Trade Services and Fragmentation

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POLICY RESEARCH WORKING PAPER 2548

International Provision By educing the costs of sumctrade servicesas ransport.of Trade Services,Trade, insurance, and finance,and Fragmentation liberalizing rade n servicescan generatebenefitsn themarkets or every kind of

Alan V. Deardorff trade they acilitate.t canalsostimulate the fragmentation ofproduction of both goodsand services, hus increasinginternational trade and thegains from trade even further.

FILEOPYThe World BankDevelopment Research GroupTrade UFebruary 2001


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International Provision of Trade Services,Trade,and Fragmentation

Alan V. DeardorffThe University of Michigan

Paper prepared for a WorldBank Project,WTO 2000

Keywords: Services Trade Correspondence:Fragmentation Alan V. DeardorffJEL Subject Code: Fl Trade Department of EconomicsF13 Commercial Pol Universityof MichiganAnn Arbor, MI 48109-1220

Tel. 734-764-6817Fax. 734-763-9181E-mail: [email protected]://www.econ.lsa.umich.edu/-alandear/


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International Provision of Trade ServicesTrade and Fragmentation

AlanV.DeardorffTheUniversity f Michigan

I. IntroductionA signal accomplishment f the UruguayRoundof multilateral rade negotiationswas theincorporation f trade in services nto a GATT-like rameworkwithin he WorldTradeOrganization.The incentive o acknowledge ven he existenceof trade in servicescameprimarilyfrom U.S. private-sector ervice providerswho chafed under estrictions hatlimited heir ability o operate n foreignmarkets. They were understandably nviousofthe institutional acilitiesmade available o goods raders by the GeneralAgreementonTariffs and Trade (GATT) or limitingbarriers o marketaccess. Theseservice providerssucceeded n rnaking he case, first in the UnitedStates and hen in the GATTnegotiations, hat similar ules shouldapply to international ervice ransactions. Theresult was the GeneralAgreementon Trade in Services,GATS,which s now one of threerather unequalpillars of the WTO.' The GATShas so far not accomplished ery much inthe way of actual liberalization. But the framework or negotiation hat it provides for thenext round of trade negotiationspromises o foster a process hat many hope will

' I have benefited from discussions of the topic of this paper with Bernard Hoekman, Bob Stern, KathleenTrask, and Jaume Ventura.' The other two are the GATT itself and the agreement on trade related intellectual property rights (TRIPs).See Deardorff (1997) for a more complete discussion of the World Trade Organization.


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eventuallydo for trade in serviceswhat fifty years of GATT negotiationsdid for trade ingoods.

The motivefor liberalizing rade in services,comingas it did from the serviceindustries hemselves,was to permit rationalization f serviceactivitiesalong he lines ofcomparative dvantage. It was also,not incidentally, ntended o expand he sales andprofitsof those serviceproviderswho were operating rom the base of such acomparative dvantage. In this sense, he benefitsfrom rade liberalization n services,aswell as the costs to those withoutcomparative dvantage, re the same as those that tradetheory has long attributed o liberalization f trade in goods. Indeed,many have arguedthat the fundamentalsof trade in servicesare really no different rom trade in goods,andonly the difficultiesof measuring nd monitoring rade in servicesmake it distinctive,from a practicalpolicy perspective.

However, or many services he benefitsfrom iberalization xtend, n a sense,beyond his, and that is what I will focus on in this paper. Many servicesplay a criticalfacilitating ole in the international rade of productsother han themselves, ncludingboth goods and other services. This is most obviously rue of transportation ervices,which are necessary or all international rade in goods. But it is also rue, perhaps o alesser extent,of other services such as finance, nsurance, nd communication, s well assome professional ervices hat are often needed n order to complete he internationalexchangeof goods. And this is equally f not more rue of international xchangeofservices hemselves. Tourism, or example,dependscriticallyon international rovisionof passenger ransportation.

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It follows, herefore, hat liberalization f trade in servicescan generatebenefitsbeyond he servicesectors hemselvesby reducing he real barriers o trade in othersectors. This is not entirelyunique o services,of course. Much rade in goods s of

intermediate roducts, and liberalization f goods rade yieldsmany of its benefitsnottoconsumersdirectly,but by reducing he costs of other goods. But the mechanismbywhich service rade can stimulategoods rade s somewhatdifferent,and it bearsexamination n its own right. That will be the main purposeof this paper: to illustrate,with simple trade theory, how liberalization f trade in servicescan enhance he gainsfrom trade in goods.

I will do this first, in section I, by using the standardpartial equilibrium rademodel to compare he benefitsof trade liberalization n goodswith those from reducedcosts of trading hat might arise from liberalization f trade in services. In section III, Iadd the role of trade services o the discussion,and then in section V I write down amore specific ramework or determiningand decomposing heir costs. Thisdecomposition llows me to identifyand focuson the severalways that these costscan bereducedby permittingserviceproviders o operateacross nationalborders. The gainshere include he gains from exploitingcomparative dvantage,of course,but they also gobeyond his by permittingproviders o avoid duplicationof certainfixed costs, andperhapsby allowing hem to operateover shorterdistances. In sectionV, I provide abrief discussionof several specific ypes of trade services,and the extent o which heyconform o the more generaldescriptionof my model.2 See, amongothers, Deardorff 1985).

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The benefits from services liberalization become larger if we also add anotherphenomenon that has been attracting increasing attention recently among tradeeconomists: fragmentation. Suppose that technologies permit production of goods tc befragmented across countries - split into parts that can be done in different locations - andsuppose also that fragmentation, like trade, requires additional inputs of internationallyprovided services. If those services are unavailable or prohibitively expensive,fragmentation will not occur. But as technology and/or trade liberalization in servicesmake them available or bring down their costs, fragmentation will become viable afterall. Thus liberalization of services trade can yield even further benefits by permittinggreater fragmentation-based trade. This is not fundamentally any different from othergains from trade. But I will argue, in section VI, that it has the potential to bequantitatively more important.

The importance of all of this, as I mention in my concluding section VII, isincreasing as negotiations within the WTO continue to reduce barriers to trade and asresistance to globalization also mounts. When this paper was first commissioned anddrafted, a new round of WTO negotiations seemed imminent. That is no longer the case,after the events in Seattle in late 1999.4 However, more limited negotiations within theWTO continue, and there is nonetheless scope for extending the liberalization that hasalready begun, especially in services. The arguments of this paper suggest that thepayoffs may be particularly great for expanding the coverage and effectiveness of theGATS.

3 Sanyaland Jones (1982), n fact, argued hat all trade s of ntermediateroducts, hat hey called"middleproducts."

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II. Gains from Reductions n TradeBarriersTo start, let us look at the conventional enefitsfrom rade liberalization. That is,considera good that is imported rom a large worldmarketsubject o a tariff. Figure 1

shows in two panels what the effectsof lowering hat tariff will be, under two differentassumptions. Panel A showswhat happens if the initial tariff is not prohibitive,whilepanel B shows the prohibitivecase. In both, the new tariff is positiveand permits rade.The downward loping line in each panel shows the demandfor importsof a goodwithinthe importingcountry,whilepw is the given world price.

In panel A, the initial ariff, t,, raises he price of imports o pw+tl,,which s belowthe interceptof the demandcurve and thereforepermitsa quantityof the good, ql, to beimported. When he tariff drops o t2, the pricefalls to pw+t2, and the quantityof importsrises o q2. The welfareeffects of this are well-known: Consumer urplus (net ofproducersurplus or competingdomesticproducers) ises from area a to areaa+b+c,while ariff revenuechanges fromb+d o d+e. The net effect is that the country's welfarerises by the shadedarea,c+e. It is perhapsworth noting hat if the tariff had fallen tozero, then the net gain would also includeareaf:

In panel B, the initial ariff is high enough o drive mports o zero, and hedomesticprice is elevatedby less than the tariff, ust to the interceptof the demandcurve.Here there is no tariff revenue o be lost from tariffreduction,and he country gains theentire shadedareasa+b,composedof the increase n consumersurplusa and tariffrevenueb. The gain in welfareappears o be much largerhere, but note that the tariffreduction s also much larger. A tariff cut comparable o that in panel A would have4 See DeardorffandStern2000) for somediscussionof thoseevents.

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yielded ess, but since t would include he revenuefrom the higher new tariff, it mightstill be larger han the gain in panel A. In contrast, f the new tariff were zero in this case,then again areaf would be added o the country's net gain.

Now suppose hat trade is not costless,as so far assumed,but rather that to getgoods to the domesticmarketfrom he world market,where hey were boughtat pricePw, requires hat traderspurchasecertain rade services,such as transportation. In someways such service costs would seem o be analogous o tariffs, n that they add to thedomesticcost of the importedgood. Therefore t may seem hat the analysis ust done fora tariff cut would also sufficefor analyzing he effects of services iberalization, nce weestablish hat this will reduce their costs. This is not quite right, however,becauseservicecosts of trade are real costs, not just transfers o the government. A separateanalysis s needed.

Figure 2 repeats Figure 1, but for the most obviousexampleof a service cost oftrade: transportation. The difference romFigure 1 is that t, and t2 are replacedbyidentical eal costs of shipping, , ands2. These are not transfers o the domesticgovernment,but real resourcecosts. That is, they are paid to the transportation rovidersto cover he increasedcost of resources hat are requiredfor the additional ransportationservices. This could ncrease he profits or other ncomesof the serviceprovidersthemselves,but I will simplifyby assuming hat their costsare constantand that servicemarketsare competitive. It follows hat the price of the service emainsconstantandequal o average cost, thereforeyieldingno profit or other ncrease n producersurplus inthe service market tself.

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The welfare effects of this fall in shipping cost are somewhat different from thefall in the tariff. In panel A, the new gain for the country is the shaded area b+c, all ofwhich is a gain in net consumer surplus. There is no tariff revenue for the government tolose, but on the other hand area e is now an increase in real resource costs, not just atransfer to government. Clearly the gain from a drop in shipping costs can be larger orsmaller than the gain from an equal drop in a tariff, depending on whether area b isgreater than or smaller than area e. If shipping costs were to fall to zero, on the otherhand, then the gain would necessarily be larger than an equal drop in a tariff.

If transport costs are initially prohibitive, however, as in panel B, then the gainfrom their decline is necessarily smaller than from an equal drop in a prohibitive tariff,unless both of them drop to zero. The reason is simply that the new shipping cost is areal cost, while the new tariff is not.III. Gains from Reductions in Barriers to Services TradeThe simplest way to think about trade liberalization in services generally is within thesame framework of Figure 1. For example, suppose we are interested in constructionservices, which can potentially be provided by work crews from a foreign company, solong as they are permitted to operate within the domestic country and are not taxed tooheavily. Figure 1 will apply exactly to this case, panel A for a case in which imports ofconstruction services are subject to additional taxes or other fees paid to the localgovernment, panel B to the case where foreign providers are simply excluded. Similarly,suppose that foreign construction companies are allowed to operate within the country butsubject to requirements that they jump through various real hoops not required ofdomestic companies. Then the case is that of Figure 2, which of course could also

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include the actual ransportcostsof getting heir crews and equipment o the country'sborders.

In general, hen, the gains from tradeliberalization n servicesmay be very much

analogous o liberalization f tariff and non-tariffbarriers o trade in goods,and this trademay be analyzed n the sameways. This is a point hat I and others made when tradeinservices irst began to be discussed,as in Deardorff 1985).

However, hereis one categoryof services hat has some specialfeaturesworthnoting: trade services. By these I mean any services he demands or which arise directlyfrom trade itself,presumably rom trade in other industries.Perhaps hese servicescar,also be analyzedwith the tools above,but their specialfeaturesmake hem worth lookingat specifically.

The prototypical rade service s transportation. will focus mostlyon that, andmy terminologywill reflect hat, but there are certainlyother services hat have thesefeaturesas well, as I will discuss ater.

The key is that since rade by definitioncrossesnationalborders,any services hatcater to that trade are likelyto be needed on both sidesof the border as well. But if tradein services s not permitted that is, if serviceprovidersare not allowed o operateacrossthese borders then trade itself is likely to be more costly, if it is possible at all.

An examplecomeseasily to mind in the case of transportation.As I understandit, prior to the North AmericanFree TradeAgreement NAFTA),Mexican ruckers werenot allowed o operatewithin he UnitedStates,nor U.S. truckers nside Mexico. If agood was to be shippedby truck between he two countries, hen it had to be carriedon

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one country's trucks to the border, unloaded, and then reloaded onto the other country'strucks at the border, and finally shipped the rest of the way.

The costs of this awkward arrangement are obvious, and surely large. Evenassuming that the countries allowed the trucks far enough inside their borders to permitthem to unload and reload on the same lot, so that they did not have to hand-carry goodsacross the border, this restriction of trucking added to the transportation process a whollyunnecessary step of unloading and reloading.

In addition, it must surely be true that trucking firms incur a portion of other fixedcosts that do not vary with distance shipped,' and that had to be duplicated by firms fromboth countries every time a good was traded in this way. Adding any other sources ofincreasing returns to scale and distance that might be present in transportationtechnology, and one can easily imagine that trade costs were greatly enhanced by thisprohibition on (literally) cross-border provision of transportation.

This trucking example will provide the template for my rudimentary model ofcross-border provision of trade services. But before I embark on the modeling, however,let me stress the importance of all this, for which the model itself is unnecessary. Thepoint will be that trade in trade services brings down the real cost of trade. The benefitsfrom this may be represented by movement along a demand curve for the service itself,like those of Figures 1 and 2 applied to the service industries, but that misses what is soimportant about these services. Rather, by allowing cross border provision of tradeservices we bring down the costs of trade in other things, not just for those services butfor everything else. Thus, while a reduced barrier to trade in construction services will

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increase net consumer surplus of demanders of buildings, a reduced barrier to trade intransportation or another trade service will increase net consumer surplus in everyindustry where trade in the product can avail itself of those services. We're talkin' bigbucks here, or at least big utils.

IV. A Model of Trade ServicesConsider any service, such as transportation, that provides an input that is useful foraccomplishing the trade in a good or goods. Output of the trade service is measured insome appropriate units, such as units of the good transported, value of the good insured,etc. Output may also be characterized by one or more other dimensions that areimportant for determining the usefulness of the service to traders, such as distance orspeed, although I will initially allow for neither of these and later, in this paper, willincorporate only distance. In all cases I will focus on the service associated with aparticular shipment of a good, S, from a foreign country, F, to the home country, H. I aminterested in determining what gives rise to the portion of the cost of shipping the goodthat arises from input of a some arbitrary trade service, and how this trade-service costmay change as we liberalize trade in the service industry. This cost may be thought of asone component of the shipping cost examined in Figure 2.

To start with, suppose that the per unit cost of the trade service - what I will nowcall the shipping cost, s - is simply constant, at a rate c that varies across countries wherethe service providers may be based, in response to the usual determinants of comparativeadvantage. That is, service providers from country I, will have a constant cost cI(AI wl)

Loading and unloading are themselves such fixed costs.10


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where AI is the technology available in country I for providing this trade service and wI isa vector of factor prices, including wages, in country I. Together, these two argumentsembody the usual Ricardian and Heckscher-Ohlin determinants of comparativeadvantage, the latter entering through relative factor endowments that determine factorprices in general equilibrium. In general these may themselves depend on the opennessof trade in services, although that is not something I will allow for here.

Suppose that initially there is no trade in services, and that the home countrypermits this particular trade service to be provided only by domestic firms with costsCH(AH,wH). iberalization of trade in services would presumably permit these servicesto be supplied by a provider based in the foreign country, F, from which the good is beingimported. Its costs are cF(AF,wF). Or the service might come from a provider based insome third country, I, with costs cI(AIWI). If either of these is lower than cH(AH,wH),then we have the usual gains from trade arising from comparative advantage. However,as noted above, these gains will manifest themselves in lower trade costs of otherindustries.

Following the trucking example that I mentioned above, however, I will nowcomplicate the service technology, allowing its unit cost per amount shipped to dependon both quantity shipped and distance. Consider again a shipment S of a good from anarbitrary location A to another location B. The quantity shipped is QS. Then, using aservice provider from country I, the total cost of the service for the shipment is assumedto take the following form:

C' =CO + CIQS + C2 DAB + C3QsDAB (1)

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where the parameters ci, like c above, depend on technology and factor prices in countryI:

C = (Co,...,CO)= (co Al W ) C3(A', w')) ('The first of these parameters, co, is a fixed cost per shipment that does not depend

on the quantity shipped, nor on the distance shipped. It's presence does not imply theexistence of increasing returns to scale, in the usual sense, since it will be repeated forevery shipment that the service firm administers. However, it does imply that the cost perunit shipped, sI=CIIQS, declines with the quantity shipped. An example would be thebureaucratic requirements for getting permission for a shipment. The cl parameter issimply cost per unit shipped, analogous to the only cost allowed above, such as the costof loading and unloading. Parameters c2 and c3, on the other hand, involve distance. c2 isa cost per unit of distance, but note that it does not depend on quantity shipped, andtherefore should be thought of as another fixed cost. It too will cause s to decline withquantity shipped. In the trucking example, this would include much of the variable costof transportation, such as the driver's wage, which depends on time spent on the road butnot on how much is in the truck. Finally, C3 is a cost that depends on both distance andquantity, such as part of the fuel cost in transportation that depends on both distance andload.

In general, then, the service cost of a shipment depends on both the quantityshipped and distance, through parameters that in turn depend on technology and factorprices of the country providing the service:

C' = C(Qs, D; A', w') (3)

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The service cost per unit shipped, s, is this divided by QS, which I will abbreviate assI(D), since I will not be varying QS:

s CI/Qs=C(Qs D;A',w')/QS=sI(D) (4)That is the technology, and some notation to represent it. Now I make a critical

assumption about policy: I assume that, in the absence of trade in services, serviceproviders are permitted to operate only in their own countries. What this means, for theservices needed to accomplish a shipment from foreign country F to home country H, isthat only a Foreign service provider can service the shipment up to the border, and only ahome-country provider can service it from there on. Thus I will represent the origin ofthe shipment as location F, within country F, and the destination a location in H called H.But no service provider is permitted to service it the whole way. Instead, there is alocation B on the border between the countries (or perhaps in international waters), whereone provider stops and the other takes over.

With this assumption, the total service cost for the shipment in service autarkybecomes

CA?r1=CF(QS DFB;AFWF)+CH (Qs,D,,;AH, WH)= (cF +c H) + (cF + cl)Qs (5)

FcDrB +cHDBH + C3 Q DFB +CHQSDBHand the service cost per unit shipped - again in service autarky - is

sAut[CF(QS ,DF.;AF WF)+CH(Q SDBH;AHWH)] QS(C +C (CF +CH) (6)+ C2DFB+ 2 DBH+(CFDFB+C3DBH)

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If trade in services is now permitted, service for the entire shipment will beprovided by a single provider, and in general it may or may not be a provider from one ofthe two countries who are trading the good. Let country L, which may be H or F, havethe lowest cost of providing the service for this particular route from point F to point H.not necessarily passing through point B. This then is the cost if free cross-borderprovision of services is permitted:

S 5ree DL = Q +C 2 +C DFHs =s DFH Q+c;I Qs 3< min[sF (DH), sH(DFH)]

H,F

This cost is evidently lower than the cost in autarky, sAut. To see the severalways that cross-border provision of services can reduce these costs, I now decompose thecost reduction into three parts, numbered 1, 2, and 3, as follows:

Aul FreeLAUIFree =5SF(D ) +S (DBH)- (DFH)1:= [s DFB) SL(DFB)]+ [S (DBH ) SL(DBH)]2: + QS + CL[(DFB + DBH)-DFH] (8)3: + I S +CL(2-1)

1. Comparative Advantage: The first line of the decomposition in (8) is theconventional gains from trade due to comparative advantage. It includes the costreduction that is possible if a different producer, operating from a different base ofcomparative advantage, does essentially what was being done before. That is,continuing to service the shipment in two parts within each country, we replace theservice providers in both with the low-cost provider that may operate from a different

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countryand that therefore,with better echnologyand/ordifferent actor prices,maybe able to provide he service or lower cost. Of course t is possible that the low-costprovider s from one of these wo countries hemselves, n which case one of thebracketed ermsin line 1 is zero. Thesegains maybe large or small dependingontheimportanceof comparative dvantage n this context.They may even be negative, fthe low-costprovider's advantagederivesmainlyfrom servicing ongerdistances hanthese internal ones.

2. ReducedDistance: It is possible hat the border ocation, hrough which rade mustpass if service rade is not permitted,happens o lie exactlyon the least cost traderoute between he two countries, n which case the secondeffect identifiedabove willbe zero. But in general his will not be the case, and a more direct route will exist thatbypasses hat particularborder ocation. In general, herefore, here will be some costsavingssimply from traversingand servicinga shorterdistance,as DFH


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"(2-1)" in line 3 of the decomposition, to remind us that fixed costs are being reducedfrom twice the curly-bracketed expression to only one times it. Of course, whetherthis is in fact a large source of cost savings depends on the size of these fixed costs,which could for some technologies be negligible. But casual observation suggeststhat it is often large.

This is all that my model has to say directly about the cost savings from cross-I -der provision of trade services. However, realistically, there are several more suchsources of savings that may enter, and these should be mentioned even though they do

not appear explicitly in the model.4. Economies of distance: This one is in the model, at least partially, but it is hard lo

separate from the other effects. Different service technologies may be more or lesswell suited to serving shipments over longer distances, and often those suited forlonger distances will not be commercially viable for the short distances that lie onlyinside of countries. The specification of technology used above incorporates thisfeature, to an extent, through the cost parameters that do and do not vary withdistance. Thus the least cost provider may achieve that low cost, once trade is free,primarily because its costs that vary with distance are small compared to its fixedcosts that do not. As mentioned above, either or both bracketed expressions in line 1of (8) could be small or even negative if the low cost provider is inefficient over shortdistances, and the cost savings from the more appropriate technology would then bemerged into the savings from reduced fixed costs in line 3. Perhaps moreimportantly, the formulation here has not allowed for any choice of techniques, except

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across providers. But in fact such choicesdo exist, and even a domesticprovider hatcurrentlyservices only short routes may substitutemoreappropriate echniquesonceservice rade makes them useful. This substitution, f it occurred,could only reducecosts further.

5. Economiesof scale: As I stressedabove, he formulationhere, despite appearance,does not includeany economiesof scale. That s, a serviceprovidersavesnothing ncosts by serving multipleshipmentsof the same size and distance. Yet sucheconomiesof scaleundoubtedly xist as well, in some trade-service ndustries ust asin many other industries. As cross-border rovisionof servicespermitsmore efficientproviders o displace hose less efficient, he surviving irms will become arger andmay thereforehave lower costs. There is nothing new about this effect,but onceagain t should be remembered hat this cost saving oo, if it happens,will stimulatetrade and the gains from trade in the industrieswhose rade relies on it.

6. Border Frictions:In the model here, the worst that happenswhen a trade route isarbitrarilydividedacross serviceprovidersfrom he two countries s that they simplydo their work back to back. In fact, when mpediments o cross-borderprovisionofservices exist, it is likely that the costsof interfacingbetween he two providerswillbe higher. In the U.S.-Mexicanruckingexample hat motivatedmy model,one caneasily imagine hat the costsof transferringa cargo from a Mexican ruck to anAmericanone will exceed ust the costsof unloadingand then reloading. If theequipmentused by both truckingcompaniesare not compatible, t may be necessaryto repack a load or transfer t also to anothershippingcontainer. If proceduresusedby the two work crewsare not the same,additional nefficienciesmay arise from the

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effort to make them conform. At a minimum, one may simply need a roof over theheads of the workers and their cargo, something that would have been providednaturally at the origin and destination of the shipment. These additional costs couldhave been included in the model here, at the cost of a bit more notation, but it seemsenough merely to point them out separately.

7. Time: I mentioned earlier that an important dimension of service provision is time.but I did not include it explicitly in the model here. No doubt the time cost associatedwith different modes of trade servicing could mostly be included implicitly in theparameters of this model. But it is worth mentioning separately as well, sincereduced time costs seem likely to be one of the important benefits of cross-borderservice provision. When services must be provided by separate institutional entities. itis almost inevitable that time will be wasted in coordinating them. This is time thatcould easily have been saved if a single provider were permitted to handle the wholejob. In a world where timely provision of inputs and outputs has become one of themost critical elements of competitive success, these time benefits must be far fromtrivial.

8. Regulatory Costs: Many services are regulated by governments. To the extent thatthese regulations exclude foreign services providers completely, then of courseliberalization of services trade means changing these regulations. In some cases,however, foreign service providers are permitted to operate within a country, but theregulations that apply to them increase their costs compared to domestic firms. Forexample, trucking companies may be permitted to carry cargo into a country but notout, forcing them to bear the cost of returning the trucks to their home market empty.

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Regulations may also require that certain categories of demanders - especiallygovernment agencies themselves - use domestic providers. Like nontariff barriers ingoods, these asymmetric regulations undermine competition and efficiency, and theirremoval will be beneficial. In addition, applying the same regulations to both foreignand domestic service providers may facilitate the use of a single provider for an entiretransaction, permitting the sort of cost reduction that has been the subject of thispaper.

9. Red Tape Costs: Even if the same regulations apply to both foreign and domesticproviders in an industry, it may still be necessary to bear the costs of satisfying theseregulations in both countries in order to service a complete international transaction.This was mentioned above as one of the sources of the fixed cost, co, in the model, butthe duplication of this cost will not be eliminated merely by permitting providers tooperate in both countries subject to their domestic regulations. They will still have tofill out forms in both countries, undergo inspections in both, etc. Services tradeliberalization therefore needs to include provisions for either harmonizing theregulations themselves across countries, so that a single set of procedures will satisfyregulators in both, or it should include mutual recognition agreements whereby firmsneed only be certified in one country in order to operate in both. Of course, this raisesdifficult issues when countries disagree on what levels of regulation are needed toprotect their citizens' health and safety. But only if this problem is resolved can thefull benefits of cross-border service trade be enjoyed.

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V. Specific Trade ServicesThe discussion so far has attempted to be general, saying things that may apply to anyand all trade services. In this section I say a few words about each of several specific andfamiliar trade services, primarily to address whether they seem to fit well or poorly intothe mold of this model. In addition, in some cases, I will acknowledge specialcharacteristics of these specific trade services that may make them particularly importantfor enhancing trade in goods.6

Transport ServicesThe model was largely motivated, as said above, by the example of trucking

services between Mexico and the United States. It therefore seems to fit best thecircumstances of transport services more generally. Certainly, transportation services ofall sorts are characterized by costs that vary with both quantity shipped and distance. Inaddition, there routinely exist fixed costs per shipment that are independent of quantity,distance, or both, such as take-off and landing costs of aircraft, maintenance of railwaytracks, and the pay of stevedores in ocean shipping.

Policies regulating the cross-border provision of transport services are apparentlyas widely varied as the services themselves, but they are notoriously encumbered byrestrictions favoring national suppliers. These range from restrictions on domestic flightsby international carriers to the notorious Jones Act restrictions on ocean shipping withinU.S. territorial waters. Some of these restrictions are meant less to protect domesticsuppliers than to protect favored categories of labor, often at the suppliers' expense, and

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thus seem to operate more directly on the cost parameters of an industry than on who canoperate. But either way, one can expect liberalization of trade in transport services togreatly lower the costs of trade.

InsuranceInternational trade is inevitably more risky than domestic trade, because of the

broader range of unpredictable shocks to which it is subject from climate, culture, andgovernment interference, not to mention the financial uncertainty of different nationalcurrencies and markets. Insurance to protect against these uncertainties is therefore anessential input to international trade, even more so than to domestic commerce. Formany of these uncertainties, it is not strictly necessary for the insurance provider tooperate physically in a foreign territory, and therefore much of the required insurance canbe provided completely by a domestic carrier within, say, the exporter's country of origin.The principal gain from trade in insurance services may therefore be the availability oflower cost insurance from a foreign carrier - the gain attributed to comparative advantageabove.

However, there are surely some risks associated with trade within a foreigncountry that are not well covered by a domestic carrier. Indeed, some risks may not evenbe recognized as requiring insurance, leaving a trader exposed to risks that they are notaware of, but that they could have known if they had hired the services of a local provideras well. As a result, the prudent international trading company is likely to require theservices of several insurance companies specializing in their several countries of

6 See Hoekman and Primo Braga (1997) for a useful discussion of many actual barriers to trade in services.21


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operation. And as in the transport case, the costs of this more complete coverage is likelyto be reduced if a single provider, operating routinely in all relevant markets, can providethe coverage.

In other words, while the terminology of the model here was largely taken fromthe transport industry, it seems likely that it fits the market for insurance as well, althoughperhaps to a lesser extent.

CommunicationIncreasingly in the modem world, intemational trade requires rapid and effective

communication to specify the details of a transaction and tailor them to the needs of allconcerned. It would be hard to overestimate the importance of modem communicationtechnologies for the growth of world trade in recent decades. And yet to a surprisingextent, communications are still encumbered by different national standards andrestrictions on who can use them, forcing intemational businesses to work around theserestrictions by patching together pieces from different companies and differenttechnologies. The rise of the internet is changing much of that, and perhaps such nationalrestrictions on communications will lose their bite as this occurs. But greater freedom ,orcommunication firms to operate world-wide will nonetheless still serve a purpose offacilitating trade.

Travel ServicesMuch of the travel industry - both passenger transportation and other services

such as hotels, restaurants, and local transportation - is geared to tourists and therefore

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not directly relevant here except as a category of trade itself that relies heavily on tradeservices. However, these same services are also used by those who travel on business,and these are an essential input to international trade. In spite of advances in long-distance communication, the on-site presence of people in face-to-face contact andengaged in direct oversight of activities continues to be essential for internationalcommerce. Travel services are therefore a nontrivial input to international trade, even ingoods.

Like the other categories of trade services considered here, travel services can beprovided more efficiently if done by single, or at least allied, providers that span nationalborders, so as to coordinate reservations and other aspects of their service. Much of thishas already been facilitated in recent years by the formation of international networks ofairlines and hotel chains, but these are seldom as efficient as a single larger or mergedfirm operating across borders.

Professional ServicesInternational transactions, no less than domestic ones, require the services of all

manner of professionals. Lawyers are needed to vet contracts with both domestic anforeign suppliers and customers. Accountants must keep the books in a mannercompatible with different national requirements. Expansion of a company's operations islikely to require the services in different countries of architects, contractors, real estateagents, and the like. In each case, the service must be tailored to the local market, so thatit may seem that separate providers are necessarily called for. However, the servicesmust also be integrated and compatible with what is being done by the same firm in other

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countries, and this requires effective communication among them. This is most easilyaccomplished if the national-based providers work together regularly, as they would ifthey were part of a single multinational service company. Looked at in this way, thecosts of professional services may not be all that different from others discussed here.And for many such services, such as law, professionals from one jurisdiction areprohibited from practicing in another.

Financial ServicesThe final service category I will consider is financial services. This includes a

wide variety of services that are necessary for international trade, ranging from exportfinancing to foreign exchange. However, this is the one category where it is not obvious,to me at least, that international provision of the services is really necessary. Most of atrading firm's financial needs can be met, I suppose, within a national firm that knows theclient well, and except for minor transactions, like providing currency to the firm'soverseas travelers, the national firm need not have a presence abroad.

However, this does not in any way diminish the importance of the financialservices themselves, or mean that well-functioning world financial markets are notcritically necessary for international trade. In Deardorff (2000), 1 examine the disruptionthat can be caused for trade by a financial crisis that undermines confidence in a nation'scurrency and its financial institutions. To the extent that more integrated world financialmarkets can lessen the likelihood of such disruptions, trade and the gains from trade willbe among the beneficiaries.

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international rade, even beyondwhat it was whenproductswere more typicallyproducedin one place.

This expanded ole of servicesdue to fragmentation lso gives ise to additionalpotentialgains from furtherreductions n the costs of services,such as have been thefocus of this paper. In one sense,one can simply hink of the effects of reduced radecosts depicted n Figure 2 as being repeatedover an ever larger number of tradedfragments,and thus multiplying he gains from trade.

Another approach s shown n Figure 3, which s adapted rom Deardorff 1999).There, the gains from trade in a simple Ricardian rademodel are contrastedwith thegains from fragmentation n the same model. The Ricardian traight-line ransformationcurve for two goodswithout fragmentation s shownas the line Q1Q2, and the level ofconsumption n autarkyas point CAut. Conventional rade allows he country ospecialize n good 1, producingat Q1 and trading at world prices given by the slope ofline Q1A to achieve consumption t pointCFree. If the technology or good 1 becomesfragmented,however, hen the country can specialize n just one fragment whicheverone it producesrelativelymost cheaply and trade the fragmenton the world market fora larger quantityof good 1 than it could have produced tself without fragmentation,Q,'.The country's budget line trading on the world market s thereforeshifted out byfragmentation, nd it can achieve he higher consumption evelCFrag. The messagehereis that fragmentation xpandsa country's consumption ossibility et, not just byimproving ts terms of trade of one final good for another,but by expanding he

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maximum attainable amount of all final goods, almost as though by an improvement inproductivity. 8

But fragmentation also involves much greater inputs of services than would be

needed for trade in final goods only, in order to coordinate the fragments. Therefore,these gains are conditional upon the availability of such services at low cost. The recentemergence of fragmentation as an increasingly important phenomenon in the globaleconomy owes its existence to technological improvements that have brought these costsdown to historically low levels. The additional benefits from even greater fragmentationwill depend on lowering these costs still further through the sorts of liberalization of tradein services that have been examined in this paper.

VII. ConclusionThe message of this paper is that there is tremendous scope for the world to benefit byliberalizing trade in services. This is especially true for trade in what I have called tradeservices - those that facilitate trade in goods and in other services. By bringing down thecosts of trade services, liberalization can generate benefits that are not confined only tothe services markets themselves, but that will appear in the markets for every other kindof trade that they facilitate.

The paper has examined a variety of ways that removing barriers to the cross-border provision of trade services can lower their costs. These include the gains thatconventionally arise from comparative advantage, but in the framework presented here

8 It is not literally hat productionpossibilities re necessarily xpanded y fragmentation, s explainedmore fully n Deardorff 1998),where productionpossibilities re viewed n three dimensions ncluding

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there are additional gains as well that are plausibly larger. These arise especially whenrestrictions in services markets require that the services needed to facilitate a single trademust be provided by two different national service providers. When that is the case,removal of such restrictions has the added benefit of eliminating duplicated fixed costs.

Regardless of the size of any cost reduction in trade services, the benefits for tradeare arguably enhanced by the phenomenon of fragmentation. The more that productionprocesses become split across locations, with the fragments tied together and coordinatedby various trade services, the greater are the gains from reductions in service costs. Sincefragmentation seems to characterize an increasing portion of world specialization andtrade, the importance of service liberalization is growing apace.

All of this is particularly timely right now, as the world hesitates in its forwardmovement toward more liberal trade. The creation of the World Trade Organization andthe GATS provided a framework for making real progress in reducing barriers to trade inservices. Had a new trade round been inaugurated at the Seattle 1999 ministerialmeeting, as expected, then the arguments made in this paper could have buttressed thecase for intensive negotiations in services, where the payoffs can be so great. As it is,however, the timing and perhaps even the likelihood of a new round is in doubt. Abacklash against many aspects of globalization now questions the benefits and the equityof reducing trade barriers and constraining trade policies. How these issues will beresolved is not yet clear, but it does seem evident that the benefits from servicesliberalization are immune to many of these objections. I would hope that the members of

both an intermediatenput and the finalproduct,as well as the other good that both may be traded for.

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the WTO will be able to move ahead in services liberalization even as other aspects of theWTO agenda may be stalled.

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ReferencesArndt, Sven W. 1997 "Globalization nd the Open Economy,"North American Journal ofEconomicsandFinance8, pp. 71-79.Deardorff,Alan V. 1985 "ComparativeAdvantageand InternationalTrade and Investmeni inServices," in Robert M. Stern, (ed.), Trade and Investment n Services: Canada/USPerspectives,Toronto: OntarioEconomicCouncil,pp. 39-71.Deardorff,Alan V. 1997 "An Economist'sOverviewof the WorldTrade Organization,"n KoreaEconomic nstitute,The Emerging WTO System and Perspectivesrom Asia, Joint U.S.-KoreaEconomicStudiesVol. 7.Deardorff,Alan V. 1998 "Fragmentationn SimpleTradeModels,"DiscussionPaperNo. 422,ResearchSeminar n InternationalEconomics,University f Michigan, anuary7.Deardorff,Alan V. 2000 "FinancialCrisis,Trade,and Fragmentation,"DiscussionPaperNo. 453,ResearchSeminar n IntemationalEconomics,University f Michigan,April 18.Deardorff,Alan V. and RobertM. Stem 2000 "What he Public ShouldKnowabout Globalizationand the World Trade Organization,"Working Paper No. 460, Research Seminar onInternationalEconomics,University f Michigan, uly 20.Dixit, Avinash K and Gene M. Grossman 1982 "Trade and Protection with MultistageProduction,"Reviewof EconomicStudies59,pp. 583-594.Feenstra,Robert C. 1998 "Integrationof Trade and Disintegration f Production n the GlobalEconomy," ournalof EconomicPerspectives 2,(Fall),pp. 31-50Feenstra, Robert C. and Gordon H. Hanson 1996 "Globalization,Outsourcing,and Wage

Inequality,"AmericanEconomicReview86,May,pp. 240-45.Grossman,Gene M. and ElhananHelpman 1999 "The Internationalizationf EconomicAcitivity,"NationalScienceFoundation rant,July.Hoekman,Bernard and Carlos A. Primo Braga 1997 "Protection nd Trade in Services,"OpenEconomiesReview8 pp. 285-303.Hummels,David,DanaRapoport, nd Kei-MuYi 1998 "VerticalSpecialization nd the ChangingNatureof WorldTrade,"FRBNYEconomic olicyReview, une,pp. 79-99.Jones, Ronald W. and Henryk Kierzkowski 1990 "The Role of Services in Production and

InternationalTrade: A TheoreticalFramework," n RonaldW. Jones and Anne0. Krueger,eds.,ThePoliticalEconomyof International rade: Essays n Honorof RobertE. Baldwi?4Cambridge,MA: Blackwell, p. 31-48.Sanyal, Kalyan K. and Ronald W. Jones 1982 "The Theory of Trade in Middle Products,"AmericanEconomicReview72,pp. 16-31.

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p

dpw+t X

q, q2 qA. Reductionof a non-prohibitiveariff

p

pw t

PWI

0 ~~~2qB. Reductionof a prohibitiveariff

Figure 1TariffReduction

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p

pws

q1 q2 q

A. Reduction of a non-prohibitivetransport cost

p

Pw+S2

0 q2 q

B. Reduction of a prohibitivetransport cost

Figure 2Reduction in Transport Cost

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X2B

AFragACFreeQ2 W

CAN\U

Q' \1' XI

Figure 3Gains fromTrade and Fragmentation

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