Judicial Quality, Incomplete Contract, and Quality of Trade
Xiaomin Cui, Miaojie Yu, Rui Zhang
This paper studies how judicial quality affects average quality of trade for industries with different dependence on contract enforcement environment. By alleviating hold-up problem, better judicial quality lowers production costs relatively more for contract-intensive industries that intensively use relationship-specific inputs. We build a simple model to incorporate hold-up problem and the consequent relatively higher input costs for contract-intensive industries into a firm heterogeneous model with endogenous quality choice. Our theory suggests that better judicial quality does not necessarily raise average export quality for contract-intensive industries relatively more due to two offsetting effects: quality upgrading of existing exporting firms and increasing entry of less-productive firms. In contrast, better judicial quality always raises average import quality relatively more for contract-intensive industries since only foreign firms with high enough productivities are able to compete in that market due to pro-competitive effect. By using bilateral unit value and quality index constructed by Feenstra and Romalis (2014), as well as contract intensity from Nunn (2007), we empirically confirm the predictions regarding judicial quality's impact on average quality of trade. Our results are robust to measurement issues, potential confounding factors, and possible reverse causality.
Keywords: Judicial Quality, Quality of Trade, Contract Intensity
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