The quality of contracting institutions is among the most important determinants of the relationship between buyers and sellers engaged in international trade. Contractual frictions are magnified in international trade by the fact that if one of the parties reneges on a written contract the dispute has to be resolved in local courts (as opposed to international courts) even though the parties are residents of different countries. This imbalance causes the risk for opportunistic behavior in an international transaction to be greater than in a domestic one and helps to explain why international trade flows are generally significantly lower than domestic trade flows. Moreover, the fact that contracting institutions are generally worse in developing countries than they are in developed ones means that potential gains from trade are being lost, as is technology transfer from developed to developing countries. At the same time, recent research has shown that variation in the quality of contracting institutions is actually a source of comparative advantage, which in turn determines trade patterns.
While problems with formal contract enforcement in developing countries tend to exacerbate opportunistic behavior, in some settings informal mechanisms have been put in place to try to improve enforcement. Informal mechanisms require either repeated interaction leading to reputation and trust or other side constraints to try to improve enforcement. This is particularly important in the trade of perishable goods where the short life of a product makes it impractical to write and enforce a contract on a supplier’s reliability. Other mechanisms rely on the financing terms used in the transactions. An exporter can require the importer to pay for goods before they are shipped, can allow the importer to pay after the goods have arrived at their destination, or can use some form of bank intermediation such as a letter of credit. The chosen financing terms depend on the countries’ institutional settings of the parties participating in the transaction. Transactions are more likely to require cash in advance or a letter of credit when the importer is located in a country with weak contractual enforcement. As an importer develops a relationship with the exporter, transactions are less likely to occur on terms that require prepayment.
The theoretical literature has developed a variety of models that capture institutional features such as enforcement problems, insurance considerations or uncertainty over the parties’ commitment to the relationship. More recently the availability of microdata has allowed researchers to test the predictions of these models and discover which features are the most relevant for international trade. Some results suggest that exporters tend to sell larger volumes to countries with good contracting institutions than to countries with weak institutions; experience built via repeated interaction helps exporters to select reliable importers; and banks are more effective than the exporter in pursuing financial claims against importers.
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