WPS3925

# Productivity Matters for Trade Policy:

# Theory and Evidence

## Baybars Karacaovali* University of Maryland

### **Abstract**

There is a growing literature that investigates the effect of trade liberalization on productivity. Nearly all such studies assume that trade policy is determined independently of productivity, hence it is exogenous. I show, both theoretically and empirically, that this assumption is not valid in general and that researchers may be underestimating the positive effect of liberalization on productivity when they do not account for the endogeneity bias. On the theory side, I demonstrate that under a standard political economy model of trade protection, productivity directly influences tariffs. Moreover, this productivity-tariff relationship partly determines the extent of liberalization across sectors even in the presence of a large exogenous unilateral liberalization shock that affects all sectors. The link between productivity and tariffs is maintained after I include in my political economy model a learning-by-doing motive of protection, which also serves as the source of liberalization. On the empirical side, I examine total factor productivity (TFP) estimates obtained at the firm level for Colombia between 1983 and 1998, and find that more productive sectors receive more protection within this period. In estimating the effect of productivity on tariffs, I control for the endogeneity of the two main right-hand-side variables–the inverse import penetration to import demand elasticity ratio and productivity–by employing materials prices, the capital to output ratio, a measure of scale economies, and the TFP of the upstream industries as robust instruments. I also account for the large trade liberalization between 1990 and 1992, and find that the sectors with a higher productivity gain are liberalized less. Finally, I use a system of equations to illustrate that the positive impact of liberalization on productivity grows somewhat stronger when corrected for the endogeneity bias.

JEL Classification: D24, F13, F14.

Keywords: Productivity, trade liberalization, endogeneity, political economy of trade policy, learning-bydoing.

## World Bank Policy Research Working Paper 3925, May 2006

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Policy Research Working Papers are available online at http://econ.worldbank.org._

*Department of Economics, University of Maryland, College Park, MD 20742, email: karacaov@econ.umd.edu. I greatly acknowledge Nuno Limão for his support throughout this project. I thank John Haltiwanger and especially Marcela Eslava for generously sharing part of their data. I have benefited from the comments of Marco Arena, Thorsten Beck, Roger Betancourt, Quy-Toan Do, Allan Drazen, Jonah Gelbach, Guliz Kalender, Harry Kelejian, Varun Kshirsagar, Ramon López, John McLaren, Peter Murrell, John Shea, an anonymous referee for the World Bank Policy Research Working Paper Series and the seminar participants at the World Bank Development Economics Research Group, the University of Maryland at College Park and Fordham University.