complexity of transactions enabled by better infrastructure could facilitate the need for new institutions (e.g., courts), which then reduce future agency costs for trade (Demsetz 1967). Yet, how infrastructure affects firm performance remains under-studied. Several recent studies shed light on this key issue.

Infrastructure is found to be the most important factor in explaining firm performance in Bangladesh, China, Ethiopia, and Pakistan (Dollar et al. 2005). Using the World Bank Enterprise Survey data for these countries, Dollar et al. study how the business environment affects firm performance, including total factor productivity (TFP), wages, profits, growth rates of output, employment, and fixed assets. The measures of business environments include several proxies for infrastructure (e.g., custom efficiency, power loss, and the number of days to install phones), the share of firms with overdraft access, and the number of times per year that they are visited by government inspectors. The business environment affects TFP because better local governance makes the same bundle of inputs produce more outputs due to lower transportation and transaction costs and a better protection of property rights. Why does a better business environment lead to higher wages and profits? For countries in the same specialization cone, factor endowment decides trade structure (Schott 2003). To compete with more efficient producers (with better business environments), countries with worse business environments can only afford lower factor prices to stay competitive with efficient producers—therefore, lower wages (for labor) and profits (for capital owners). Why do better business environments lead to higher growth rates? A better business environment causes higher returns to capital, which, in turn, engenders a higher investment and growth rate initially before eventually reaching the steady state.<sup>10</sup> Since firm-level measure of the investment climate may be endogenous—for example, more profitable firms may have better connection with government officials, and may therefore face systematically more or less government harassment—the authors use location-sector average of the investment climate proxies to measure local business environment. They also control for country dummies. This approach mitigates two issues: (i) firm measures of business environment may be closely related to omitted variables at the firm level, and (ii) firm answers on investment climate may be responses rather than

> 10 The positive relationship between investment and business environment in general and infrastructure in particular does not have to hold everywhere—there could be a negative relationship in some small neighborhood (or on a more grand scale in some former socialist countries such as the Soviet Bloc). An example is that infrastructure is much worse in India than in China. To adapt to the bad electricity system, firms tend to purchase their own power generators, which increase investment. So this example may run counter to the positive relationship between investment and infrastructure. Even though Indian firms may have more power generators, they still have lower capital-labor ratio relative to China, which possesses a better infrastructure (based on the author’s check on investment climate data for both countries).

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