Cultural proximity and inter-firm trade

Low-quality institutions are prevalent in emerging economies, generating micro-level trade frictions. Consequently, firms may rely on informal institutions and socio-cultural ties between firm owners, to overcome such frictions. Using new microdata on firm-to-firm trade from India with information on prices, transactions, and caste and religious connections, we find that higher caste and religious proximity reduces prices, and fosters trade at intensive and extensive margins. We provide supporting evidence on such proximity alleviating contracting frictions. We formalize these findings in a quantitative inter-firm trade model with cultural proximity between firm owners. A policy counterfactual analysis indicates that an economy composed of culturally closer firms features lower costs, lower prices, higher sales, and higher welfare than an economy with culturally distant firms.