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The Basic Economics of Trade in Services

Brian Copeland and Aaditya Mattoo

What are services and how do they differ from goods?

Services:A process: a transaction involving an agreement to perform certain tasksOften require simultaneous production and consumptionOften require direct interaction between producers and consumers

Goods:Tangible and storableDo not require direct interaction between producers and consumers

Services covered by the General Agreement on Trade in Services

1. Business services2. Communication

services3. Construction services4. Distribution services5. Educational services6. Environmental services

7. Financial services8. Health-related and

social services9. Tourism and travel-

related services10. Recreational, cultural

and sporting services11. Transport services12. Other services not

elsewhere included

How is service trade different from goods trade?

Modes of supplyMajority of goods trade involves shipping goods from one country to anotherCross border trade accounts for less than half of services tradeMuch service trade requires direct contact between producer and consumer

Types of trade barriersServices tend to be highly regulated – domestic regulations often both respond to market failures and protect local suppliers from foreign competitionIdentifying and measuring trade barriers is complex

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How are services traded?

Cross-border tradeServices produced in the exporting country and consumed in the importing country

Consumption abroadConsumers travels to country of service provider

How are services traded? (2)

Commercial presence (Foreign direct investment)Service provider from one country establishes a business or professional establishment in a foreign country to provide services to consumers in that country

Presence of natural persons (Labor movement)Services provided by nationals of one country in the territory of another

Some stylized facts about service trade

In recent years, service sector accounted for about 50% of GDP in developing countries, and about 60% of GDP in OECD countriesServices trade is about 20% of total world cross-border tradeMore than half of annual world FDI flows are in services Value of sales abroad by foreign affiliates of US service firms is estimated to be 3.5 times greater than their cross-border exports

What explains the pattern of trade in services?

Motives for Trade 1: ExamplesIndian call centres provide back-office and customer care services for American firmsNannies from the Philippines move to Canada temporarily to provide childcare servicesEco-tourists fly to the Amazon for a week in the jungle

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Motives for Trade I: Comparative Advantage

Trade caused by differences between countriesSources of differences:• Technology• Labor skills• Climate• Institutions (legal systems, regulatory systems)

Endogenous vs. exogenous differences; short run vs. long run

Which mode will be used to export services?

Depends on technology, consumer preferences,regulatory environment.

If there are no trade barriers, the most efficient mode will be chosenDo gains from trade depend on the mode of supply?

Gains from trade via factor mobilityMPL MPL*

MPLMPL*

O O*L2 L1

A

E

D

C

B Initially L1

construction workers at Home; w<w*

Trade equalizes wages. L1 - L2

Home workers work in Foreign.

Global WelfareMPL MPL*

MPLMPL*

O O*L2 L1

A

E

D

C

B

Global output rises by ABC

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International Income DistributionMPL MPL*

MPLMPL*

O O*L2 L1

A

E

D

C

B

If migration is temporary, and all income is remitted back Home:

Gain to Home = ACD

Gain to Foreign = ADB

Domestic Income DistributionMPL MPL*

MPLMPL*

O O*L2 L1

A

E

D

C

B

Wages rise at home as workers leave; but this will reduce returns to domestic capital

Wages fall in foreign as workers arrive; but this will increase returns to domestic capital

Questions

Role of income distribution effects in explaining resistance to mode 4 tradeCan an inflow of foreign workers raisereturns to domestic workers? Are foreign workers substitutes or complements for domestic workers?

Motives for Trade II: Examples

Engineers from Canada design a wood-processing plant in the U.S.Engineers from the U.S. design a bridge in Canada

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Motives for Trade II: Increasing Returns to Scale

Differences cannot explain all tradeMuch trade occurs between similar countries

New theories of trade rely on increasing returns to scale

Labour market example:Two similar students; one becomes an engineer, the other a doctorGains from specialization (differences caused by opportunities in trade)Fixed costsLock-in

Market Niche EffectsProduct variety valued by final consumers (restaurants, music, movies)Product variety in producer services valued by firms (specialized suppliers of legal services, engineering services, consulting services, etc.)Fixed costs create incentives for producers to invest in the development of specialized skills and service provision capabilities

Market Niche Effects (continued)Since services are differentiated and in some cases unique, trade in similar services can occur between similar countriesServices may be supplied by any of the four modes (depends on type of service)

Gains from tradeIncreased product variety - consumers gain access to both domestic and foreign specialized productsNew specialized services may emerge than are only viable with a large global marketScale economies - producers gain access to larger markets

Income distribution effectsUnlikely to be as serious as in case of trade driven by differences between countries

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Motives for Trade III: Examples

McDonald's fast food franchises located all over worldUS owned firm runs an electricity-generating system in a foreign countryForeign-owned insurance companies provide local insurance services

Motives for Trade III: Firm-Specific Intangible Assets

Firm-level fixed costs vs. plant level fixed costsFirms develop specialized knowledge, skills, reputations, access to supply networksThese intangible assets can be exploited by establishments owned by firms in various countries.

Gains from tradeAvoids duplication of firm-specific investments in fixed costsIncreases variety of available services

Income distribution effectsForeign direct investment increases demand for local labor in host country. Demand for labour may fall in source country.Returns to some types of capital in may fall in host country, and rise in source country. Other local capitalists will benefit from access to producer services made available via foreign direct investment

Motives for Trade IV: Examples

Financial service firms based in New York and London providing financial services to clients throughout the world Movie production companies based in Hollywood export movies

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Motives for Trade IV: AgglomerationSpillover effects across firms

Knowledge spillovers, common pool of laborSpecialized suppliers of producer services

If face-to-face contact is important, producers of final goods and services, and producers of intermediate goods and services have incentives to locate close to each otherIf costs fall with access to a wider variety of intermediate goods and services, agglomeration can occurCore and periphery pattern of production emerges

Gains from tradeConcentration of production in the core will reduce production costs and allow for access to a wider variety of specialized services

Distributional effectsWages will be likely be higher in the core than in the peripheryThose in the periphery may lose via reduced local product variety and increased transport or communication costs in dealing with coreLiberalization of service trade will likely affect the core-periphery pattern in ways that are difficult to predict - this is an active area of current research

Motives for Trade V: Examples

Airline companies form alliances with partners in other countriesFedEx, UPS and other courier services Cellular phone services

Motives for Trade V: Networks

Quality and benefits to consumers depend on access to networks of other consumers and producers.Linkages between networks within individual countriesInternational networks developed and run by large firms exploiting firm-specific intangible assets

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Gains from tradeNetwork externalitiesLower cost services

Distributional effects

Trade Policy

What are examples of trade barriers in the service sector?

Trade Barriers in the Service SectorTariffs are relatively uncommon. Why?Quotas are pervasive

Local content requirements in broadcastingLimits on the number of foreign firms; limits on percent foreign ownership in banking, insurance, etc.Foreign providers completely shut out in some sectors (transport within a country)Foreign exchange restrictions can limit consumption abroad (tourism, education)Limits on movement of foreign personnel

Trade Barriers (2)Discriminatory regulations

Preferential procurementDelays at the borderLack of transparency of domestic regulations

Licensing and certification requirementsDoctors, engineers, accountants, etc.Compliance can be costly (sometime graduation from a domestic education institution required)Regulations both to ensure quality of service and to protect local suppliers

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TariffsGain in producer surplus: A

Loss in consumer surplus: A+B+C+D

Tariff Revenue: C

Net Social Loss: B+D

Restrictions that do not generate revenue

Loss in consumer surplus: A+B+C+D

Gain in producer surplus: A

Net Social Loss: B+C+D

QuotasGain in producer surplus: A

Loss in consumer surplus: A+B+C+D+E

Quota Rents: C+D

Net Social Loss: B+E if quota rent captured, B+C+D+E if not

Potential Losses from Quotas

Quotas do not generate revenue, unless auctionedQuotas create domestic market powerLobbying and corruption costs for rights to import or establish a local commercial presence

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Restrictions on Foreign Direct Investment in Competitive Markets

Loss in consumer surplus: A+B+C

Gain in producer surplus: A

Net social loss: B+C

Are there always gains from trade liberalization?

Partial liberalization may be worse than no liberalizationTrade liberalization in the presence of imperfect domestic regulation may reduce welfareThere may be a good reason to favour domestic providers

Partial reform: the persistence of barriers to entry

O Q M

J

P M

P D

H

P

B G

C

A F

E D

Q D

M R

M C

Q

D

F o r e i g n e n t r y i n t o a m o n o p o l i s t i c m a r k e t

Q C

Initially domestic monopoly

Foreign firm enters and each gets half the market

Price falls: PM to PD.

Gain in CS: PMACBPDLoss in Profit: APMPD GDE

Net social gain ABC -GBED

Partial reform: Liberalizing one mode and not another

Initially tax on temporary labormovement and cross-border trade banned

Now allow cross-border trade at price p

Price falls, consumption rises

Gain in CS: ABCDLoss in PS: ALoss in taxes: CH

Net gain: B+D - H

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Imperfect regulation and trade liberalizationExample: Trade in Professional Services

(engineers, doctors)

Suppose that initially, there is imperfect screening for qualityOn average each professional generates external damage costs

Trade in professional services with imperfect screening

Suppose both foreign and domestic professionals generate same harm from mistakes

Price fallsOutput rises

Gains from trade ignoring harm: A+B

Actual gains: A - (E+C)

Simultaneous trade reform and screening reformOnly qualified personnel provide services

Price falls to PQ

Domestic output falls to Q1

Gains from trade without domestic reform: H+I

Additional gains from domestic reform:B+E+C+A+F+K+G

National Treatment vs. Recognition of Credentials

Gain from trade under National Treatment: A

Gains when satisfactory foreign credentials are accepted: A+B+E+C

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FDI with Average Cost PricingForeign Firm

replaces domestic firm

Price falls: Po to P1

Output rises

Gain in CS : ABCD

FDI with Markup PricingMarkup is π.

Foreign firm replaces domestic firm.

Price falls, output rises

Gain in CS: ABCE

Loss in domestic profit: ABCFGH

Social gain: E -(F+G+H)

Local Product Squeezed Out by Trade

Demand shifts in when foreign firm enters

Local product is no longer viable

If local product re-introduced at p = MC:

Gain in CS = A+BLoss in PS = B+C

Net gain = A-C

Local production generates positive externality

Eliminating tariff generates standard gains from trade, but reduces external benefits from local production

Net social gain A – B

Production subsidy is superior to tariff

National treatment problematic

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Terms of Trade EffectsLiberalization of service trade will affect world demand and supply for goodsThis will lead to changes in world goods pricesNet effects of trade liberalization depend on direct effects of trade liberalization in targeted sectors plus possible terms of trade effects in other sectorsHowever, since these terms of trade effects are caused by the net effect of all countries liberalizing, an individual small country cannot avoid this by refusing to liberalize

Trade Agreements vs. Unilateral Liberalization

Service trade is growing in part because countries have unilaterally liberalized -governments respond to consumer and producer demands

Why have trade agreements?

Reciprocity Political economyAvoid trade wars

CommitmentHelps government resist local political pressures for trade barriersHelps mitigate hold-up problem

Rules based systemInstitutions to deal with disputes, reduce transactions costs, etc.

Potential Costs of Trade AgreementsService trade agreements can be much more complex and intrusive into domestic policy than were agreements on goods tradeTrade agreement requires trade-offs between policy flexibility, domestic sovereignty and market access for foreign service providersGovernments need to ensure that they retain enough policy flexibility to address market failures and internal income distribution objectives