Productivity, trade, and institutional quality: a panel analysis.

AuthorDoyle, Eleanor

Recognizing that gains historically attributed to trade capture instead the roles of institutions and geography, we estimate the relationship between labor productivity and trade for a panel of countries, 1980 to 2000. We use real and nominal openness as measures of trade. The endogeneity of trade and institutional quality is accounted for with instruments. Our trade instrument is based on a theoretically motivated gravity equation and uses a more comprehensive data set than in related studies. Fixed- and random-effects and system-GMM panel estimation methods address potential biases associated with cross-section estimations. We find a robust relationship between real openness and labor productivity from the 1990s. Countries that trade more generate higher levels of productivity, supporting an institutional theory of growth. We find evidence that countries with low-quality institutions benefit from openness to trade and that the positive effect of trade on labor productivity is lower for more populated countries.

JEL Classification: F14, F43, 040

  1. Introduction

    Interest in the relationship between trade and performance (variously taken as levels or growth of output or productivity) is evident across an extensive range of economic research. Empirical evidence points to a relationship between trade and income growth via productivity through, for example, technology transfer effects and scale economies (sec Yanikkaya 2003 for a survey), although specific results vary with country sample, time period, and econometric approach. The problematic nature of how to accurately construct and examine this causal relationship is indicated by the range of theoretical investigations undertaken to date.

    Developments in applied econometrics have generated varied approaches to investigate how trade and performance are related, but more recent research has focused on whether estimated links capture the roles of institutions and geography, rather than positive trade effects. There is particular agreement that in focusing on improving understanding of the determinants of economic performance, institutions and their differential quality across

    Received July 2008; accepted January 2010.

    countries must be included (Levchenko 2007). Motivated by related literature we investigate the effect of international trade and institutional quality on productivity across a sample of approximately 100 countries (1) from 1980 to 2000 going beyond the cross-section approach associated with such empirical investigations to date. Our contributions include our focus on a panel estimation approach, application of a theoretically motivated measure of trade using a comprehensive data set, and a comprehensive measure of institutional quality.

    The measurement of trade in this literature includes explicit examination of exports only (in export-led growth studies) and their relationship with output, living standards, or productivity. Related research includes openness as the measure of trade, taking into account both exports and imports as separate but related channels that drive output or productivity growth. (2) The standard measure of openness is the sum of exports and imports expressed as a fraction of GDP, in nominal terms. However, this measure creates difficulties if productivity gains are greater in manufacturing than in services. Specifically, employing Openness as the trade variable creates difficulties because of the potential impact of Balassa-Samuelson effects that arise when wealthy trading economies experience higher consumer price levels than poorer economies because of higher productivity in traded goods sectors being passed on via higher prices to the sheltered parts of the economy. (3) Similarly to Alcala and Ciccone (2004) (4) we use alternative versions of Openness to compare findings and extend their cross-country analysis to a panel setting. To take account of the potential endogeneity of trade and institutional quality and our dependent variable, Productivity, we use instruments. Following the work of Hall and Jones (1999) and Acemoglu, Johnson, and Robinson (2001), the choice of instruments for institutional quality rests on the relationship between historical European influence and diffusion of the European institutional structure.

    The work of North (1990) and Landes (1998), in particular, highlighted that differences in income and growth are determined by the institutional framework and has been incorporated into the trade/growth debate. North (1997, p. 114) in his 1993 Nobel lecture offered a definition of institutions as "the humanly devised constraints that structure human interaction. They are made up of formal constraints (rules, laws, constitutions), informal constraints (norms of behavior, conventions, and self imposed codes of conduct), and their enforcement characteristics." The proposition that weak economic institutions hinder growth is not particularly novel, but an assumption of neoclassical economics that institutional competition and public choice might reduce or eliminate them possibly explains their exclusion from research until recently. Difficulties surrounding measurement in the context of the quotation above provides further practical rationale for their exclusion. Related literature points to several alternative measures to operationalize the concept. Furthermore, given the persistent nature of institutions (Acemoglu and Johnson 2006) availability of sufficient appropriate data is problematic.

    Our article is structured as follows. Section 2 provides some background literature on the trade-growth relationship identifying those challenges associated with measures of Openness and Institutional Quality in empirical work. In Section 3 the selected productivity equation we estimate is presented with detailed discussion of the instruments, because a thorough empirical examination must address issues of endogeneity. Analysis and findings based on our estimated results are provided in section 4, and our summary and conclusions are offered in section 5.

  2. Empirical Relationships: Trade, Growth, and Productivity

    Many arguments potentially explain why trading countries experience higher output or productivity than their more closed counterparts. Open economies can benefit from specialization, which allows for the generation of higher levels of income due to comparative advantage. When more of a country's available resources are devoted to producing goods in which it has comparative advantages (i.e., lower opportunity costs of production) and it can import the goods in which it is less efficient, overall national output and consumption are higher than under autarky. Through creating international demand for domestic resources that might otherwise remain unused, a further (demand-side) basis for making more efficient use of resources exists in relation to trade. Static effects of specialization change the economy's production (and labor) mix in line with comparative advantage, and this, coupled with the ability to trade at international prices, leaves consumers better off. If dynamic benefits also accrue, as markets and market access expand, the potential for greater division of labor arises, and the skills of labor may rise in response to greater division of labor. Hence, productivity improvements are observed in an outward expansion of the production possibilities frontier (Myint 1958).

    As trade expands, the potential to exploit international communication of ideas and technology increases and may intensify competition in both import and export markets, increasing incentives for both imitation and innovation and accelerating the rate of technical progress that can lead to efficiency gains through more competitive cost structures and productivity improvement. Connolly (2003) notes that developing countries rely more heavily on trade (focusing on imports of high technology goods) than do developed countries as a source of productivity growth. Furthermore, foreign exchange constraints may also be eased because increased exports provide a source of foreign exchange for countries that wish to purchase imports of final products or inputs that embody domestically unavailable technology.

    The extent to which positive externalities are generated from involvement in international markets, through resource allocation, economies of scale, and pressure on new training, for example, underpin how the hypothesis operates in practice (Medina-Smith 2001). Analyses of such issues are evident in the substantial export-led-growth literature (theoretically associated with the view of trade as an engine of growth), in the alternative causal explanation manifest in Verdoorn's law (as explained in Kaldor 1967) (5) and in studies investigating bidirectional

    causality that may arise when productivity increases that are made through the exploitation of scale economies lead to increased exports (Kunst and Marin 1989), which can occur if the market structure changes (brought about by increased trade) result in fewer firms and if scale economies allow for increased competitiveness through further cost reductions. (6)

    In the context of new trade theory, models have been developed indicating how international trade leads to growth by increasing the number of specialized production inputs (Romer 1990; Grossman and Helpman 1991; Rivera-Batiz and Romer 1991). Helpman and Krugman (1985) show that this outcome is ambiguous, and Grossman and Helpman (1991) also pointed out that tariffs could be growth reducing. Yanikkaya (2003) indicates how trade restrictions can promote growth, under particular conditions and especially for developing countries.

    Hence, before the inclusion of (explicit) measures of "institutions" research indicated that the impact of trade on growth was equivocal-dependent on market competition, market contestability, and whether the market structure was stable with regard to trade disturbances or might be altered and lead to...

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