The Effects of Contract Enforcement and Corruption on Trade

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The role that institutions play in facilitating trade is receiving increasing attention. A recent article in The Regional Economist examined two indicators of the effects institutions can have: contract enforcement and corruption.

Research Officer and Economist Subhayu Bandyopadhyay and Senior Research Associate Yang Liu, both with the St. Louis Fed, and Suryadipta Roy, an assistant professor of economics at High Point University, explained how each of these institutional factors may affect trade and discussed studies that related to each factor.

Contract Intensity

The authors provided an example of goods manufacturers and their suppliers to show why contract enforcement matters. Some goods require specialized parts to be produced. These parts are considered contract-intensive, as satisfaction of the contract terms for delivery becomes important in ensuring timely and efficient production of the final good.

Weak judicial systems mean contracts between the manufacturers and their suppliers may not be properly enforced, which could drive the costs of supplied goods up. The firms needing these goods will end up importing them, while exporting other goods.

A 2014 study by economists Nathan Nunn and Daniel Trefler showed that advanced economies, which usually have better institutions, undertake production and exports of sophisticated, high-quality products (which are more contract-intensive by their very nature) to a greater extent compared with low-income countries.¹ Also, the high-income countries with similar institutional structures traded disproportionally more with one another than with low-income countries.

Corruption

The authors noted that countries with high levels of corruption are characterized by burdensome regulations, which are exploited by dishonest officials to extract bribes from traders, thereby driving up the costs of trade. A 2007 study by Bandyopadhyay and Roy found that greater corruption significantly increased import duties and other related taxes, while reducing the trade to gross domestic product ratios of the respective nations.²

Conclusion

The authors concluded, “What is clear from our discussion is that the literature in international trade has reached a consensus that improved institutions facilitate trade and that production of more-sophisticated products requires better institutions. Keeping these two issues in mind, developing nations have to find ways to improve their institutions. This is a complex problem, especially for developing nations facing resource constraints.”

Notes and References

¹ Nunn, Nathan; and Trefler, Daniel. “Domestic Institutions as a Source of Comparative Advantage,” Handbook of International Economics, April 2014, Vol. 4, pp. 263-315.

² Bandyopadhyay, Subhayu; and Roy, Suryadipta. “Corruption and Trade Protection: Evidence from Panel Data,” Federal Reserve Bank of St. Louis Working Paper 2007-22A, May 2007.

Additional Resources

• Regional Economist: Contract Enforcement, Corruption Controls and Other Institutions Affect Trade, Too
• On the Economy: What Determines How Much Countries Trade?
• On the Economy: How to Measure the Black Market