Trading on continuity: Product quality upgrading under weak institutions

A substantial share of aggregate exports is generated through long–term relation- ships between firms. Yet, many export relationships are short–lived, with average durations of only one to two years and few surviving much longer (Aeberhardt et al., 2014). The longevity of such relationships is central to both the static and dynamic quality choices of exporting firms. Producing high–quality goods not only involves higher marginal costs but also firm–specific technological capabilities, whose benefits often accumulate over time. As a result, longer relationships are more likely to justify the upfront effort and investment associated with quality provision. While many forces can limit the duration of exporter–importer relationships (e.g. demand volatility, search frictions, financing), a central mechanism is the strength of contracting institutions.1 Contract enforcement is central because quality upgrading requires relationship–specific investments whose returns are realized only over time. With strong enforcement, exporters and buyers can credibly commit to honor these investments, which sustains longer horizons and supports upgrading. In weak institutional environments, by contrast, credible commitment is harder to achieve, so the risks of hold–up or premature termination loom larger. While higher prices or upfront payments are often seen as natural ways to compensate for this type of risk, they do little to ensure the long–term continuity needed to realize the gains from relationship–specific quality provision. As a result, institutional strength shapes not only whether trade relationships survive but also how quality evolves within them. Understanding this mechanism helps explain both cross–country variation in export composition and the life–cycle dynamics of quality upgrading.

This paper studies how the strength of contracting institutions shapes the dynamics of product quality within firm–buyer relationships in international trade. While canonical models emphasize firm heterogeneity and learning about foreign demand as key determinants of product quality (Verhoogen, 2008; Brambilla et al., 2012; Manova and Zhang, 2012; Hallak and Sivadasan, 2013), this literature largely abstracts from the bilateral nature of firm–to–firm relationships. More sophisticated, differentiated products tend to be contract intensive (Nunn, 2007) and thus highly relationship–specific. In such settings, exporters depend critically on the stability of their trading relationships. Premature termination risks the loss of sunk investments and forecloses the return to quality provision, that realizes only in the long–term. When courts cannot enforce agreements effectively, relational contracting and reputation building can become substitutes for contract enforcement, shaping firms’ production and investment decisions (Macchiavello, 2022).

I develop a tractable dynamic model in which exporters choose product quality over time while facing uncertainty about whether a new export relationship will endure. This friction matters because quality provision also involves relationship–specific effort – such as technical customization, documentation assistance, or service guarantees – that is costly, non–contractible, and only profitable if the relationship lasts. Institutional strength in the destination country affects how firms form expectations about relationship duration. In well–functioning legal environments, exporters can rely on formal enforcement and anticipate stable relationships. In contrast, firms entering destinations with weak institutions face a greater risk of early termination and limited enforcement options. To mitigate this risk and foster continuity, they front–load relationship–specific effort as part of their broader quality provision, thereby activating informal relational incentives. This effort translates into higher quality at entry and, conditional on relationship survival, steeper long–run quality upgrading. The model predicts (i) an inverse relationship between institutional strength and entry quality, and (ii) a negative relationship between institutional strength and long–run quality growth. While motivated by observed differences in quality dynamics across institutional contexts, the model is deliberately stylized. It offers a tractable framework to explain these patterns and guide the empirical analysis by clarifying the underlying mechanisms and generating testable predictions. I test these predictions using German firm–product–destination data from 2011 to 2020. The evidence aligns closely with the theory. In weak–institution destinations, exporters enter with higher estimated quality at entry, upgrade more gradually at first, but eventually surpass growth dynamics in strong–institution markets after three to four years. In strong–institution destinations, estimated initial quality is lower but rises quickly in the early years before plateauing. By years seven to eight, growth rates converge, suggesting relational mechanisms such as relationship–specific effort and repeated business have largely closed the institutional gap.

My analysis touches several strands of literature in international trade and development. A first strand of research studies how institutions shape international trade. On the theoretical side, Levchenko (2007) models institutional strength within incomplete contracts, predicting that stronger enforcement favors industries reliant on relationship–specific inputs. Nunn (2007) provides complementary evidence that weak enforcement reduces exports in contract–intensive sectors. Relatedly, Essaji and Fujiwara (2012) and Fa lkowski et al. (2019) show that weaker institutions are associated with lower average product quality, while Ndubuisi and Owusu (2022) combine customs data and institutional indices to document how trust and enforcement jointly shape export upgrading. These papers focus on institutions in the exporting country rather than the destination country and abstract from within–relationship quality dynamics – two gaps my paper fills.

A second strand highlights relational contracting and reputation as substitutes for contract enforcement. Macchiavello and Morjaria (2015), studying Kenyan rose exports, exploit a political shock to show that long–term relationships insure against enforcement risk, sustaining trade and quality. Bondareva and Pinker (2019) provide a theoretical model of dynamic relational contracts in supply chains, while Macchiavello (2022) reviews evidence from coffee, cut flowers, and garments, emphasizing how long–term relationships substitute for weak formal enforcement, though largely in sector–specific contexts. A closely related theoretical contribution is Board and Meyer-ter Vehn (2013), who develop a dynamic model in which sellers optimally “over–invest” in quality early on to establish credibility with buyers. Since quality is persistent, this increases future revenue even if the firm is believed to be walking away in the future. My paper builds on these mechanisms but shifts the focus from signaling seller reliability to sustaining relationship durability. In my framework, exporters front–load relationship–specific effort not primarily to build a market–wide reputation, but to increase the likelihood that a given trading relationship survives long enough to realize returns from quality provision.

A third strand connects firm heterogeneity, destination characteristics, and export quality. Building on the heterogeneous firms framework of Melitz (2003), Verhoogen (2008), Kugler and Verhoogen (2012), and Hottman et al. (2016) show that more productive firms produce higher–quality goods and command higher prices, and that richer consumers’ greater willingness to pay induces firms to upgrade quality. Empirical evidence supports this demand–based channel. Bastos and Silva (2010) find within–firm–product correlations between prices and destination income for Portuguese exports, and similar patterns appear in China, France, and Hungary (Manova and Zhang, 2012; Martin, 2012). While this literature explains how demand fundamentals shape cross–country variation in export quality, it largely over- looks the bilateral and dynamic nature of firm–buyer relationships. My model instead focuses on the role of institutional frictions in shaping exporters’ expectations about relationship duration. In weak – institution environments, where legal guarantees are limited, firms front–load relationship–specific effort as part of quality provision to secure long–term payoffs. This generates distinct dynamic quality trajectories across institutional settings, driven not by demand per se, but by incentives to sustain cooperation over time.

Keywords: international trade, institutions, quality, survival, Germany

JEL-Classification: F10, F12, L14