intra-industry trade and protectionism: the case of the buy national policy

Intra-industry trade and protectionism: the case of the buy national policyAuthor(s): Dong-Hun KimSource: Public Choice, Vol. 143, No. 1/2 (April 2010), pp. 49-65Published by: SpringerStable URL: http://www.jstor.org/stable/40661004 .

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Public Choice (2010) 143: 49-65 DOI 10. 1007/sl 1 127-009-9490-3

Intra-industry trade and protectionism: the case of the buy national policy

Dong-Hun Kim

Received: 14 November 2008 / Accepted: 26 July 2009 / Published online: 4 August 2009 © Springer Science+Business Media, LLC 2009

Abstract This article examines the factors that lead governments to open up their public procurement markets to international competition with a particular emphasis on the effect of intra-industry trade. Contrary to the conventional notion that intra-industry trade entails less political pressure for protectionism than inter-industry trade, I argue that such notion does not prevail in the case of discriminatory public procurement. Firms in a market with a high degree of intra-industry trade are more likely to resist the removal of discrimination than would firms in a market with a high degree of inter-industry trade. Empirically, I find support for the argument both at sub-national and cross-national settings.

Keywords Public procurement • Intra-industry trade • Protectionism • Buy national policy

JEL Classification F13 F14 F52 F59

1 Introduction

Is intra-industry trade related to less trade protectionism? Arguments based on distributional consequences of trade tell us that intra-industry trade entails less political action than inter-industry trade and is more favorable to free trade policies (Krugman 1981; Marvin and Ray 1987; Rodrik 1995; Alt et al. 1996). The puzzle, however, remains unsolved. Re- cent studies challenged this conventional wisdom by investigating the effects of political institutions (Kono 2009) and the collective action problem (Gilligan 1997) that modify the impact of distributional consequences on trade policies. However, there are only a few, if any, studies on the impact of intra-industry trade on policies of non-tariff barriers (NTBs). Yet, this is critical since NTBs have gradually replaced tariffs (e.g. Bhagwati et al. 1998; Kono 2006), and a large part of the current international trade flow is of the intra-industry type (Brakman et al. 2006). This article further challenges the conventional wisdom by examining the impact of intra-industry trade on discriminatory procurement policies (e.g. the

D.-H. Kim (131) Department of Political Science and International Relations, Korea University, Seoul, South Korea e-mail: [email protected]

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50 Public Choice (2010) 143: 49-65

"buy national" policies), which is a well-known NTB (Deardoff and Stern 1998). The conventional wisdom claiming that intra-industry entails less political action than inter-industry trade is not necessary valid in the case of discriminatory procurement policies. In the public procurement market, intra-industry trade leads to more discriminatory procurement against foreign firms. In the following, I begin by discussing discriminatory procurement practices.

Favoritism toward domestic firms in the government procurement market is one of the well-known non-tariff barriers (NTB) to international trade. Some prohibit government pur- chases of certain imports outright, while others provide preferential treatment to domestic producers. Certain informal practices also discriminate against foreign producers - for example, soliciting bids on a short notice with minimum publicity, which denies foreign firms access to information on government contracts. Since, in most countries, government is the largest consumer in the market, the government procurement sector has been considered an enormous potential market that could be opened up for international trade.1 Not surprisingly, the attempts by U.S. Congress to insert the "Buy American" clause in the stimulus package in early 2009 caused a fierce debate around the world.

Government procurement, however, has been largely omitted from the scope of multilateral trade rules. As far as the rules of the world trading system are concerned, the government procurement market is rather exceptional in that it lies beyond the scope of the disciplines of the GATT/WTO. The General Agreement on Tariffs and Trade (GATT), originally negotiated in 1947, explicitly excluded government procurement from its national treatment obligation (Art. HI of the GATT). More recently, it was also exempt from the 1995 Gen- eral Agreement on Trade in Services (Art. XIII. 1 of the GATS). As an effort to introduce government procurement into the general multilateral trade rules, the 1979 Agreement on Government Procurement (GPA) achieved limited success in subjecting government procurement to the principles of nondiscrimination and transparency at the end of the Tokyo round.2 However, it was not part of the general GATT agreements; it was a "side" agreement that was negotiated in parallel with the GATT talks due to fact that the GATT explicitly excluded government procurement from the principles of nondiscrimination. Consequently, the GPA of 1979 only applied to those GATT contracting parties who signed it. In the 1990s, during the Uruguay Round, a new GPA was concluded and became one of the agreements administered by the WTO. This new agreement has a much wider scope than the 1979 agreement, extending to sub-national governments and state enterprises. However, like its predecessor, the new GPA is still voluntary and binds only the WTO members who signed it. By 2008, only 37 countries had signed the GPA, which represent less than one quarter of the WTO members.

Why do some allow foreign competition in government procurement while others do not? It is because governments face a dilemma. As consumers who need to purchase the necessary products and services, governments have an incentive to buy them at the best possible terms by opening up their procurement markets to foreign competition.3 Governments, however, are not ordinary purchasers like individual consumers. As political actors who want to

'2001, public procurement, excluding military spending and compensation for government employees, was estimated to account for 6 to 15% of GDP in OECD countries and as much as 20% of GDP in non-OECD countries (OECD 2001). It should also be noted that not only the overall size of the government procurement market that is large but also a wide range of goods and services are purchased by government including sophisticated products such as chemicals, machinery, transportation equipment, electrical equipment and electronics.

2For the history of negotiations, see Blank and Marceau (1996). 3 For the issues of an asymmetric information problem arising in procurement contracts, see, e.g, Laffont and Tiróle (1993), and Levaggi (1999).

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Public Choice (2010) 143: 49-65 51

maximize political support, they often purchase for reasons other than direct consumption, such as to raise the income of a particular group or to increase employment in a particular region. Awarding lucrative contracts in exchange for political support by imposing discriminatory regulations in the procurement market has its incentives.4 This article suggests that a high degree of intra-industry trade strengthens government's incentive as a political actor and leads to a more protectionist procurement policy.

2 Intra-industry trade and protectionism

According to the standard trade theories (often referred to as the Heckscher-Ohlin model and the Ricardo- Viner model), winners and losers from free-trade can be identified by examining the changes in the relative factor prices caused by international trade. The Stolper- Samuelson (S-S) theorem (Stolper and Samuelson 1941) discusses precisely how relative factor prices change in response to a change in the relative price of goods. When the relative price of a labor intensive good increases in a labor abundant country due to international trade, it will cause an increase in the wage rate and a fall in the rental rate on capital. Al- though this brings the wage rate to increase relatively more than the price of a labor intensive good, the benefit from international trade is uneven. Owners of the abundant factor will find their real income rising while owners of the scarce factor will find their real income falling. Not surprisingly, this clean conclusion of the S-S theorem has been widely applied to explain political conflict within one country (Magee et al. 1989; Rogowski 1989; Alt et al. 1996; Thorbecke 1997; Hiscox 2002).

Empirical challenges to the standard trade theory, however, spawned the development of trade theories that emphasized economies of scale and product differentiation. During the past few decades, intra-industry trade - when a country exports and imports the same or very similar products - became an important characteristic of international trade. Since the standard trade theories dealt only with inter-industry trade - when a country exports and imports different products - studies on international trade explored the effect of the market structure on the trade pattern to explain intra-industry trade (see e.g. Helpman 1999). A general ex- planation goes as the following: consider an industry where a product is differentiated, and let each variety of the goods be made with increasing returns to scale. Since products differ from each other and each firm's product possesses a certain amount of consumer brand loyalty, every variety will be demanded in most countries.5 Thus, the production of and demand for the differentiated products will generate intra-industry trade. According to the standard trade theory, a capital abundant country will export capital intensive goods and import labor intensive goods. However, if there are different varieties of both types of goods, then the capital abundant country will also import some varieties of capital intensive goods. It is, therefore, possible for both inter-industry and intra-industry trade to occur when products are differentiated. If a market is characterized by perfect competition, constant returns to scale, and product homogeneity, we are more likely to see inter-industry trade that is driven by comparative advantage. On the other hand, if a market is characterized by imperfect competition, increasing returns to scale, and differentiated products, we would see

4Note that a government becomes both a market participant (consumer) and a market regulator, and, thus, previous works on protectionism in private sectors are not so appropriate in analyzing protectionism in the government procurement market. 5 There is a subtle difference in how models differ in this regard. See Dixit and Stiglitz (1977), Lancaster (1979), and Helpman and Krugman (1985).

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52 Public Choice (2010) 143: 49-65

more intra-industry trade (e.g. a state imports and exports different types of wine) that does not reflect a comparative advantage. In a single country, then, it is possible to have sectors where either an inter-industry or intra-industry prevails depending on the market structure of the sector in question.

In terms of the political consequences of trade, theories on intra-industry trade offered several new insights. When countries are open to trade, the market size is enlarged for each firm in each country due to the increase in the number of potential buyers. Put differently, opening of trade will not change the total output of the domestic industry because extra export occurs as import takes a part of the domestic market. Then, opening of trade has little impact on the domestic factor prices. There are few inter-industry shifts in production that put pressure on factor prices (Krugman 1981; Gilligan 1997; Verdier 1998). In addition, consumers will have more varieties to choose from. It is possible that gains from variety can offset any losses in factor income resulting from inter-industry shifts in production that occur as the S-S theorem predicted. Thus, even if one is a scarce factor of production in the S-S context and tends to lose from trade, the gain from the increased variety of goods can offset the losses from being a scarce factor. Unlike inter-industry trade, it is possible for everyone (within a country) to gain from increased trade. In other words, intra-industry trade entails less redistributive effect and lower adjustment cost than inter-industry trade. Accordingly, there should be less political pressure on and less conflict over trade policies where intra-industry trade prevails (e.g. Marvin and Ray 1987; Levy 1997; Rodrik 1995; Verdier 1998).6

3 Intra-industry trade and discriminatory public procurement

The conventional wisdom suggests that intra-industry trade entails less political action than inter-industry trade and, thus, is more favorable to free trade policies. The present paper, in contrast, argues that intra-industry trade could be more politically contentious than inter- industry trade and, more importantly, will lead to more protectionism in the case of government procurement policy. In particular, I argue that, ceteris paribus, firms in a market with a high degree of intra-industry trade are more likely to resist the removal of discrimination than would firms in a market with a high degree of inter-industry trade. To illustrate this argument, I compare the effect of discriminatory procurement in a perfect competition market, where inter-industry trade prevails, to its effect in an imperfect competition market, where intra-industry trade prevails.

3.1 Distributional consequences of intra-industry trade

Baldwin and Richardson (1972) and Baldwin (1984) provided a counter-intuitive argument on the distributional consequences of discriminatory public procurement in a perfect competition setting. In contrast to the general presumption that discrimination reduces imports and increases domestic output in comparison to free trade, they showed that discrimination has little or no effect on the overall import and domestic output unless the government purchase is larger than the domestic supply. To see the logic of Baldwin and Richardson's "ineffectiveness proposition", suppose that in a market for computers before discrimination

6 By extending this argument, many also argued that there will be relatively less conflict between countries

that have a higher share of intra-industry trade. See, for example, Krugman (1981), Rodrik ( 1 995), and Verdier (1998).

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was imposed, the government demand of computers was 40, and the private sector 60, 45 of which the domestic industry supplied while 55 computers were imported.7 Now suppose that the government initially bought 10 computers from abroad and subsequently decided to buy only domestic computers. The domestic industry now has to supply 10 more computers to the government and 10 less to the private sector; but foreign industry now has 10 unsold computers that they can supply to the private sector. Total imports and domestic outputs remain unchanged.8 Now change the scenario and suppose that government demand is 60 computers, private demand is 40, while everything else remains the same as before. The government in this situation must import at least 15 computers since the domestic industry supplies only 45 computers. If the government decides to buy only domestic products, the domestic industry will have to increase its supply to meet the demand, and import will be decreased. As a result, the relative price of computers will increase since the additional factors of production that the domestic industry needs to satisfy the government demand must come from other industries. Thus, discriminatory government procurement policy causes the country to specialize more in the production of computers. Discriminatory government procurement affects specialization and trade volume when government demand exceeds domestic supply.

According to Baldwin and Richardson's proposition, then, we should expect to see some kind of a political mobilization based on economic interests only when the government demand is relatively larger than the domestic supply. On the other hand, we should see little or no political pressure on the imposition or on the removal of discriminatory government pur- chases when the government demand is relatively small, since discrimination has no effect on imports and domestic output. Unfortunately, however, these implications are only applicable to those industries whose market setting is characterized by perfect competition. In international trade, their predictions are only applicable to the industries where comparative advantage has force and, thus, where inter-industry trade prevails.

In the case of an imperfect competition market setting, in contrast to the "ineffective proposition," government discrimination against foreign products in procurement always increases domestic output and decreases import, regardless of the size of the government demand. Consider the following hypothetical situation.9 First, under an imperfect competition market (e.g. the monopolistic competition setting), it is important to remember that each producer has some degree of monopoly power in the market for the variety it produces due to product differentiation (e.g. each firm's product possesses a certain amount of consumer brand loyalty). Suppose that a sector is characterized by monopolistic competition where each firm produces a differentiated product and enjoys (internal) an increasing return to scale.10 There are 50 domestic suppliers of wines - a total of 100 suppliers in the world - each producing a different variety of wine. For the sake of simplicity, say the price is $1

7For a detailed review of the "ineffective proposition", see Evenett (2002). 8 It is important to remember that domestic and foreign goods are identical and, thus, the prices of imports and domestically produced goods cannot diverge. Discrimination tends to bid down the price of imports, as the supplies formerly bought by the government are thrust onto the private market. But, at the same time, the price of domestic goods will rise as the government shifts entirely to domestic suppliers. However, the tendency of price movements leads the private sector to exactly the opposite direction. It will substitute imports for domestic goods and will do so only to the extent necessary to restore equality between the two prices. 9For related formal treatments, see Miyagiwa (1991) and Trionfetti (2000). 10Note that the illustration represents an extreme case that assumes the elasticity of substitution between products to be almost zero. As long as the degree of substitutability between products is higher under a perfect competition setting, the argument does not change.

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per unit for all products. Suppose that government demand is $100 and domestic private demand is $200, and the demand from the foreign private economy and foreign governments are also $200 and $100 respectively. Both the government and the private economy buy all 100 varieties in the world. In this case, domestic producers face the total demand of $300, a demand of $50 each from the domestic government and the foreign government, and a demand of $100 each from the domestic private economy and the foreign private economy. If the government decides to purchase only domestic wines by discriminating against foreign producers, domestic producers now face an increased total demand of $350. It is because the demand from the domestic and foreign private economy and the foreign government remained the same while the demand from the domestic government has increased from $50 to $100. H Note that discrimination by the domestic government results in an increase in domestic supply and a decrease in foreign supply, regardless of the size of government demand.

Discriminatory policy always increases domestic output and decreases import when the market is characterized by imperfect competition and differentiated products. As noted previously, in terms of the international trade flow, imperfect competition market structures result in intra-industry trade. Then, we should always expect to see domestic political pressure for discriminatory government procurement where intra-industry trade prevails. By the same logic, if the foreign supply to government increases due to the elimination of discriminatory policies, the domestic supply needs to be decreased. This, again, happens regardless of the size of government demand, and we should always expect to see political pressure against the elimination of discriminatory procurement policies.

3.2 Political lobbying, intra-industry trade, and government procurement

Based on the preferences of industries discussed thus far and assuming that firms or industries will take political action to receive benefits or to avoid the ills from removing discriminatory government procurement, the working hypothesis is that countries with a high degree of intra-industry are less likely to subject public procurement to foreign competition when government demand is relatively small. Nevertheless, there are certain factors that intervene between the preferences of industries and the outcome (Rowley 1984). The cost of political action, for instance, is not trivial.12 Firms have to lobby the government, and the collective action problem can be serious due to the pubic-good nature of lobbying (Olson 1965).13 If the problem is serious for firms in a sector where intra-industry trade prevails, they would not engage in a costly political action even if the elimination of discriminatory procurement creates adjustment costs.

As Gilligan (1997) noted, however, the collective action problem is far more serious for the firms in a sector where inter-industry trade prevails. The main reason is that, in a sector with intra-industry trade, a firm, after all, is a monopolist in that particular variety and has no incentive to free-ride (Gilligan 1997). Lobbying becomes a private good for the firms in a sector with intra-industry trade. On the other hand, firms in a sector where inter-industry trade prevails face a collective action problem. For example, consider the apparel industry (e.g. T-Shirts, Uniforms) where products are less differentiated. There are several firms that

1 1 As mentioned previously, the reason why the demand from the private economy remains the same is due to the assumption of product differentiation. 12For an excellent survey of public choice perspective on the issues of trade policy, see Rowley (2001). 3 For a discussion of the interest-group theory of politics on protectionism, see Grossman and Helpman

(2001).

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Market Structure

Perfect Competition Imperfect Competition (Inter-industry Trade) (Intra-industry Trade)

No effect on import and Decreases import and domestic output. increases domestic output.

Smaller No (little) political support or Domestic firms support opposition should be discrimination and oppose the expected. GPA.

In the lobbying efforts, firms In the lobbying efforts, firms Gov. Demand have an incentive to free-ride do not have an incentive to (in respect to in lobbying. free-ride in lobbying, domestic supply)

Decreases import and Decreases import and increases domestic output. increases domestic output.

Larger Domestic industry should Domestic firms support support discrimination and discrimination and oppose the oppose the GPA. GPA.

In the lobbying efforts, firms In the lobbying efforts, firms face an incentive to free-ride. do not face an incentive to

free-ride.

Fig. 1 Intra-industry trade, political lobbying, and discriminatory public procurement

produce similar products, and they all have the possibility to become a government contrac- tor. In other words, all firms have potential gains from discriminatory government procurement, and thus, lobbying for discrimination is a public good for them. The bottom line is that, in general, firms in a sector where intra-industry trade prevails enjoy a monopolistic status in that particular variety, and lobbying for government contract for that particular variety will closely resemble a private good. Therefore, firms in a sector where intra-industry trade prevails are more likely to act politically.

Figure 1 summarizes the argument. When government demand is relatively larger than domestic supply, discrimination in government procurement always decreases import and increases domestic output regardless of the market structure. Domestic producers in both market structures support discrimination and, therefore, oppose its elimination. In contrast, when government demand is relatively small, we should see no or little political pressure from an industry in a market where inter-industry trade prevails since discriminatory government procurement affects virtually nothing. But, in a market where mira-industry prevails, we should still expect to see political support for discrimination from firms that are favored by the discriminatory government procurement. It is because discrimination increases domestic output and decreases the import of foreign variety regardless of the size of the government demand. By the same logic, ceteris paribus, domestic firms that are currently favored by discriminatory procurement should always resist removing discrimination against foreign products in government procurement since removing it will require them to decrease output, which entails adjustment costs. In addition, the collective action problem strengthens the argument. The collective action problem in lobbying for discriminatory procurement is less serious for firms in a market where intra-industry trade prevails than for firms in a market where inter-industry trade prevails. Firms in inter-industry trade have little incentive

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56 Public Choice (2010) 143: 49-65

to take political action when government demand is relatively small and much incentive to free-ride, even when they decide to act, when demand is relatively large. Taken together, in the case of government procurement, we then have a different prediction from the conventional wisdom about the intra- versus inter-industry comparison, and I have the following hypothesis.

H Countries (central/federal governments) with a high degree of intra-industry trade are less likely to subject public procurement to foreign competition.

4 Empirical analysis

To empirically investigate the effect of intra-industry trade on the government decision to allow foreign competition in public purchasing, we need to know the full extent to which governments discriminate in their procurement policies. Unfortunately, comprehensive and comparable cross-country data on such discrimination has not been collected. Measuring de facto discrimination against foreign firms will be impossible unless countries publish their procurement records. On de jure discrimination, however, we do have, much knowledge (e.g. the Buy American Act of 1993 of the United States). In this article, therefore, I empirically examine the de jure discrimination against foreign firms although it is a less ideal measure than the de facto discrimination. More specifically, I make use of each country's commitment to the 1994 Government Procurement Agreement (GPA) of the World Trade Organization (WTO) to examine its discriminatory behavior toward foreign firms.

There are several reasons why varying commitment to the GPA can be useful in examining discriminatory behavior. First of all, the GPA of the WTO imposes international constraint on discrimination and demands transparency in government procurement. It not only bans de jure discrimination but also has stipulations to cut de facto discriminatory measures such as provisions on transparency (Reich 1999; Arrowsmith 1998). The countries that join the GPA are legally obliged to ban de jure and, possibly, de facto discriminatory practices. Furthermore, unlike other multilateral agreements of the WTO, the GPA is a plurilateral agreement; that is, it is voluntary and binds only those WTO members who sign it. Thus, a country's commitment to the GPA can be a useful proxy for its intention of non-discriminatory behavior, including de jure and defacto discrimination (Hoekman and Mavroidis 1997; Arrowsmith 2003). 14

14Due to the possibility of a country's commitment to the international agreement being just a "cheap talk," I do recognize that this could be a weak measure. Let me provide additional justifications. First, the members of the WTO are not obligated to join the GPA when they join the WTO. It is voluntary and binds only those who sign the agreement. There is no reason to join the GPA in order to receive the benefits of the WTO. Second, and more important, the GPA makes use of the WTO dispute settlement body. It allows the members to bring cases of the GPA to the WTO dispute settlement procedures, and the cost to the defectors (or defendants), if they do not comply with the ruling, can be substantial. Furthermore, the GPA requires its members to allow their contracts to be contested by foreign private bidders before domestic adjudicating bodies, which also ante up the cost if they renege from commitment. Third, as Simmons (2000) and Simmons and Hopkins (2005) argued, international agreements incur reputational costs for a government if it reneges. A government, by joining the agreement, is raising its reputational stake higher. Finally, according to the report of the WTO (1999), there is substantial evidence that members of the GPA are actually complying with the GPA. Taken together, it would be safe, although not ideal, to assume that a country's commitment closely reflects its intention of non-discriminatory policy.

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4. 1 Models, variables, and results

The dependent variable, GPA, is a dichotomous variable indicating countries (central/federal governments) that voluntarily agreed to join the Government Procurement Agreement (GPA) of the WTO in 1994. Thus, those countries that were obligated to join the GPA in 2004 as members of the European Union - Czech Republic, Hungary, and Bulgaria - are not coded as members. For the main explanatory variable, Intra- Industry Trade, I employ the Grubel and Lloyd (1975) measure for each country j, defined as the following.

/ ^W ̂ I "V li Ji I '

Intra-Industry Trade: = I 1 - ~ ~" - - 1 100

' Z^i xi + Mi )

For this measure, I use the 4-digit SITC data from the UN Comtrade database. X¡ and M¡ are a country's exports to and imports from a trading partner of commodity i , respectively. The value of the index ranges from 0 to 100. A value of 0 is given when a country either exports or imports but not both, and the higher the value of the index, the greater the degree of intra-industry trade.15

The remaining independent variables are included to account for factors that previous researches have linked to discriminatory procurement policies. First, I take into account the possibility of the usual forces of trade politics being involved in discriminatory government procurement policies. Import Share is the import of goods and services as a share of GDP for each country averaged from 1989 to 1993. This variable controls for the possibility of the level of import competition increasing the general preference for protectionism and, thus, also affecting a government's decision to open up public procurement to foreign competition. Second, it is possible that the financial status of state governments may in- fluence governmental decisions (Hoekman 1998). Elimination of barriers to procurement contracts can bring budgetary savings to governments through increased competition, and thus I included the Deficit variable, a measure of each central/federal government's deficit as a percentage of the total expenditure averaged from 1989 to 1993. Third, I consider the ability of government bureaucracy to subject government procurement to international competition, including its capacity to gather information, evaluate the bidder's proposal, and monitor foreign contractors. As Arrowsmith (2003) conjectured, the cost of opening up the public procurement market can be significant enough to deter developing countries that lack administrative/technical capacity from subjecting their procurements to international competition. Reich (1999) also noted that international competition in public procurement could impose too heavy an administrative burden on procuring entities since governments need to evaluate numerous and often complex bids from foreign suppliers.16 To control for the possibility of governments with a low level of bureaucratic capacity hesitating to open up the procurement market, I include the Bureaucratic Capacity variable that measures the quality of government bureaucracy. I employ a measure from ICRG (International Country Risk Guide) which ranges from 0 to 100, 100 representing the highest quality. Finally, the LnGDP variable is included to control for the size of a country's economy, which is the log of gross domestic product averaged from 1989 to 1993.

15 1 use the average value from 1989 to 1993 to account for the fact that the GPA was negotiated during the Uruguay Round. 16 See also Chappell and Shughart (1992) for the discussion of incentives of government purchasing agents when dealing with a large number of small firms.

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Table 1 Intra-industry trade and foreign competition in public procurement

Variables (1) (2) (3) (4)

Intra-industry Trade -0.037** -0.044** -0.037** -0.043**

(0.014) (0.015) (0.017) (0.018) Deficits 0.744** 0.561 0.722** 0.622

(0.076) (0.431) (0.296) (0.664) LnGDP 1.544** 1.411** 1.537** 1.427**

(0.254) (0.552) (0.378) (0.601)

Import share 0.003 0.005

(0.009) (0.012) Bureaucratic capacity 0.004 0.004

(0.010) (0.008)

Intra-industry Trade* 0.004** 0.004** Size of Gov. Demand (0.001) (0.001) Size of Gov. Demand -0.002 -0.005

(0.027) (0.022) Constant -14.562** -13.711** -14.357** -14.326**

(2.562) (3.677) (5.442) (5.979) N 78 78 78 78 Pseudo-/?2 0.467 0.467 0.468 0.468

Robust standard errors in parentheses. * p < 0. 1 ,

** p < 0.05 (two-tailed)

The empirical results are presented in Table 1. I use logit specifications to estimate the models since the variable GPA is dichotomous. All models have 78 observations, all of which are WTO members.17 First of all, the outcomes are consistent with the hypothesis. As predicted, in all models, the coefficients for the Intra-industry Trade variable are negative and statistically significant. This demonstrates that the conventional wisdom which claims that intra-industry entails less adjustment costs and thus less political action than inter-industry trade is not necessarily applicable to all types of protectionism. In the case of the discriminatory government procurement policy, domestic firms engaged in intra-industry trade have more to lose when discrimination against foreign firms is eliminated than do the firms in inter-industry trade. The empirical evidence supports the claim that the high degree of intra-industry trade reduces the propensity to subject government procurement to foreign competition.

In Table 1, Models 3 and 4 include the interaction term to provide further evidence for the argument. As mentioned in the previous section, countries with a high degree of intra- industry trade are less likely to join the GPA regardless of the relative size of government demand due to the cost of collective action. However, since I do not know, ex ante, if the cost of collective action would actually offset the benefits of rejecting the GPA, it would be

17 Since I selected the sample based on the membership to the WTO, there is a possibility of having a selection bias to the standard logit results. To check for the possibility of unobservable factors, which would lead a government to join the WTO, affecting the propensity to join the GPA, I re-estimated all the specifications with the Heckman selection method. The Wald test of the independent equation that test p = 0 showed that p is not significantly different from 0 in all models, and x2 in all models were far from being significant. Therefore, a selection bias due to sample selection is not serious in the empirical results.

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plausible to assume that there would be cases in which, among the countries with a relatively large government demand, the collective action problem for firms engaged in inter-industry trade is not so serious. Therefore, I take into consideration the size of the government demand in Models 3 and 4.18 The prediction is that since firms in both types of trade face adjustment costs due to the GPA when the size of government demand becomes relatively large, the reductive (or negative) effect of intra-industry trade should decline as the relative size of government demand increases. As predicted, the coefficients for the interaction term are positive and significant. This evidence clearly indicates that the empirical result is not mainly driven by the collective action problem but rather, it is the distributional consequences of the intra-industry trade that are the main forces behind the result.

Among the control variables, the Bureaucratic Capacity variable is not statistically significant. This suggests that governments with a higher capacity were not necessarily more likely to subject their public procurement to foreign competition than those with a relatively low capacity. The Import Share variable is also not statistically significant, which imply that the politics involved in government procurement differ somewhat from the usual politics of trade. The LnGDP variable, however, is positive and highly significant, suggesting that large economies tend to open up more than the smaller ones. Finally, the Deficits variable is significant in Models 1 and 3, implying that governments are more likely to open up their procurement market to foreign competition when they face budgetary difficulties.

4.2 Robustness check

In this section, I explore the robustness of my findings by examining the extent to which the results hold up at the sub-national level. In particular, I make use of U.S. states. An important feature of the Agreement of Government Procurement (GPA) of the WTO is that it covers not only central/federal government entities but also sub-national entities such as regional governments. Unlike other countries, the United States suggested a voluntary compliance plane for its state governments due to political difficulties in binding them (Southwick 1992; Cooper 1993). 37 state governments have agreed to cover their state procurement under the GPA, and the agreement was accepted in 1994. This natural setting provides several advan- tages to the empirical examination of the argument. First of all, it avoids many unobservable differences in culture and institutions that exist across countries while having enough cases and sufficient variations in key variables for testing the hypothesis. Also, it allows us to hold constant some legal institutions that might affect the behavior of firms. In addition, there have been several studies that empirically estimated the relative size of the U.S. government demand. According to these studies, non-defense federal procurement and state government procurement in the United States rarely exceed 10% of the total demand in various industries (Francois et al. 1997; Baldwin and Richardson 1972). Even in the construction

18The variable Size ofGov. Demand records the size of government procurement market as a share of each country's respective GDP. This variable is from the latest study by OECD (2001) which uses the System of National Accounts (SNA) by the UN to compute the magnitude of procurement of goods and services by central/federal governments. It should be noted that there are two caveats in this measure. First, technically, this measure should consider the investment expenditure realized by governments to the current acquisitions. The data on the investment segment, however, is only available for OECD countries; and thus, I do not consider the investment segment of expenditure in calculating the measure. In addition, this measure should be the relative size of government demand in respect to domestic supply not a share of GDP. Again, data limitation dictated the measurement. Since it is difficult to estimate the size of domestic supply, I am hence making an assumption that the size of government demand in respect to the domestic supply would also be large when the size of government demand as a share of GDP is large.

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60 Public Choice (2010) 143: 49-65

industry, where the biggest government contracts are available, the federal government demand is only about 2% of the total demand and about 10% for state and local governments (Francois et al. 1997). I thus make use of the U.S. state governments whose relative size of government demand is known to be smaller than the domestic supply, which will allow us to arrive at a clear conclusion about the effect of intra-industry trade.

The dependent variable is a dummy variable indicating the U.S. states that voluntarily joined the Government Procurement Agreement (GPA) of the WTO (joined = 1 , not joined = 0). As discussed earlier, 37 state governments have agreed voluntarily to cover their state procurement in 1994.19 State governments applying the GPA to their procurement are: Arizona, Arkansas, California, Colorado, Connecticut, Delaware, Rorida, Hawaii, Idaho, Illinois, Iowa, Kansas, Kentucky, Louisiana, Maine, Maryland, Massachusetts, Michigan, Minnesota, Mississippi, Missouri, Montana, Nebraska, New Hampshire, New York, Okla- homa, Oregon, Pennsylvania, Rhode Island, South Dakota, Tennessee, Texas, Utah, Ver- mont, Washington, Wisconsin, and Wyoming.

For the main independent variable, I first measured the degree of intra-industry trade for the industries at the three-digit SIC level.20 Again, I employ the intra-industry index offered by Grubel and Lloyd (1975) to measure the degree of intra-industry trade for each industry. That is:

|X/-M,|

where X¡ and M¡ represent the value of exports and imports of industry i respectively, and the vertical bars in the numerator denote an absolute value. The value of the index ranges from 0 to 1 , and the higher the value of the index itt¡ , the greater the degree of intra-industry trade.

But, since the unit of analysis is the U.S. state, I devised the variable Intra-industry Trade to measure the degree of intra-industry trade in each state. The variable was derived by taking the summation of the degree of intra-industry trade for each industry at the three- digit SIC level (iitj), weighting each degree by employment in an industry in a given state (Ejj) as a proportion of the total employment in the state (£,). Hence for state j the degree of intra-industry trade (Intra-industry Trade j) is the following:

?<»■(!) where I used the average value of the itt¡ index from 1986 to 1993 since the GPA was negotiated during the Uruguay Round. E¡j is the number of workers in state j in industry /, and Ej is the total manufacturing workforce in state j. The summation is over all industries at the three-digit SIC level.

Following the cross-national analysis, I added several control variables to address other concerns of governments. As with the Intra-industry Trade variable, I used an average value

19 In terms of sub-national entities covered by the GPA, the United States suggested a voluntary compliance plane for its state governments due to political difficulties in binding them. In other words, the United States has not chosen to enter into an international agreement that would pre-empt state laws without the consent of the states. For further details about the inconsistency among voluntary compliance plans for state governments, the commerce clause, and the federal government's foreign affairs power, see Cooper (1993), and Guay (2000). 20 Since the GPA with agreed coverage of entities was accepted in 1994 and entered into force in 1996, the measurements for variables cover the pre-1994 period.

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Public Choice (2010) 143: 49-65 61

from 1986 to 1993 for all the control variables. First, I included LnGSP, which is the log of real gross state product, to control for the size of a state's economy.21 Second, I included the Deficit variable, a measure for each state's deficit as a percentage of the total expenditure. The data is from the U.S. Bureau of Census (1995). Third, I also took into account the possibility of the usual forces of trade politics being involved in discriminatory government procurement policies and included two variables that are identified as important factors in explaining protectionism in the United States. First, I included a variable to control for the degree of import penetration in each state. The Import Penetration variable is measured as employment in selected import-sensitive industries in proportion to the total state manufacturing employment.22 Second, I included the Foreign Employment variable, which is a measure of a state's total employment by foreign firms in the manufacturing sector as a proportion of the total employment in the manufacturing sector, to capture workers' insecurity that might deter state governments from joining the GPA.23 Scheve and Slaughter (2004) provided a strong evidence that links foreign direct investment and economic insecurity at the individual level. They found that workers in industries that are highly exposed to foreign direct investment (inflow) were more likely to have a perception of economic insecurity. As they pointed out, if international economic integration were to limit the ability of a government to provide social insurance, or is perceived as such, then individuals may oppose further liberalization of international trade (Scheve and Slaughter 2004). Hence, a high level of foreign direct investment raises worker's insecurity, and thus, may contribute to the backlash against globalization. According to this scenario then, because the most common argument in favor of protectionist procurement policies is that they create jobs and gener- ally benefit local workers, there should be a higher opposition to the GPA in states that are highly exposed to foreign companies. Government Ideology is also included to consider the overall preferences of state governments.24 A higher value represents a more liberal government. Finally, to control for the possibility of governments with a low level of bureaucratic capacity hesitating to open up the procurement market, I included the Bureaucratic Capac- ity variable that measures the number of government officials and central staff concerned with financial administration of a given state government. It is employed on the grounds that the more staff working in government procurement activities, the better the government is at gathering information and evaluating the increased numbered of bids, and, thus, suffers fewer transaction costs by joining the GPA.

The results of the analysis on the US states are presented in Table 2. As in Table 1 , 1 used the logit specification to estimate the models. The Intra- Indus try Trade variable is negative and is significant in all specifications, which is consistent with the hypothesis and Models 1 to 4. As expected, the U.S. states with a high degree of intra-industry trade are less likely to join the GPA of the WTO, adding robustness to the cross-sectional analysis. Following the cross-national analysis (Table 1 ), I also included the interaction term in Models 7 and 8.25

21 The data is from SPPQ Data Resource. http://www.ku.edu/pri/SPPQ/research.html. Accessed 10 May 2008. 22 Import sensitive industries were identified according to Bednarzik (1993) at the four-digit SIC level. An import sensitive industry is defined as an industry with an import penetration ratio above 30% or an industry with an annual growth rate of 2% in import penetration ratio. The import penetration ratio is the ratio of imports to imports plus total domestic shipments. The data comes from the U.S. Bureau of Census (1992, 1998). 23 The data comes from Fahim-Nader and Zeile (1996). 24 It is from Berry et al. (1998), and is updated on the ICPSR website. 25 For the variable Size ofGov. Demand, in the case of the US states, I estimated the total size of procurement in 1993 for each state by following the formula used by the U.S. federal government in its report to the

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62 Public Choice (2010) 143: 49-65

Table 2 The effect of intra-industry trade: U.S. states

(5) (6) (7) (8)

Intra-industry Trade -12.769** -14.931** -25.156** -25.031**

(6.145) (7.019) (10.139) (10.037) Deficits -10.973 -11.207 -12.861 -13.755

(11.426) (11.028) (11.048) (11.539)

LnGSP -0.180 -0.848 -1.793 -1.645

(0.068) (0.889) (1.227) (1.254) Import penetration 7.375 5.816 -1.616 -1.847

(10.572) (11.298) (11.953) (12.336) Foreign employment -0.346** -0.372** -0.407** -0.398**

(0.122) (0.139) (0.148) (0.149) Bureaucratic capacity 0.026 -0.034

(0.026) (0.052) Ideology -0.003 0.001

(0.021) (0.024) Intra-industry Trade* 0.004** 0.004** Size of Gov. Demand (0.002) (0.002) Size of Gov. Demand -0.002** -0.002**

(0.001) (0.001) Constant 13.928* 22.461* 38.972** 37.361**

(7.338) (13.237) (18.464) (18.633) N 50 50 50 50 Pseudo-/?2 0.258 0.270 0.333 0.338

Robust standard errors in parentheses. * p < 0. 1 ,

** p < 0.05 (two-tailed)

The coefficients for the interaction term are positive and statistically significant, indicating that the negative effect of intra-industry declines as the relative size of government demand increases. Among the control variables, the Foreign Employment variable is statistically significant in all models. The degree of employment by foreign firms seems to have a negative effect on the U.S. state government's decision. Consistent with Scheve and Slaughter (2004), the U.S. states that are highly exposed to foreign firms are less likely to join and subject their procurement to foreign competition.

5 Conclusion

Compared to the role of government policy on opening up the private markets (e.g. re- ducing tariffs on commercial goods), a government's decision to extend free trade to the public market has rarely been studied. This article contributes to the growing body of research on non-tariff barriers (NTBs) by examining the conditions under which governments

WTO (WTO 1995). It is Current Operation plus Capital Outlay minus Compensation, and all these three components are subsets of direct expenditures of each state.

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extend free trade to the public sector. A key finding is that the conventional wisdom that intra-industry trade entails less political action is not valid in the case of discriminatory procurement policy. Domestic firms in a market where intra-industry trade prevails have more to lose if discrimination against foreign firms is eliminated than firms in a market with inter- industry trade. Accordingly, firms in a market with a high degree of intra-industry trade are more opposed to opening up the public procurement to international competition than firms engaged in inter-industry trade.

This paper complements recent works that challenge the widely accepted view about intra-industry trade (Kono 2009; Gilligan 1997). The argument and the evidences in this paper demonstrate that we should be cautious when applying intra-industry trade as a factor for lower protectionism among developed countries. Intra-industry trade involves different political dynamics in the case of non-tariff barriers. In the case of discriminatory government policies, intra-industry is more contentious and is related to more trade protectionism than inter-industry trade.

Acknowledgements I thank John Conybeare, Jeffrey Drope, three anonymous referees and the editors of this journal for the helpful comments and suggestions. All remaining errors are my own.

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