Institutional change in the global economy: How trade reform can be detrimental to welfare

Abstract

This study develops a theoretical model of trade with heterogeneous firms and imperfect contracting institutions to examine the impact of trade liberalization on the quality of economic institutions. The model has three main features: (1) institutions are a source of comparative advantage, (2) weak institutions benefit some firms in the open economy, and (3) those firms lobby for sup-optimal institutions in a political game. Greater trade openness increases the distributional effect of institutions and firms' incentive to engage in political lobbying. The political and economic power of firms is linked to the country's comparative advantage. Trade reform is most likely detrimental to institutions in countries specializing in goods requiring bad institutions. The unintended consequences of trade reform on institutions have important implications for the gains from trade and welfare for developing countries in the global economy.