Trust-Based Trade

Abstract

Weak enforcement of international contracts substantially reduces international trade. We develop a model where agents build reputations to overcome the difficulties that this institutional failure causes in a context of incomplete information. The model describes the interplay between institutional quality, reputations and the dynamics of international trade. We find that the conditional probability that a firm will stop exporting decreases and the its foreign sales increase with the export experience of the firm. The reason is that the informational costs that an exporter faces fall as the exporter becomes more confident about the reliability of its distributor. An improvement in the institutional quality of a country affects its imports by changing both the incentives of current exporters and by inducing entry of new ones. Trade liberalization induces current exporters to increase their sales. It could induce entry as well, but this will happen only when the initial tariff is high and/or the institutional quality of the country is low.