We are grateful to Daron Acemoglu, Shawn Cole, Allan Drazen, Simon Johnson, Nuno Limao, Marc Melitz, Miguel Messmacher, Thierry Verdier, Alan Winters and participants at the World Bank workshop, BREAD conference, and the IMF Annual Research conference for helpful suggestions. We thank Anita Johnson for providing very useful referencesCorrespondence: International Monetary Fund, 700 19th St. NW, Washington, DC 20431. E-mail: firstname.lastname@example.org; email@example.com.
Economic institutions, such as quality of contract enforcement, property rights, rule of law, and the like, are increasingly viewed as key determinants of economic performance. While it has been established that institutions are important in explaining income differences across countries, what in turn explains those institutional differences is still an open question, both theoretically and empirically.
In this paper we ask, how does opening to international trade affect a country's insti tutions? This is an important question because it is widely hoped that greater openness will improve institutional quality through a variety of channels, including reducing rents, creating constituencies for reform, and inducing specialization in sectors that demand good institutions (Johnson, Ostry and Subramanian, 2005; IMF, 2005). While trade openness does seem to be associated with better institutions in a cross-section of countries,1 in prac tice, however, the relationship between institutions and trade is likely to be much more nuanced. In the 1700s, for example, the economies of the Caribbean were highly involved in international trade, but trade expansion in that period coincided with the emergence of slave societies and oligarchic regimes (Engerman and Sokoloff, 2002, Rogozinski, 1999). During the period 1880-1930, Central American economies and politics were dominated by large fruit-exporting companies, which destabilized the political systems of the countries in the region as they were jockeying to install regimes most favorable to their business interests (Woodward, 1999). In the context of oil exporting countries, Sala-i-Martin and Subramanian (2003) argue that trade in natural resources has a negative impact on growth through worsening institutional quality rather than Dutch disease. The common feature of these examples is that international trade contributed to concentration of political power in the hands of groups that were interested in setting up, or perpetuating, bad institutions.
Thus, it is important to understand under what conditions greater trade openness results in a deterioration of institutions, rather than their improvement. The main goal of this paper is to provide a framework rich enough to incorporate both positive and negative effects of trade on institutions. We build a model in which institutional quality is determined in a political economy equilibrium, and then compare outcomes in autarky and trade. In particular, to address our main question, we bring together two strands of the literature. The first is the theory of trade in the presence of heterogeneous firms (Melitz, 2003, Bernard et al., 2003). This literature argues that trade opening creates Page 2 a separation between large firms that export, and smaller ones that do not. When countries open to trade, the distribution of firm size becomes more unequal: the largest firms grow larger through exporting, while smaller non-exporting firms shrink or disappear. Thus, trade opening potentially leads to an economy dominated by a few large producers. The second strand of the literature addresses firms' preferences for institutional quality. Increasingly, the view emerges that large firms are less affected by bad institutions than small and medium size firms.2 Furthermore, larger firms may actually prefer to make institutions worse, ceteris paribus, in order to forestall entry and decrease competition in both goods and factor markets.3 In our model, we formalize this effect in a particularly simple form. Finally, to connect the production structure of our model to the political economy, we adopt the assumption that political power is positively related to economic size: the larger the firm, the more political weight it has.
We identify two effects through which trade affects institutional quality. The first is the foreign competition effect. The presence of foreign competition generally implies that each firm would prefer better institutions under trade than in autarky. This is the disciplining effect of trade similar to Levchenko (2004). The second is the political power effect. As the largest firms become exporters and grow larger while the smaller firms shrink, political power shifts in favor of big exporting firms. Because larger firms want institutions to be worse, this effect acts to lower institutional quality. The political power effect drives the key result of our paper. Trade opening can worsen institutions when it increases the political power of a small elite of large exporters, who prefer to maintain bad institutions.
When is the political power effect stronger than the foreign competition effect? Our comparative statics show that when a country captures only a small share of world produc tion in the rent-bearing industry, or if it is relatively large, the foreign competition effect of trade predominates. Thus, while the power does shift to larger firms, these firms still prefer to improve institutions after trade opening. On the opposite end, institutions are most likely to deteriorate when the country is small relative to the rest of the world, but captures a relatively large share of world trade in the rent-bearing industry. Intuitively, if a country produces most of the world's supply of the rent-bearing good, the foreign compe tition effect will be weakest. On the other hand, having a large trading partner allows the largest exporting firms to grow unchecked relative to domestic GDP, giving them a great Page 3 deal of political power. We believe our framework can help explain why, contrary to expec tations, more trade sometimes fails to have a disciplining effect and improve institutional quality. Indeed, our comparative statics are suggestive of the experience of the Caribbean in the 18th century, or Central America in the late 19th-early 20th: these were indeed small economies that had much larger trading partners, and captured large shares of world trade in their respective exports. At the end of the paper, we describe in detail three cases that we believe our model captures well: the Caribbean sugar boom in the 18th century; the coffee boom in Latin America in the 19th; and the cotton and cattle boom in Central America in the mid-20th century.
Our environment is a simplified version of the Melitz (2003) model of monopolistic competition with heterogeneous producers. Firms differ in their productivity, face fixed costs to production and foreign trade, and have some market power. If the domestic variable profits cover the fixed costs of production, the firm enters. If the variable profits from serving the export market are greater than the export-related fixed cost, the firm exports. Variable profits depend on firm productivity, and thus in this economy only the most productive firms export. Melitz (2003) shows that when a country opens, access to foreign markets allows the most productive firms to grow to a size that would not have been possible in autarky. At the same time, increased competition in the domestic markets reduces the size of domestic firms and their profits. The distribution of profits thus becomes more unequal than it was in autarky: larger firms grow larger, while smaller firms become smaller or disappear under trade.
The institutional quality parameter in our model is the fixed cost of production. When this cost is high, institutions are bad, and fewer firms can operate. Narrowly, this fixed cost can be interpreted as a bureaucratic or corruption-related cost of starting and operating a business.4 More broadly, it can be a reduced-form way of modeling any impediment to doing business that would prevent some firms from entering or producing efficiently. For example, it could be a cost of establishing formal property rights over land or other assets. Or, in the Rajan and Zingales (2003a) view of the role of financial development, our institutional quality parameter can be thought of as a prohibitive cost of external finance.
In our model, every producer has to pay the same fixed cost. We first illustrate how preferences over institutional quality depend on firm size. We show that each producer has an optimal level of the fixed cost...