Market Size, International Trade, and Institutional Quality

Institutions, such as contract enforcements and rule of law, are arguably one of the most important determinants of economic development. This paper exploits the insight into the relation between geography and economies of scale and investigates how the market size and international trade affect institutional quality. I adopt an incomplete-contract approach to model institutions. Due to contract incompleteness, a firm can hold up its suppliers and distort production. When the effective market size facing firms is larger, due to trade liberalization, or increases in population or numbers of trading partners, benevolent governments have incentive to improve institutional quality to facilitate production to meet the larger demand. Interestingly, in my multiple-country framework, the competition in institutional quality also matters in a Nash-equilibrium sense. The institutional qualities increase in trade-liberalized countries whereas those in the non-liberalized ones may decrease. This paper also empirically shows the positive impact of real effective market size on institutional quality, supporting the model.