The ‘Institutions Hypothesis’ and International Trade

According to Douglas North’s ‘Institutions Hypothesis’, powerful groups within a society will manipulate their nation’s economic institutions in their own interests if they are not bound by appropriate constraints, with potentially deleterious effects on economic development. The main focus is on institutions that specify and enforce contracts and property rights to reduce transactions costs. Existing powerful groups block the enforcement of property rights, and with it investment in new technology, in order to protect their economic rents. Societies are able to make technological advances only if they can defeat such groups. The literature on the interaction between economic institutions and international trade shows that poor institutions can be a source of rent for some groups while institutions can also be a source of comparative advantage in trade. Consequently, the welfare consequences of institutional comparative advantage are often ambiguous. Another branch of the literature focuses instead on the interaction between international trade and political institutions, for example studying the effects of constraints imposed by democratic institutions on the executive branch of government. Trade and growth are found to expand far more in countries where the executive cannot use their power to monopolize the gains from trade.

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