Trade, Inequality, and the Political Economy of Institutions
48 Pages Posted: 31 Jan 2006
Date Written: January 26, 2006
We analyze the relationship between international trade and the quality of economic institutions, such as contract enforcement, rule of law, or property rights. The literature on institutions has argued, both empirically and theoretically, that larger firms care less about good institutions and that higher inequality leads to worse institutions. Recent literature on international trade enables us to analyze economies with heterogeneous firms, and argues that trade opening leads to a reallocation of production in which largest firms grow larger, while small firms become smaller or disappear. Combining these two strands of literature, we build a model that has two key features. First, preferences over institutional quality differ across firms and depend on firm size. Second, institutional quality is endogenously determined in a political economy framework. We show that trade opening can worsen institutions when it increases the political power of a small elite of large exporters, that prefer to maintain bad institutions. The detrimental effect of trade on institutions is most likely to occur when a small country captures a sufficiently large share of world exports in sectors characterized by economic profits.
Keywords: International Trade, Heterogeneous Firms, Political Economy, Institutions
JEL Classification: F12, P48
Suggested Citation: Suggested Citation