Trust, Efficient Contracting and Export Upgrading

Ndubuisi, Gideon; Owusu, Solomon Article — Published Version Trust, Efficient Contracting and Export Upgrading The European Journal of Development Research Provided in Cooperation with: Springer Nature Suggested Citation: Ndubuisi, Gideon; Owusu, Solomon (2021) : Trust, Efficient Contracting and Export Upgrading, The European Journal of Development Research, ISSN 1743-9728, Palgrave Macmillan UK, London, Vol. 34, Iss. 6, pp. 2708-2729, https://doi.org/10.1057/s41287-021-00486-x This Version is available at: https://hdl.handle.net/10419/287621 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ Vol:.(1234567890) The European Journal of Development Research (2022) 34:2708–2729 https://doi.org/10.1057/s41287-021-00486-x ORIGINAL ARTICLE Trust, Efficient Contracting andExport Upgrading GideonNdubuisi1,2· SolomonOwusu1,2 Accepted: 21 October 2021 / Published online: 15 November 2021 © The Author(s) 2021 Abstract Informal contracting institutions constitute an essential part of a country’s overall contracting institution, however, the nascent literature examining the effect of contracting institutions on the quality of products a country produces and exports, have paid a limited attention on the role of informal contracting institutions. We fill this gap in the literature by examining whether higher trust levels, as an informal contracting institution, leads to product-quality upgrading by reducing contractual frictions and opportunistic behaviors. Using industry-level data spanning 1995– 2014, we examined this relationship using the generalized difference-in-difference method. We find that contract-intensive industries in trust-intensive societies experience a disproportionally higher increase in the production and export of higherquality products compared to those industries in low-trusting societies. This result holds after controlling for conventional sources of comparative advantage and formal contracting institution. Hence, the result underscores the importance of informal contracting institutions for improved economic performance and stress the crucial fact that countries with strong and efficient informal institutions can still benefit in market-related activities even in the presence of weak formal institutions. Keywords Informal institution· Trust· Contractual frictions· Export quality Résumé Les institutions contractantes informelles constituent une partie essentielle du système contractant global d’un pays. Cependant, la littérature naissante qui étudie l’effet des institutions contractantes sur la qualité des produits qu’un pays fabrique et exporte, a accordé une attention limitée au rôle des institutions contractantes informelles. Nous comblons cette lacune dans la littérature en cherchant à savoir si des niveaux de confiance plus élevés, en tant qu’institution contractante informelle, conduisent à une * Gideon Ndubuisi [email protected] Solomon Owusu solomon.o[email protected] 1 Deutsches Institut für Entwicklungspolitik, Bonn, Germany 2 UNU-MERIT/Maastricht University, Maastricht, TheNetherlands 2709 Trust, Efficient Contracting andExport Upgrading amélioration de la qualité des produits en réduisant les frictions contractuelles et les comportements opportunistes. À l’aide de données issues de l’industrie couvrant la période 1995-2014, nous avons examiné cette relation à l’aide de la méthode des doubles différences généralisées. Nous constatons que, dans les sociétés où le niveau de confiance est élevé, les industries qui générent de nombreux contrats connaissent une augmentation forte et disproportionnée de la production et de l’exportation de produits de qualité supérieure, par rapport à ces mêmes industries dans des sociétés où le niveau de confiance est faible. Ce résultat reste valable après avoir contrôlé les sources conventionnelles d’avantage comparatif et l’institution contractante formelle. Par conséquent, les résultats soulignent le rôle important que jouent les institutions contractuelles informelles dans l’amélioration de la performance économique. Ils mettent aussi l’accent sur un fait essentiel : les pays dotés d’institutions informelles solides et efficaces peuvent toujours bénéficier d’activités liées au marché, même lorsque les institutions formelles sont faibles. JEL Classification D70· F00· F10· F14 Introduction A long-standing consensus in the literature suggests that differences in the quality of products produced and exported by countries play a significant role in explaining the variation in cross-country export success and overall economic performance. Importantly, products at the higher quality spectrum face less elastic demand, and they provide higher profit margins than more standardized and lower quality products (Hallak 2006; Hausmann etal. 2007; Khandelwal 2010; Amiti and Khandelwal 2013; Huchet-Bourdon etal. 2017; Papageorgious etal. 2019; Henn etal. 2020). Consequently, a large body of literature has emerged examining the drivers of the quality of products produced and exported with prior studies largely focusing on economic factors such as factor endowments, trade liberalization, foreign direct investment (FDI), income and preferences, innovative capability, technology transfer, and financial development (Mora 2002; Schott 2004; Faruq 2011; Harding and Javorcik 2012; Amiti and Khandelwal 2013; Zhu and Fu 2013; Crino and Ogliari 2017; Ndubuisi and Owusu 2021). More recently, socioeconomic factors such as institutional quality are gaining traction in the literature (Faruq 2011; Essaji and Fujwara 2012; Falkowski etal. 2019). Notably, this literature argues that upgrading product quality often requires producers to source inputs or technologies outside a firm’s boundary or collaborate with multiple parties. These make product quality upgrading a contract-intensive endeavor, as it requires producers entering into a contractual relationship with third parties, which exposes the production process to contractual frictions such as the classical holdup problem. In which case, product quality upgrading depends on the effectiveness of contracts governing the contractual relationship among implied parties. Until date, extant studies that examine this relationship have focused mainly on formal institutional quality (e.g., the rule of law, bureaucratic quality, and judicial 2710 G.Ndubuisi, S.Owusu quality), while ignoring the role of informal contracting institutions such as trust. This is surprising given that informal contracting institutions, such as trust, constitute an essential part of a country’s overall contracting institution (Lyons and Mehta 1997; Knack and Keefer 1997; Mccannon et al. 2017; Gil and Zanarone 2017; Ndubuisi 2020a). The objective of the current paper is to fill this gap. In particular, we examine how trust, as an informal contracting institution, leads to improvements in product-quality by reducing contractual frictions. Trust is the subjective probability that an economic agent assesses that others will perform a particular action (Gambetta 1988). Its importance as an informal mechanism of contract enforcement is well documented in the literature (Arrow 1970; Lyons and Mehta 1997; Knack and Keefer 1997; Bjørnskov and Méon 2015; Ang etal. 2015; Mccannon etal. 2017; Gil and Zanarone 2017; Ndubuisi 2020a). Arrow (1970), for instance, notes that in the absence of trust, it would become very costly to arrange for alternative sanctions and guarantees, and many opportunities deriving from mutually beneficial cooperation would have to be forgone (p. 70). Similarly, Lyons and Mehta (1997) argue that efficient exchange relations, especially where unobserved efforts are important, are facilitated when the parties trust each other. As argued further by the authors, this occurs because trust reduces specification and monitoring costs, encourages better investment decisions, and ensures rapid and flexible responses to unforeseen events. By the same token, we conjecture that a higher level of trust would lead to product quality upgrading because it encourages stable and much longer efficient contractual relationships with third parties, such as suppliers of sophisticated and customized inputs. To empirically examine this conjecture, we utilize an industry-level data across 71 countries over the period spanning 1995–2014. As an empirical strategy, we employ the generalized difference-in-difference method developed by Rajan and Zingales (1998) and has been used extensively elsewhere in the literature (e.g., Levchenko 2007; Nunn 2007; Essaji and Fujiwara 2012; Manova 2013; Crino and Ogliari 2017; Ndubuisi 2020b). In particular, rather than asking whether trust-intensive societies produce and export higher quality products, our empirical strategy evaluates whether industries that are more prone to contractual frictions, such as the classical holdup problem, experience a disproportionately increase in the production and export of higher-quality products in trust-intensive societies than those industries in low-trusting societies. Utilizing this approach offers at least two gains. First, it minimizes concern over omitted variable bias as it allows the inclusion of different fixed effects at the country and industry level. Secondly, it allows us to focus on a specific mechanism, in our case, the reduction in contractual frictions, through which the examined variables are related. As an empirical measure of an industry’s vulnerability to contractual frictions, we use Nunn (2007)’s industry contract-intensity measure (2007). The index classifies products to the extent their production is prone to imperfect contract enforcement and, therefore, to the quality of contracting institutions. In which case, in the absence of trust (which is the focus of the current paper) and effective formal contracting institution (which has been the focus of extant studies), countries would suffer a comparative disadvantage in those industries. For the measure of trust, we follow the trust-related literature (e.g., Zak and Knack 2001; Pelvzner etal. 2008; Dearmon 2711 Trust, Efficient Contracting andExport Upgrading and Grier 2011; Ndubuisi 2020b), and use the trust indicator from the World Value Survey, measured as the proportion of a country’s population that “agrees” with the statement, “Most people can be trusted”. Finally, we rely on the novel method developed by Khandelwal etal. (2013) to infer product-quality from bilateral export data. Previewing the empirical results, we find that trust-intensive societies have a comparative advantage in the production and export of higher quality products in industries that are more vulnerable to contractual frictions. This result persists after controlling for conventional sources of comparative advantage and formal contracting institutions. Hence, our result suggests that trust, as an integral part of a country’s overall contracting institution, exerts a positive impact on product-quality upgrading independent of formal contracting institutions’ quality. Among others, two potential channels/mechanism may index this effect. Firstly, trust as an informal enforcement mechanism substitutes formal enforcement mechanisms where they are either lacking or are weak. In which case, a country having weak formal contracting institutions may still specialize in producing and exporting higher quality products, provided the informal contracting institutions are strong. Secondly, trust as a complement to formal contracting institution leads to a more efficient formal contracting. Such could include promoting ex-ante negotiating efficiency by allowing greater flexibility to respond to changing market conditions because contracting parties have greater confidence in each party’s information. It could also emerge from lowering the amount of time and resources contracting parties devote to ex-post bargaining and haggling over problems that arise in the course of exchange (Dyer and Chu 2003; Ndubuisi 2020a). This paper contributes to different strands in the literature. First, it relates to nascent literature that considers the impact of culture on product upgrading (e.g., Faruq and Webb 2016; Fan etal. 2018). In particular, while Faruq and Webb (2016) studied the export quality effects of cultural diversity using the Hofstede’s four original cultural dimensions (i.e., power distance, uncertainty avoidance, individualism, and masculinity),1 Fan etal. (2018) examined the export sophistication effects of cultural diversity using the cultural diversity index constructed by Ashraf and Galor (2011). We contribute to this literature in three ways: (a) using an inferred product-quality measure2; (b) focusing on social trust (which is a contracting institution) instead of culture; and (c) focusing on a specific channel through which social trust affects product quality. Secondly, as product-quality upgrading is an important element of innovation, our study also contributes to the literature examining the nexus between trust and innovation, which tend to use either patent application counts (Akçomak and ter Weel 2009) or R and D intensity (Ndubuisi 2020b). In particular, our results suggest an innovation effect of social trust in the form of vertical upgrading. Finally, to the extent that product-quality determines export successes and economic growth, our study also contributes to the nascent literature on the trade effect of trust (e.g., Guiso etal. 2009; Ndubuisi 2020a) and the erstwhile literature on the development effect of trust (see Knack and Keefer 1997; Dearmon and Grier 2011). 1 Faruq (2016) measures quality using a fisher price index. 2 Export sophistical and prices criticized in the literature. 2712 G.Ndubuisi, S.Owusu The remainder of the paper is organized as follows. “Related Literature” section presents a related literature review, while “Research Method” section discusses the research methodology, specifying the empirical model and describing the different data sources used in the analysis. “Empirical Results” section presents the empirical results. “Conclusion” section concludes. Related Literature Studies investigating the drivers of product-quality upgrading have gained increasing traction in recent years. Underpinning this rise lies the gains associated with a country producing and exporting higher quality products. Particularly, it is now widely argued that producing and exporting higher quality and sophisticated products is associated with better economic performance, including economic growth and development, export success, and better labor market outcomes (Brooks 2006; Hausmann etal. 2007; Verhoogen 2008; Khandelwal 2010; Amiti and Khandelwal 2013; Crino and Ogliari 2017). Extant studies examining the drivers of export upgrading have predominantly focused on the role of economic factors such as trade liberalization, foreign direct investment (FDI), income and preferences, innovative capability, and financial development (Mora 2002; Schott 2004; Faruq 2011; Harding and Javoricik 2012; Amiti and Khandelwal 2013; Zhu and Fu 2013; Crino and Ogliari 2017; Ndubuisi and Owusu 2021; Owusu 2021). Beginning with the factor-endowments, pioneer studies such as Acharyya and Jones (2001), Mora, (2002), Schott (2004), and Hummels and Klenow (2005) show that country characteristics such as income, preferences, and resource and capital endowments affect the quality of products. Regarding trade liberalization, existing studies suggest that it enhances the quality of exported products (Amiti and Khandelwal 2013; Fan etal. 2015; Bas and Strauss-Kahn 2015; Manova and Yu 2017). The export quality enhancing effects of trade liberalization can accrue in two ways. First, trade liberalization, say, in the form of input tariff liberalization provide domestic firms access to cheaper and higher-quality intermediate inputs needed for productivity improvement, which are important drivers of export upgrading. Second, trade liberalization can also affect export quality through a pro-competitive effect by lowering output tariffs, which raise product market competition and could force domestic firms to either lower their markups or revise their product quality (Bas and Strauss-Kahn 2015). Similar to the trade liberalization literature, studies on the effect of FDI on export quality generally points to a positive relationship (Faruq 2011; Harding and Javorcik 2012; Zhu and Fu 2013; Anwar and Sun 2018). As noted by Harding and Javorcik (2012), FDI enhances the quality of exported products because it serves as an important conduit of technology transfers and spillovers to local firms, which tend to drive down the marginal cost of production and boost the innovative ability of local firms. Also, multinationals are usually exposed to better technology, possess superior production capabilities, and have access to cheaper sources of finance. The culmination of these makes it possible to produce higher quality goods than those previously produced and exported by the host country. Closely related to the FDI 2713 Trust, Efficient Contracting andExport Upgrading literature, studies on the nexus between product quality and credit access are rooted in the argument that product-upgrading is a cost-intensive endeavor. Along this line, access to quality and affordable credit enables domestic firms to upgrade the quality of their products. Indeed, Fan etal. (2015) note that limited access to finance causes firms to act in ways that would be suboptimal in normal times, which may lead them to produce lower-quality products. In general, available empirical evidence corroborates the important role of finance for product upgrading (Fan etal. 2015; Crino and Ogliari 2017; Ciani and Bartoli 2020). Whereas the above studies focus mainly on economic factors, few studies have also analyzed the role of socioeconomic factors such as institutional quality (Faruq 2011; Essaji and Fujiwara 2012; Falkowski etal. 2019). The theoretical underpinning of these studies is based on the transaction cost theory wherein poor institutional quality proliferates uncertainties about the circumstances in which producers and final good producers could operate and collaborate to produce the optimal output. Along this line, Faruq (2011) empirically shows that malfunctioning social and political institutions can impair the ability of producers to improve the quality of their exported goods by discouraging innovation and investment. Essaji and Fujiwara (2012) and Falkowski etal. (2019) employ an augmented factor-proportion model and found that countries with a stronger rule of law or judicial system have a comparative advantage in exporting higher quality contract intensive final goods. Whiles these few literature have provided crucial insights on the nexus between institutions and export quality, they have focused mainly on formal institutional quality. The role of informal contracting institutions in this relationship is largely ignored. This is surprising given that informal contracting institutions, such as trust, constitute an essential part of a country’s overall contracting institution (Arrow 1970; knack and Keefer 1997; Bjørnskov and Méon 2015; Mccannon etal. 2017). We fill this gap in the literature by examining whether higher trust levels, as an informal contracting institution, leads to product-quality upgrading by reducing contractual frictions and opportunistic behaviors. Along these lines, our paper relates closely to the nascent literature that considers the impact of culture on product upgrading (e.g., Faruq and Webb 2016; Fan etal. 2018). Utilizing export prices as a quality measure, Faruq and Webb (2016) studied the export quality effects of cultural diversity using Hofstede’s four original cultural dimensions (i.e., power distance, uncertainty avoidance, individualism, and masculinity). On the other hand, Fan etal. (2018) examined the export sophistication effects of cultural diversity using the cultural diversity index constructed by Ashraf and Galor (2011). We make three notable innovations in this literature including (a) using an inferred product-quality measure as opposed to export prices or export sophistication as used in the two studies3; (b) focusing on social trust (which is a 3 The use of prices as quality has been hugely criticized in the literature on many grounds. For example, Hallak and Schott (2011) argue that rather than differences in product-quality, prices of exported products may vary because firms can sell at a discount due to lower production costs or undervalued exchange rates. Also, Amiti and Khandelwal (2013) note that unit prices may be inappropriate measures for quality when products possess both vertical and horizontal attributes since differences in unit values of a similar product from different countries at different development levels may capture in part wage differentials. For criticism on using export sophistication as a quality measure see Minondo (2010). 2714 G.Ndubuisi, S.Owusu contracting institution) instead of culture; and (c) focusing on a specific channel through which social trust affects product quality. The latter has the added advantage of focusing on a potential mechanism through which the explanatory variable of interest affects the outcome variable, thereby enabling us to overcome potential endogeneity issues. Research Method Empirical Strategy Our empirical strategy relates product-quality to country-industry interaction to investigate whether higher levels of trust leads to product-quality upgrading. It builds on Rajan and Zingales (1998) seminal work. In that study the authors interact industry variable (financial dependence) with a country-specific measure of financial development to study the differential output growth effects of financial development. To this end, the empirical model that guides our analysis takes the form: where Qualityi,j,t is the quality of product j, i denotes a country, while t is the year index. s denotes industry, and 𝜇i,j,t describes the error term. 𝜏t is year dummies, while 𝜏i,𝜏s and 𝜏j are country, industry and product fixed effects, respectively. trusti,t is a country-specific measure of the level of trust. Contract intensitys is an industryspecific measure of contractual friction vulnerability. That is, it captures the relative importance of contracting to an industry. The index is both country and time-invari- ant. Hence, we exclude its direct measure from the equation since the industry fixed effects would capture it. In line with our research objective, 𝛿2 is the coefficient of interest, and we expect it to be positive and statistically significant. However, the total effect of trust on product-quality is captured by 𝜕( Qualityi,j,t ) 𝜕(trust i,t )=𝛿1+𝛿2contract intensitys , while the variance of the total effect is given by Var( 𝛿 1) +Contract Intensity 2 s ×Var ( 𝛿 2) +2contract intensity s ×Cov(𝛿 1 𝛿 2) . Finally, X′ is a vector of control variables. We follow studies that utilize a similar empirical framework as ours (e.g., Nunn 2007; Essaji and Fujwara 2012; Manova 2013; Ndubuisi 2020a) and include standard country-industry measures of comparative advantage. This includes an interaction variable between industry skill-intensity and country endowment of skilled-labor and an interaction variable between industry capital-intensity and country endowment of physical capital.4 (1) Qualityi,j,t =𝛿 0 +𝛿 1 trust i,t +𝛿 2( trust i,t ×contract intensity s) +𝛾X � +𝜏 t +𝜏 i +𝜏 s +𝜏 j +𝜇 i,s,j,t 4 Data on countries’ human and physical capital are from the Penn World Table (PWT), while data on industry factor intensities are from Manova (2013). 2715 Trust, Efficient Contracting andExport Upgrading Data Sources Product Quality Measure Comparable cross-country data on domestic products are hardly available. Hence, a common approach in the literature is to use data on exported products. While our empirical analysis follows this approach, another empirical challenge is that tradable products’ quality is unobserved. While the conventional approach has been to use prices as an empirical measure on the assumption that price equals quality, this approach has come under large criticisms. Recently, Khandelwal etal. (2013) developed a novel method to infer quality indirectly from observed prices and demands given an explicit functional form.5 Particularly, it infers product quality as unobserved attributes of a variety that make consumers willing to purchase relatively large quantities of the variety despite relatively high prices charged for the variety. In which case, the intuition behind the approach is that conditional on price, a variety with a higher quantity is assigned higher quality. Hence, following Khandelwal etal. (2013), we infer the quality of product j shipped to a destination country d by country i in year t, using the following empirical demand equation based on Eq.(2): where ki , j , d , t is the quantity of product j produced by country i and exported to destination country d in year t, pi , j , d , t and qi , j , d , t is the price and the quality of the exported product. Pd,t and Yd,t is the price index and income level of the destination country, while 𝜎 is the elasticity of substitution. We take logs of the demand equation and arrive at Eq.(3) which we would estimate using OLS: where the destination country time-varying fixed effect 𝜏d,t absorbs both Pd,t and Yd,t , 𝜏j denotes product fixed effects which control for variation across products, such as the difference in prices and quantities across product categories due to the inherent characteristics of products. 𝜓i,j,d,t is the error term. The inferred quality estimate is, then, given by the estimated residual of Eq.(3) as: Following Manova and Yu (2017), we set the elasticity of substitution across products at the commonly used value of 5. To infer the product quality, we utilize the BACI-CEPII dataset (Gaulier and Zignago 2010), which contains bilateral export values and quantities at the 6-digit Harmonized System Classification (HSC) for a large number of countries. We define a product as a 6-digit HSC, while a product price is the product’s unit price (i.e., value divided by quantity). Accordingly, we (2) ki , j , d , t =(q i , j , d , t ) 𝜎−1 (p i , j , d , t ) −𝜎 (P d , t ) 𝜎−1 (Y d , t) (3) ln ( k i,j,d,t) +𝜎ln ( p i,j,d,t) =𝜏 d,t +𝜏 j +𝜓 i,j,d,t (4) qi , jd , t = 𝜓 i , j , d , t ∕( 𝜎 −1 ) 5 For studies that have employed similar approach see Fan et al. (2015), Manova and Yu (2017), Falkowski etal. (2019) and Ndubuisi and Owusu (2021). 2722 G.Ndubuisi, S.Owusu contract-intensity, while TableA5 in Online Appendix shows the results when we use the Herfindahl index of intermediate input. As discussed in “Contract Intensity” section, we use both indexes as alternative proxies for an industry’s susceptibility to contractual frictions. In both columns, the results are consistent with those reported in Table1, indicating that our prior results do not depend on how we measure industry susceptibility to contractual friction. Finally, extant studies that adopt the generalized difference-in-difference approach differ in how they model the serial correlation, ultimately influencing the standard errors. For instance, Rajan and Zingales (1998) report robust standard errors, while Seitz and Watzinger (2017) and Igan etal. (2016) report standard errors clustered at the country-level and country-indus- try level, respectively. To ensure our results are not driven by how we modeled the serial correlation, TableA6 in the Online Appendix shows the results using different standard errors. Columns 1 and 2 show the results when we use standard errors clustered at the country level, while columns 3 and 4 show the results when we use standard errors clustered at the country-industry level. In column 5 and 6, we cluster at the industry level. In all cases, the baseline result on the interaction variable between trust and contract-intensity is preserved. Additional Results This section provides additional results to show the robustness of the baseline results. While this paper’s focus is on trust, which is an informal contracting institution, it can either substitute or complement formal contracting institutions (Mccannon etal. 2017; Ndubuisi 2020a). It could also be that trust only strengthens formal contracting institutions. Bjornsko and Meon (2015), for instance, find that trust affects total factor productivity through economic-judicial institutions. If the latter is the case, trust should not significantly affect the product quality of contract-intensive industries once we directly account for the differential effect of formal contracting institutional quality. We address this concern in column 1 of Table3 by including an interaction variable between industry contract-intensity and country-specific measure of a formal contracting institution, as measured by the interaction variable between contract-intensity and “Law & Order”. Although introducing this variable reduces the number of observations and the size of the interaction variable’s estimated coefficient between trust and industry contract-intensity, the interaction variable between trust and industry contract-intensity remained positive and statistically significant at the 1%. Interestingly, the estimated coefficient of the interaction variable between formal contracting institution and industry contract-intensity is also significantly positive, confirming results in the extant literature (Essaji and Fujiwara 2012; Falkowski etal. 2019). Therefore, the significant positive estimated coefficient of the interaction variable between trust and contract-intensity suggests that trust, as an informal contracting institution, influences the contract-intensive industries over and above those of formal contracting institutions. In which case, it is consistent with studies suggesting that trust plays a role in contracting independent of the level of formal contract mechanism (Knack and Keefer 1997; Bjørnskov and Méon 2015; Ang etal. 2015; Ndubuisi 2020a). 2723 Trust, Efficient Contracting andExport Upgrading Table 3 Trust and product quality: robustness results Robust standard errors in square brackets ***p < 0.01, **p < 0.05, *p < 0.10 (1) (2) (3) (4) (5) Trust − 0.0017 − 0.3327*** − 0.3901*** − 0.5189*** − 0.2915*** [0.033] [0.031] [0.030] [0.028] [0.030] Trust × Contract intensity 0.0675** 0.4138*** 0.5541*** 0.7004*** 0.3623*** [0.033] [0.030] [0.029] [0.027] [0.029] Human capital − 0.6174*** − 0.6357*** − 0.6511*** − 0.5550*** − 0.5383*** [0.013] [0.013] [0.013] [0.013] [0.013] Human capita × Skill intensity 0.0646*** 0.0589*** 0.0526*** 0.0595*** 0.0525*** [0.001] [0.001] [0.001] [0.001] [0.001] Physical capital − 0.0078** − 0.0171*** − 0.0532*** − 0.1205*** − 0.2210*** [0.004] [0.004] [0.004] [0.005] [0.004] Physical capital × Capital intensity 0.1455*** 0.1965*** 0.1984*** 0.2573*** 0.2174*** [0.011] [0.011] [0.010] [0.010] [0.010] Law & Order − 0.1328*** [0.003] Law & Order × Contract intensity 0.1482*** [0.004] Log private credit − 0.0948*** [0.005] Log private credit × Contract intensity 0.1657*** [0.006] Human capital × Contract intensity 0.2007*** [0.008] Physical capital × Capital intensity 0.0725*** [0.003] Log GDP pc 0.2530*** [0.007] Log GDP pc × Contract intensity 0.1786*** [0.005] Sector dummies Yes Yes Yes Yes Yes Country dummies Yes Yes Yes Yes Yes Year dummies Yes Yes Yes Yes Yes # Observations 3,859,816 3,836,614 4,307,606 4,307,606 4,307,606 R2 0.36 0.35 0.35 0.35 0.35 2724 G.Ndubuisi, S.Owusu Besides formal institutions, studies have found that the trust level may be correlated with other country characteristics such as a country’s level of development, financial development, and human capital (Guiso etal. 2004; Dearmon and Grier 2011; Bjørnskov 2012). If these country characteristics were also a source of comparative advantage in contract-intensive industries, then our baseline results would be spurious. We address this concern by introducing an interaction variable between industry contract-intensity and different country characteristics. The results are reported in columns 2 to 4 of Table3. Column 2 shows the results when we interact industry contract-intensity with a country-specific measure of financial development. Column 3 reports the interaction variable results between capital and contract intensive, while column 4 shows the result for the interaction with human capital. Finally, column 5 shows the result for the interaction of industry contract-intensity and country-specific GDP per capita. In the four columns, we continue to observe that contract-intensive industries in trust-intensive societies experience a disproportionally higher increase in the production and export of higher-quality products compared to those industries in a low-trusting society. Hence, the results reported in Table3 support our conjecture of a positive effect of trust on product-quality upgrading, by reducing contractual frictions and opportunistic behaviors. Extended Analysis: High‑Tech Industries andQuality Upgrading High-tech firms engage in the production of complex goods, requiring specialized knowledge outside the firm’s boundary. This requires that firms share specialist knowledge, which is strictly confidential because they offer competitive advantages (Jong and Woolthuis 2008). Akin to this, high levels of uncertainties associated with the production of complex goods also imply that many issues and unforeseen circumstances need to be managed during the relationship, leading to underinvestment in those industries under a poor contracting environment. Even where formal contracting institution is strong, they may be expensive, lengthy, and insufficient in accounting for such contingencies that are rather a norm than the exception in hightech business relations. On the other hand, as higher levels of social trust leads to more efficient contracting, it is also possible that high-tech industries in trust-inten- sive societies would experience a higher increase in the production and export of higher quality goods due to the trust-induced contracting efficiency gains. Against this backdrop, this section extends our analysis by examining whether social trust affects high-tech industries’ product quality. As is common in the literature (e.g., Hsu etal. 2014), we proxy the industry’s technology sophistication using R&D intensity, which we retrieve from Kroszner etal. (2007). Table4 reports the results. In particular, it replicates Table1, but this time focuses on the interaction variable between trust and industry R&D-intensity (as a proxy of industry technology sophistication). Consistent with our expectation, the interaction variable’s estimated coefficient between trust and industry R&D-intensity is significantly positive at all conventional significance levels in all the columns in the table. In general, the result is consistent with the argument that a higher level of trust enhances business contracting, which is somewhat consistent with those in Ang etal. (2015). 2725 Trust, Efficient Contracting andExport Upgrading Conclusion It is now widely accepted that producing and exporting higher quality products is essential for economic growth and export competitiveness. Hence, there is now a large body of literature geared towards unbundling the drivers of cross-country and industry differences in product quality. While prior studies largely focused on economic factors, more recent studies, although few, have begun to examine the role of institutional quality as a driver of product-quality upgrading. However, this nascent literature focuses primarily on the role of formal contracting institutions. We extend this literature by examining the role of trust, as a measure of informal contracting institution. Using industry-level data spanning 1995–2014, we identified the effect of trust on product quality following the generalized difference-in-difference method developed by Rajan and Zingales (1998). Table 4 Trust and high-tech industry’s product quality Robust standard errors in square brackets ***p < 0.01, **p < 0.05, *p < 0.10 (1) (2) (3) (4) (5) (6) Trust − 0.0329** 0.0176 0.0129 0.0026 [0.015] [0.015] [0.015] [0.011] Trust × R&D intensity 5.8452*** 3.5041*** 3.5762*** 3.6991*** 3.7701*** 4.0625*** [0.144] [0.148] [0.148] [0.148] [0.148] [0.109] Human capital − 0.5606*** − 0.5001*** − 0.5170*** [0.013] [0.013] [0.009] Human capital × Skill intensity 0.0600*** 0.0594*** 0.0547*** 0.0543*** 0.0597*** [0.001] [0.001] [0.001] [0.001] [0.001] Physical capital − 0.0509*** − 0.0427*** − 0.0197*** [0.004] [0.004] [0.003] Physical capital × Capital intensity 0.1690*** 0.1669*** 0.1422*** 0.1418*** 0.1859*** [0.010] [0.010] [0.010] [0.010] [0.008] Product dummies No No No No No Yes Sector dummies Yes Yes Yes No No No Sector-year dummies No No No Yes Yes No Country dummies Yes Yes No Yes No Yes Country-year dummies No No Yes No Yes No Year dummies Yes Yes No No No No # Observations 4,307,606 4,307,606 4,307,606 4,307,606 4,307,606 4,307,606 R2 0.35 0.35 0.36 0.35 0.36 0.64 2726 G.Ndubuisi, S.Owusu We find that contract-intensive industries in trust-intensive societies experience a disproportionally increase in the production and export of higher-quality products compared to those industries in low-trusting societies. This result holds after controlling for conventional sources of comparative advantage and formal contracting institution. Hence, the result underscores the importance of trust, as an informal contracting institution, for improved economic performance such as product-qual- ity upgrading. At a more granular level, our result shows that countries with higher trust levels have comparative advantage in industries that are more prone to contractual frictions and opportunistic behaviors even in the absence (presence) of strong (weak) formal institutions. This occurs because higher trust levels, as an informal contracting institution, substitutes formal contracting institutions where they are lacking and complements them where they are present through efficient contracting. For instance, Dearmon and Grier (2011) note that in high trusting societies, the need for extensive contracts and the probability of outcomes ending in expensive litigation would be reduced as deals might be sealed with as little as a handshake. Similarly, Knack and Keefer (1997, p. 1252), note that in societies characterized by high trust level, “written contracts” are less likely to be needed, and they do not have to specify every possible contingency. Such open contracts but with mutual assurance that parties would not exhibit opportunistic tendencies even when the opportunity arises and the financial benefits are enormous, enables the parties to respond flexibly to changing market conditions which should leave both parties better-off. Given these benefits associated with higher trust level, our results suggest the need to promote policies that foster generalized trust as evidenced in the literature on the drivers of generalized trust (e.g., Alesina and La Ferrara 2000; Bjørnskov 2007; Murtin etal. 2018). Supplementary Information The online version contains supplementary material available at https:// doi. org/ 10. 1057/ s41287- 021- 00486-x. Funding Open Access funding enabled and organized by Projekt DEAL. Declarations Conflict of interest On behalf of all authors, the corresponding author states that there is no conflict of interest. Open Access This article is licensed under a Creative Commons Attribution 4.0 International License, which permits use, sharing, adaptation, distribution and reproduction in any medium or format, as long as you give appropriate credit to the original author(s) and the source, provide a link to the Creative Commons licence, and indicate if changes were made. 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