Institutions and offshoring; Qualitative and quantitative costs of trade

Abstract: Discrepancies between theoretical predictions and actual trade have led scholars to broaden their view of what factors that shape global trade patterns. Previous research has shown that quality of institutions play an important role in this regard. Recent literature have suggested that strong institutions should be viewed as comparative advantage rather than just a general trade barrier due to its asymmetric effects across industries. Using a gravity model based on detailed firm-level data the present study analyzes how offshoring is affected by the institutional quality in the target country and how this effect differs across industries. Results show that industries that require (i) large relationship specific investments and are (ii) characterized by extensive backward linkages are more sensitive to inferior institutions. This is valid for both the selection of country for offshoring and the size of trade volume. This study confirms previous research on relationship-specificity, however, the significant effects of backward linkages have, to the best of my knowledge, never been shown empirically before. Thus, this study adds a quantitative dimension of trade costs by showing that trade is not only affected by the nature of the buyer-seller relationship but also by the sheer number of transactions that have to be undertaken by a firm. As world trade have become increasingly vertically integrated, these results have important implications for countries' ability to join global production chains and by doing, attract trade and investments through offshoring.