The interrelation between formal and informal institutions through international trade

Abstract

AbstractThis paper theoretically examines how country‐specific formal and informal institutions are interrelated through international trade within a two‐country general‐equilibrium framework. When formal and informal institutions collectively generate institutional quality, formal institutions endogenously arise based on exogenously given informal institutions. Institutional quality governs the productivity of an institutionally intensive sector that features increasing returns. I find that in open economies, formal institutions tend to improve with the quality of informal institutions. In contrast, under autarky, formal institutions deteriorate with informal institutional quality. These results reveal that trade opens up the opportunity for enhancing formal institutions of countries with rich informal institutions.