial period. They find that those regions that relied on activities with large economies of scale and with scope for labour exploitation are characterised by lower economic development today. The mediating mechanism is the absence of sufficiently representative political institutions.

Dippel et al. (2020) provide another example of potentially detrimental effects of international trade on political institutions within this strand of literature. They analyse the impact of sugar demand shocks on the legal institutions and the agricultural wages in the British West Indies from 1839-1913. The authors document a negative relationship between the political power of the plantation owners, measured by the share of sugar in total exports, and the wages of agricultural workers. A causal mediation analysis shows that the large majority of the negative effect of the plantation system on wages operated via incarceration rates, thus supporting the role of legal coercion in reducing agricultural wages. The authors also provide suggestive evidence that planters shaped legal coercion both through legislation passed in the islands as well as through personal connections to the police and judicial apparatus in the countryside.

A third strand of literature has emphasised the impact of trade on culture and trust, and through this channel, on state formation. Nunn (2008) provided the first empirical evidence for this channel. The analysis focused on the third corner of the Atlantic trade triangle in the 17th–19th century: the African slave trade. Typically, individuals were enslaved through villages raiding one another. This generated distrust between villages and impeded the formation of larger polities. At the same time, the pre-existing states were either destroyed by bands of slave raiders or collapsed under the corruption engendered by the slave trade. Eventually, those regions that, for geographic reasons, were more exposed to the slave trade ended up with higher levels of ethnic fractionalisation—which later slowed the state formation process.

In summary, there is growing evidence that the gains from trade are larger in stronger institutional environments, and that trade itself can both improve or worsen the quality of institutions. As the effects of trade through changing institutions potentially swamp static gains, it is very surprising there is not more work on this topic. Since institutions evolve slowly over time, studies have explored historical episodes. But, perhaps, there is something systematic to be learned from the more recent past, particularly the experiences of East Asian countries that have developed rapidly alongside spectacular export growth.

References

Acemoglu, D, S Johnson and J Robinson (2005), “The Rise of Europe: Atlantic Trade, Institutional Change, and Economic Growth,” American Economic Review, 95: 546–579.

Adhvaryu, A, J F Gauthier, A Nyshadham and J A Tamayo (2024a), “Absenteeism, productivity, and relational contracts inside the firm,” Journal of the European Economic Association, 22(4):1628-1677.

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