What are services and how do they differ from goods? The Basic Economics of Trade in Services. How is service trade different from goods trade?

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1 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 tasks Often require simultaneous production and consumption Often require direct interaction between producers and consumers Goods: Tangible and storable Do not require direct interaction between producers and consumers Services covered by the General Agreement on Trade in Services 1. Business services 2. Communication services 3. Construction services 4. Distribution services 5. Educational services 6. Environmental services 7. Financial services 8. Health-related and social services 9. Tourism and travelrelated services 10. Recreational, cultural and sporting services 11. Transport services 12. Other services not elsewhere included How is service trade different from goods trade? Modes of supply Majority of goods trade involves shipping goods from one country to another Cross border trade accounts for less than half of services trade Much service trade requires direct contact between producer and consumer Types of trade barriers Services tend to be highly regulated domestic regulations often both respond to market failures and protect local suppliers from foreign competition Identifying and measuring trade barriers is complex 1

2 How are services traded? Cross-border trade Services produced in the exporting country and consumed in the importing country Consumption abroad Consumers 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 countries Services trade is about 20% of total world cross-border trade More 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: Examples Indian call centres provide back-office and customer care services for American firms Nannies from the Philippines move to Canada temporarily to provide childcare services Eco-tourists fly to the Amazon for a week in the jungle 2

3 Motives for Trade I: Comparative Advantage Trade caused by differences between countries Sources 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 chosen Do gains from trade depend on the mode of supply? Gains from trade via factor mobility Global Welfare A E B Initially L 1 construction workers at Home; w<w* D Trade equalizes wages. L 1 -L 2 Home workers work in Foreign. C A E B D C Global output rises by ABC O L 2 L 1 O* O L 2 L 1 O* 3

4 International Income Distribution A E O L 2 L 1 O* B D C If migration is temporary, and all income is remitted back Home: Gain to Home = ACD Gain to Foreign = ADB Domestic Income Distribution A E O L 2 L 1 O* B D C 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 trade Can an inflow of foreign workers raise returns to domestic workers? Are foreign workers substitutes or complements for domestic workers? Motives for Trade II: Examples Engineers from Canada design a woodprocessing plant in the U.S. Engineers from the U.S. design a bridge in Canada 4

5 Motives for Trade II: Increasing Returns to Scale Differences cannot explain all trade Much 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 doctor Gains from specialization (differences caused by opportunities in trade) Fixed costs Lock-in Market Niche Effects Product 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 countries Services may be supplied by any of the four modes (depends on type of service) Gains from trade Increased product variety - consumers gain access to both domestic and foreign specialized products New specialized services may emerge than are only viable with a large global market Scale economies - producers gain access to larger markets Income distribution effects Unlikely to be as serious as in case of trade driven by differences between countries 5

6 Motives for Trade III: Examples McDonald's fast food franchises located all over world US owned firm runs an electricitygenerating system in a foreign country Foreign-owned insurance companies provide local insurance services Motives for Trade III: Firm-Specific Intangible Assets Firm-level fixed costs vs. plant level fixed costs Firms develop specialized knowledge, skills, reputations, access to supply networks These intangible assets can be exploited by establishments owned by firms in various countries. Gains from trade Avoids duplication of firm-specific investments in fixed costs Increases variety of available services Income distribution effects Foreign 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 6

7 Motives for Trade IV: Agglomeration Spillover effects across firms Knowledge spillovers, common pool of labor Specialized 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 other If costs fall with access to a wider variety of intermediate goods and services, agglomeration can occur Core and periphery pattern of production emerges Gains from trade Concentration of production in the core will reduce production costs and allow for access to a wider variety of specialized services Distributional effects Wages will be likely be higher in the core than in the periphery Those in the periphery may lose via reduced local product variety and increased transport or communication costs in dealing with core Liberalization 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 countries FedEx, 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 countries International networks developed and run by large firms exploiting firmspecific intangible assets 7

8 Gains from trade Network externalities Lower cost services Distributional effects Trade Policy What are examples of trade barriers in the service sector? Trade Barriers in the Service Sector Tariffs are relatively uncommon. Why? Quotas are pervasive Local content requirements in broadcasting Limits 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 procurement Delays at the border Lack of transparency of domestic regulations Licensing and certification requirements Doctors, 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 8

9 Tariffs Restrictions that do not generate revenue Gain in producer surplus: A Loss in consumer surplus: A+B+C+D Tariff Revenue: C Net Social Loss: B+D Loss in consumer surplus: A+B+C+D Gain in producer surplus: A Net Social Loss: B+C+D Quotas Gain 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 auctioned Quotas create domestic market power Lobbying and corruption costs for rights to import or establish a local commercial presence 9

10 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 liberalization Trade liberalization in the presence of imperfect domestic regulation may reduce welfare There may be a good reason to favour domestic providers Partial reform: the persistence of barriers to entry P H P M P D J O G D F E A B C M R Q M Q D Q C 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 D M C Q Initially domestic monopoly Foreign firm enters and each gets half the market Price falls: P M to P D. Gain in CS: P M ACBP D Loss in Profit: AP M P D GDE Net social gain ABC - GBED Partial reform: Liberalizing one mode and not another Initially tax on temporary labor movement and cross-border trade banned Now allow crossborder trade at price p Price falls, consumption rises Gain in CS: ABCD Loss in PS: A Loss in taxes: CH Net gain: B+D - H 10

11 Imperfect regulation and trade liberalization Example: Trade in Professional Services (engineers, doctors) Suppose that initially, there is imperfect screening for quality On 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 falls Output rises Gains from trade ignoring harm: A+B Actual gains: A - (E+C) Simultaneous trade reform and screening reform Only qualified personnel provide services Price falls to P Q Domestic output falls to Q 1 Gains from trade without domestic reform: H+I National Treatment vs. Recognition of Credentials Gain from trade under National Treatment: A Gains when satisfactory foreign credentials are accepted: A+B+E+C Additional gains from domestic reform: B+E+C+A+F+K+G 11

12 FDI with Average Cost Pricing Foreign Firm replaces domestic firm Price falls: P o to P 1 Output rises Gain in CS : ABCD FDI with Markup Pricing Markup 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+B Loss 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 12

13 Terms of Trade Effects Liberalization of service trade will affect world demand and supply for goods This will lead to changes in world goods prices Net effects of trade liberalization depend on direct effects of trade liberalization in targeted sectors plus possible terms of trade effects in other sectors However, 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 economy Avoid trade wars Commitment Helps government resist local political pressures for trade barriers Helps mitigate hold-up problem Rules based system Institutions to deal with disputes, reduce transactions costs, etc. Potential Costs of Trade Agreements Service trade agreements can be much more complex and intrusive into domestic policy than were agreements on goods trade Trade agreement requires trade-offs between policy flexibility, domestic sovereignty and market access for foreign service providers Governments need to ensure that they retain enough policy flexibility to address market failures and internal income distribution objectives 13