Application of Gravity Model to the Analysis of Cross-Country Differences in the Levels of Institutional Development

This paper presents an econometric model intended to explain fundamental cross-country differences in the quality of national economic institutions by using the set of economic, geographical, cultural and historical factors. Our key research hypothesis claims that bilateral trade may be working as a critical channel for institutional evolution, including through import of institutions by less developed countries from their more institutionally advanced trade partners. We follow logic of the modified gravity model of foreign trade to justify the model specification. Econometric analysis was conducted on the performance data of more than 100 countries in 1996-2006. Our results support the hypothesis that many factors that drive international institutional differences are identical to those that define intensity of trade interactions in the traditional gravity model. As a result, global institutional progress has been showing particular historic and geographical patterns. We come to the conclusion that, after controlling for differences in the levels of per capita income, institutional cross-country differences are significantly influenced by countries’ location and geographic neighborhood, and with time countries tend to form homogeneous geographic clusters by the level of institutional development.