The main focus of the recent literature on the economics of institutions has been on the role of institutions that define and enforce contracts and property rights in enhancing economic performance. A key finding of this literature is that countries with better rule of law and more private property rights protection have on average grown faster, where faster growth is associated with better allocative efficiency. Yet a criticism of this literature is that there is a great deal of heterogeneity in institutions as well as in outcomes associated with a given institutional metric.
The literature on the interaction between economic institutions and international trade provides some insight into how such heterogeneity can arise. It does so by arguing that poor institutions can be a source of rent for some groups while institutions can also be a source of comparative advantage. Consequently, the welfare consequences arising from the interaction between economic institutions and international trade are shown to be ambiguous. For example, recent research shows that if (Ricardian) productivity is greater by a sufficiently large margin in the sector where the country has a comparative advantage, then comparative advantage is assured and opening to trade increases rent seeking, thereby reducing efficiency. But if productivity differences between countries are small then under trade they compete for the sector by improving institutional quality, and so trade liberalization increases efficiency.
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Engerman, S.L., and K.L. Sokoloff, (1997); “Factor Endowments, Institutions, and Differential Paths of Growth Among New World Economies: A View from Economic Historians of the United States.” Published in S. Harber (ed) How Latin America Fell Behind, Stanford University Press, Stanford. [Working paper version]
Nunn, N., (2007); “Relationship-Specificity, Incomplete Contracts, and the Pattern of Trade.” Quarterly Journal of Economics, 122(2): 569-600.