Regional Trade Agreements and Bilateral Trade: An Eclectic View of the Hidden Trade Costs

Abstract

Trade costs associated with institutional failures and political risks, continue to serve as a big barrier to regional and international trade. Despite this strong impediment, limited work has been done to investigate the effect of weak institutions and type of political regime on bilateral trade. In an attempt to bolster this literature, this paper investigates the effects of these hidden trade costs on bilateral trade. The paper employs an augmented gravity equation derived from a monopolistic competition model of product differentiation to examine this effect for a sample of 46 countries in three distinct regional trade blocs. Using the Poisson Quasi Maximum Likelihood, the Heckman two-stage, Tobit and Negative Binomial estimation techniques, this paper concluded that stronger institutions of trading partners leads to an increase in trade. I argue that stronger institutions of both the exporting and importing countries in the form of good regulatory and legal framework reduce the uncertainty in contract enforcement, transactions costs and ultimately increase trade. Differences in political regimes of trading partners also have a strong effect on trade. Results also indicate that regional integration boosts bilateral trade, but there is evidence of trade diversion in WAMZ and MRU trading blocs.The proposition that geographically proximate partners traded more is supported according to the results, but there is little or no empirical support for the hypothesis that differences in factor endowments predict patterns of trade in the sample of countries. The sensitivity and robustness tests results indicate that the parameter estimates are robust to different estimation techniques and specification of the gravity model.