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CHAPTER VI
In his book, Adam Smith articulated the basic mechanism of the market, whereby the pursuit of individual profit leads to the most efficient use of the country's resources in producing what consumers want to buy. It made a virtue out of greed and thus offended the moralists. In fact, Marxist theoreticians and Christian theologians are still struggling with the question how the profit motive and morality can be reconciled. For Adam Smith, it was a question not of morality, but of how things worked if people were left to pursue their own natural economic instincts. He also showed how the organization of economic activity and government policies could be analyzed to draw conclusions about their impact on the availability of goods and services. Adam Smith thus laid the foundation for modern economic theory and market-oriented policies not only within nations, but also among nations. The arguments for free trade among countries were more fully elaborated by David Ricardo in the Principles of Political Economy, published in 1817. Contrary to popular impressions, it was David Ricardo and not Adam Smith who developed the theory of comparative advantage. One of the most frequently quoted and yet least understood theories of economics, it demonstrates how trade between two countries can be advantageous whenever they have a different mix of resources and skills, even if one country is more efficient in producing all tradeable goods and services. Differences in the mix of resources and skills lead to different price relationships among the goods and services produced in each country, acid these differences in price relationships are the basis of all trade between two countries. The least understood aspect of the theory of comparative advantage is that it does not require exporters to be more efficient or to have lower labor costs than foreign producers; instead, exporters have to be relatively more efficient in utilizing the country's resources than other industries in their own country. Comparative advantage means that every country can gain from trade if it concentrates its energies in the industries that make best use of its resources and skills. The principle of comparative advantage can be seen at work not only among countries, but also within every national economy, or even within an individual office or household. Thus it is rational for an engineer to hire a draftsman who is less skilled in drawing blueprints, because it allows the engineer to more fully utilize his or her source of greatest comparative advantage, the training and experience in engineering. The engineer's income is maximized by allocating the available time to engineering work. At the same time, someone who is not as talented in drawing blueprints as the engineer, but even less talented in doing engineering work, is well advised to allocate the available time to drafting blueprints rather than engineering. Over the last two hundred years many economists have expanded the basic theoretical framework developed by Adam Smith and David Ricardo, thus adding to our understanding of the various conditions under which trade leads to gains for the participants. Conversely these economists have also laid out the conditions under which a country is better off by restricting trade. Economists have also tested the extent to which the theory of comparative advantage can be used to explain existing patterns of trade; they have done this by examining whether the composition of a country's resources can explain the composition of its exports and imports. Adam Smith and David Ricardo largely focused on trade in goods, since they assumed that most services were not tradeable. Most of the theories on international trade developed by later economists were also described entirely in terms of examples involving trade in goods, and the work carried out to test the applicability of those theories under various circumstances has been largely focused on trade in goods. Only in recent years have economists begun to examine how the extensive economic literature on international trade could be applied to trade in services. Interestingly enough, while Adam Smith laid out his arguments for free trade in terms of trade in goods, he applied the same general principles elsewhere in the book to argue against the Navigation Act, which placed restrictions on the right of foreign ships to bring foreign goods into British ports (though foreign ships were allowed to take British goods out of British ports). Smith argued, "The act of navigation is not favourable to foreign commerce, or to the growth of that opulence which can arise from it. The interest of a nation in its commercial relations to foreign nations is, like that of a merchant with regard to the different people with whom he deals, to buy as cheap and to sell as dear as possible." (1817, p. 431) Adam Smith thus saw that restrictions on the right of foreign ships to carry British imports were equivalent to an import tax on goods and could be rejected on the same grounds. This is not quite the same thing as saying that services should be imported and exported on the same basis as goods, but it showed that the same, economic reasoning could be applied to trade in services. A half century after Adam Smith, Frederic Bastiat, a French economist and member of the French parliament, applied the same tools of economic reasoning to the construction of the railroad between Paris and Madrid. When the Paris-to-Madrid railroad was being debated in the French Assembly, one member of the Assembly by the name of M. Simiot argued that it should have a gap at Bordeaux, because such a break in the line would enhance the wealth of all the porters, commissionaires, hotelkeepers, and bargemen of Bordeaux and thereby would enrich France. I t demonstrate the absurdity of the argument, Bastiat wrote, "if Bordeaux bas a right to profit by a gap ... then Angouleme, Poitiers, Tours, Orleans should also demand gaps as being for the general interest.... In this way we will succeed in haying a railroad composed of successive gaps, and which may be denominated a Negative Railway." (Quoted in Heilbroner, 1961, pp. 151-152) Adam Smith's analysis of shipping services and Frederic Bastiat's analysis of railroad services did not make as much of an impact on economic thinking as their observations about trade in goods, and international trade economists over the last two hundred years have concerned themselves largely with trade in goods. With the growing interest in trade in services in recent years, however, a number of economists have addressed themselves to the question whether the existing body of international trade theory could he applied to services. Generally, economists have concluded that the application of the existing theoretical framework can lead to useful insights about trade in services. (See, for example, Herman and Hoist, 1981; Hindley and Smith, 1984; Oulton, 1984; Sampson and Snape, 1985; Deardorff, 1985; and Richardson, 1987.) Most of the problems economists have encountered in applying existing trade theories to trade in services can he traced to the fact that trade in services is largely invisible, that it is tied to the international flow of people, information, money, and goods, and that it is closely tied to foreign investment in the importing country. Because trade in services is largely invisible, economists have difficulty in precisely identifying what is being traded. Because trade- in services is so closely tied to international movements of people, information, money, and goods, economists sometimes confuse the two. Because trade is linked to investment, some economists have questioned the value of looking at the trade dimension. The unique characteristics of trade in services do not invalidate the application of existing international trade theory. At the same time, the existing theory will have to he expanded to deal with the unique aspects of trade in services. The close link between trade in services and the international flow of people, information, money, and goods, for example, has major implications for the way economists need to organize their thinking as they probe more deeply into the theoretical, empirical, and policy issues related to trade in services. International trade in services thus has to be analyzed not only in terms of the service products that are traded, but also in terms of the means for transferring such services from one country to another. In order to analyze trade in repair services between two countries, for example, one would need to examine differences in the cost of repairing a machine in the two countries, and the relative costs and economic gains associated with five alternative means for transferring repair services-shipping the machine to be repaired from one country to another, sending a repairman to the country where the machine is located, sending information that will help a local repairman accomplish the task at less cost, bringing the foreign repairman to the factory for training, or establishing a local repair facility in the importing country (the last two options would clearly take more time. In other words, in order to understand trade in repair services, or even just to define trade in repair services, one has to develop a fairly clear concept of the family of services that can fulfill a particular economic objective, and bow the alternative means for transferring the service affect the relative costs and benefits of trade in such services. The difficulty of observing trade in services has important implications for the research strategy economists need to adopt in seeking empirical data to back up their theories. As discussed in Chapter 2, government statistics are not very well organized to shed much light on trade in services, and while current efforts to-collect-more data will be extremely useful there is an inherent limit to the government's ability to collect meaningful, detailed data. The implication for economists is that they should not expect to base their research of trade in services on aggregate data. In order to find out what services are being traded, economists will need to pursue case studies based on the experience of individual firms and to use such detailed information to interpret the aggregate data that become available. NORMATIVE AND DESCRIPTIVE THEORIES OF INTERNATIONAL TRADE The theory of comparative advantage is both a normative theory and a descriptive theory. As a normative theory, it describes a set of circumstances under which trade is economically advantageous to the countries participating in such trade. As a descriptive theory, the theory of comparative advantage seeks to explain observed trade flows among countries in terms of observed differences in the distribution of resources and factors of production among such countries.
The normative theory of comparative advantage holds that two countries can gain from international trade if 1 supply and demand in the two countries are determined on the basis of market competition, and 2/ prices charged by producers adequately measure the cost to society, and the prices paid by consumers adequately measure the value of services to society. To the extent these conditions are met, the theory of comparative advantage demonstrates that trade raises each country's standard of living by allowing each country to devote its resources to what it produces most efficiently. In terms of the terminology used by economists, trade leads to an improved global allocation of resources. To the extent that any of these conditions do not hold, trade may not be in the economic interest of the countries involved under some limited conditions. A large number of books and articles have been written to elaborate on these conditions. The theory of comparative advantage deals with only one set of economic gains generated by international trade, namely, the increase in output available for consumption that is achieved by producing a more efficient mix of goods with existing national resources. International trade can also generate dynamic gains by putting competitive pressures on domestic producers to adopt more efficient methods of production. Trade thus increases national income by changing both what is produced and how it is produced. On the other hand, sometimes strong competition from foreign producers can deprive domestic producers of the time needed to hone their skills and to develop the economies of scale that could make them fully competitive with foreign producers. Much of the economic literature in trade has been devoted to identifying the various economic conditions under which trade would not be in the economic interest of one country or another. Where such conditions can be identified in the real world, a rationale can be shown to exist either for restricting trade or for implementing government measures that would bring about the right conditions for beneficial trade. A corollary set of international trade theories describes
the circumstances under which one government or another can improve
its gains from trade by taxing imports or subsidizing exports. A government
can improve its own gains from trade by imposing duties on imports
(or by offering subsidies for exports) whenever domestic demand and
foreign supply of foreign goods are responsive to price changes, a
relatively common situation. In terms of the terminology used by economists,
a country can shift the terms of trade in its favor by imposing duties
on its imports whenever the foreign price elasticity of supply and
the domestic price elasticity of demand for foreign goods are elastic.
It can also he demonstrated, however, that if other governments adopt
the same strategy, both countries can end up losing. If each country
seeks to adopt an optimal tax on imports and an optimal subsidy on
exports, every country can end up worse off than if they all agreed
to avoid import duties and export subsidies.1 The calculation of economic gains and losses from
international trade is based on a concept of national wealth. While
the country as a whole can be shown to gain from trade, some industries
or groups of workers are likely to experience a loss of income as
a result of trade. One of the issues that has concerned economists
is the extent to which those who gain from international trade should
compensate those who lose. Economic assistance to those adversely
affected by the removal of trade barriers can reduce their resistance
to such policies. On the other hand, it is argued that economic groups
adversely affected by technological changes or by acts of God are
not compensated for such losses, and that there is no greater reason
to give preferential treatment to economic groups adversely affected
by trade. Descriptive theories of international trade seek to explain the pattern of imports and exports found in the real world on the basis of each country's economic endowment of resources and other economic variables. The theory of comparative advantage seeks to explain the pattern of trade on the basis of each country's relative endowment of the major factors of production such as capital and labor. The descriptive theory of comparative advantage was developed by two Swedish economists, Eli Heckscher (1919) and Bertil Ohlin (1933).3 The Heckscher/Ohlin theory basically says that a country will have a comparative advantage in goods that require a relatively large input of factors of production that are relatively plentiful and therefore relatively cheap in that country, and that it will have a comparative disadvantage in goods that require a relatively large input of factors of production that are relatively scarce and therefore relatively expensive in that country. A capital-rich country with high wage rates should therefore be expected to export goods that require a large amount of capital and import goods that require a relatively large input of cheap labor. One of' the first economists to examine the empirical validity of the theory was Wassily Leontief (1953), who computed capital and labor ratios for U.S. export industries and import competing industries. Leontief came up with the surprising findings that U.S. industries that competed with imports had a higher ratio of capital to labor than U.S. export industries. This was a surprising result, because everyone had assumed, on the basis of the Heckscher/Ohlin theory, that the United States would show competitive strength in industries that required a large input of capital, which was plentiful and relatively cheap in this country, and that the United States would tend to import goods with a relatively larger input of labor relative to capital, since labor was considered to be relatively scarce and therefore expensive in this country. Needless to say, Leontief's findings created considerable controversy in the profession about who was right: Heckscher/ Ohlin or Leontief. The final judgment is that both are right. The Heckscher/Ohlin theorem seems to be valid over a broad range of circumstances, but this was not evident in Leontief's findings because he had not considered other factor inputs such as human capital and natural resources, both of which are plentiful in the United States. Other economists such as Baldwin (1971), Hufbauer (1970), and Lary (1968) expanded the analysis done by Leontief to include these other factors, and their work has shown that Heckscher and Ohlin were right after all. In recent years empirical investigations have focused on the observation that countries often export and import the same type of goods. The Heckscher/Ohlin theory of comparative advantage, which assumes that trade is based on an exchange of goods that contain different resource inputs, cannot explain such intrasectoral trade. This has led to new theories that seek to explain trade flows in terms of product differentiation, leadership in new technology, institutional factors, and government industrial targeting policies. Theories based on product differentiation start from the observation that in many product areas goods produced in different countries or by different firms are quite different in quality, performance characteristics, and visual appeal. Two-way trade takes place in these products among countries with similar resource endowments because consumers have different needs and different tastes. Theories based on technology leadership and industrial targeting are based on the observation that competitive advantage in some industries has gone to firms that were first able to produce a product on an efficient scale, either by chance or by government design. The questions that have been raised about the empirical validity of the Heckscher/Ohlin theory do not undermine conclusions about gains from trade derived from the normative theory of comparative advantage.
The theory of comparative advantage tells us that trade between two countries creates mutual economic gains provided such trade is based on a competitive market and provided it does not generate other costs to society as a whole that producers do not have to pay. As a theoretical statement about relationships between economic actors and market outcomes, the theory should meet the test of logical consistency for all possible products that can be produced and exported by residents of one country and imported and consumed by residents of another country. In other words, the theory of comparative advantage as a theoretical statement about economic relationships should be equally valid whether the products encompassed by the theory are tradeable physical goods such as shoes and oranges, or tradeable services such as insurance and engineering. 4 The theory of comparative advantage is nothing more than the extension of classical economic theory to international trade. It builds on the economic principles and theories that describe the behavior of buyers and sellers in domestic markets, and describes the adjustments that occur in isolated national markets when producers and consumers from one country are allowed to participate in another country's market. Services, like goods, are produced by combining inputs of goods and services to create something of value that can be sold and purchased in the market. One should therefore be able to expect that the production, sale, purchase, and consumption of services follow the same pattern of economic behavior as the production, sale, purchase, and consumption of goods.' The remainder of this chapter is devoted to the testing of this proposition through rigorous analysis. The questions that need to be addressed are the following: Do services have any characteristics that are inconsistent with the normal operation of markets as assumed by the theory of comparative advantage? Does the link between trade in services and international movements of people, information, money, and goods somehow undermine the theory? Does the need for investment in local production and distribution facilities in the importing country invalidate the theory? In order to answer these questions, this section examines in greater detail whether the economic principles incorporated in the theory of comparative advantage govern economic behavior in services, whether the theory can encompass the related movement of people, information, money, and goods, and whether the need for foreign investment to export some services invalidates the application of the theory to trade in services. Any conclusion reached about the applicability of the normative theory of comparative advantage to trade in services in general does not directly answer the more important question whether trade in specific services will lead to gains from trade. In order to demonstrate that trade in specific services will lead to economic gains, it has to be shown that trade in such services meets the conditions set out in the theory of comparative advantage with respect to competitive markets and nonmarket costs and benefits. The normative theory of comparative advantage ultimately is only a tool for analyzing the economic benefits of trade. The following two sections are devoted to testing whether market conditions in services satisfy the preconditions set out in the normative theory of comparative advantage for the achievement of mutual economic gains. The theory holds that trade will lead to mutual economic gains if trade is the result of market competition and if trade does not generate other costs to society. not paid by producers, or does not adversely affect the availability of benefits to society not normally paid for by individual consumers. The key issues therefore are whether markets in services are competitive, 6 whether the prices charged by producers adequately reflect the costs of production to society, and whether the prices consumers are willing to pay adequately reflect the benefits to society as a whole. These are particularly important issues in the area of services, and deserve careful consideration. The final section will go over recent attempts to carry out empirical tests of the descriptive theory of comparative advantage on the basis of currently available aggregate data. The question is not whether trade leads to economic gains, but whether actual trade flows are explained by differences in the basic resource endowment of the countries involved in such trade. While the data available to researchers are extremely poor, as already noted, it is interesting that this work nevertheless seems to support the validity of the descriptive theory of comparative advantage in explaining observable trade in services.
A theory about trade in services is likely to be meaningless unless it can encompass and account for the required movements of people, money, information, and goods involved. A closely related issue concerns the link between foreign investment and trade in services. Many services, particularly services sold to households and small business enterprises, can be exported only in conjunction with the local production of services by foreign owned enterprises. Any conclusions about trade in these services has to be based on an explicit recognition of the link to investment, and a question can be raised whether the theory of comparative advantage can deal with this link. Brian Hindley (1984) addressed the question whether the movement of people or capital associated with trade in services might invalidate one of the basic assumptions of the theory of comparative advantage, namely, that trade is based on existing differences in the distribution of resources in two countries trading with each other. He rejected this argument on two grounds. First, he pointed out that as long as the distribution of resources remains different in the two countries, a rationale for trade remains. The rationale for trade depends not on the initial distribution of resources, but on the extent to which a difference remains at any one time. Second, he pointed out that unimpeded international factor movements would lead to the same adjustment in global output and prices as unimpeded international trade, and therefore the economic theory of comparative advantage could encompass both trade in services and international factor movements. 7 Another approach one could take to the issues addressed by Hindley is to establish a distinction between permanent transfers of factors of production from one country to another, and the temporary movement of people or money from one country to another for the purpose of exporting services. International movements of service workers can therefore be treated as trade in services if the stay abroad is temporary and can be treated as international factor movements if the stay abroad is for an extended period of time or is permanent. Similarly, a distinction can be made between the management of money and the transfer of capital. The temporary movement of money to another country for the purpose of importing foreign financial management services can be distinguished analytically from the more permanent transfer of money connected with a capital investment decision. There is no reason to believe that money placed in a Eurodollar account with a London bank will necessarily be invested in Great Britain, or that money deposited in a large New York City bank will be invested in the United States. Any global financial institution that readily accepts deposits from foreigners also lends money to foreigners, and will seek out the most attractive investment opportunity in a global market context. Another theoretical issue concerns the close relationship between trade in services and foreign investment in many services. Most services sold directly to consumers require significant investments in local production and distribution facilities, because the production of such services depends on close interactions between suppliers and consumers. It would be difficult for a foreign bank to provide consumer banking services without a local branch, and it would be even more difficult for McDonald's to sell hamburgers without a local facility where they can be cooked and served to customers. While foreign companies that sell consumer services can supply many of the managerial service inputs and much of the technology from the home country, they have to be able to use local facilities to produce and distribute the final product. Besides banking and fast food services, a list of services that require extensive local facilities would need to include hotel services, medical services, and local professional services sold to households and small business enterprises. As traditionally formulated, the theory of comparative advantage does not directly address investment in foreign facilities. However, as noted earlier, trade and international movements in factors of production such as labor and capital ultimately have similar economic effects on the goods and services that are produced and consumed, the cost of production and the prices paid by consumers, and the income earned by workers. Nothing in the theory of comparative advantage precludes gains from trade that depend on local investments in facilities. International trade and investment flows equally lead to a more efficient utilization of productive resources, as goods, services, and factors of production move from countries where they are relatively cheap to countries where they are relatively expensive.8 In summary, the requirement for an international flow of people, money, information, and goods makes trade in services different from trade in goods, but it does not change the underlying economic rationale for such trade as demonstrated by the theory of comparative advantage. The foreign investment required to support trade in some services introduces an added dimension that is not directly addressed in the theory of comparative advantage, but it can be shown that such investments have complementary economic effects. Although there is no logical flaw in the application of the normative theory of comparative advantage to trade in services, these arguments about theoretical consistency do not prove that an international flow of people, money, and information or foreign investment is good or bad in a broader sense. One country might deplore the more direct foreign involvement in its society, while another country might consider itself enriched by the greater variety of ideas, business experience, and cultural horizons. In order to complete our evaluation of the economic effects of trade in services, we have to examine how the level of competition and nonmarket costs and benefits of trade in services affect the calculation of gains and losses from trade. The theory of comparative advantage assumes that trade is based on market prices determined by competition, and that trade does not lead to significant nonmarket costs and benefits. Trade can still lead to gains from trade even if there is less than perfect competition and even if there are nonmarket costs and benefits, provided there is some level of competition and provided nonmarket costs do not exceed the net gains from trade, including nonmarket benefits. In order to help define advantageous trade and disadvantageous trade under less than ideal conditions, we will need to examine more closely how limited competition and nonmarket costs and gains affect the achievement of gains from trade.
A review of the degree of competition in services leads to the conclusion that in some sectors competition is limited as a result of high overhead costs, while in other sectors competition is limited as a result of government policy. The degree of competition in individual sectors varies from country to country, reflecting both differences in the development of the industry and government policies in individual countries. Whether competition is limited by government policy or by economic realities can make a considerable difference for the potential gains from trade. After all, the opening of trade could in some cases bring about the ideal competitive market conditions assumed by the theory of comparative advantage. Trade will increase competition unless the industry has the economic characteristics of a natural monopoly. In the absence of perfect competition, individual producers have the ability to set prices above the cost of production and to reap excess profits. The more limited the competition, the greater the flexibility of producers to charge higher prices. Now let us assume that an industry with little domestic competition is opened up to trade. What would happen? Competition among foreign producers would force the price down to the lowest foreign cost of production. Under this scenario, the opening up of trade would bring about the ideal market conditions envisioned by the theory of comparative advantage. The first conclusion one can draw, therefore, is that the absence of adequate domestic competition does not provide grounds for restricting trade if the opening up of trade would bring about competitive market conditions. The second scenario to be considered is one where the opening up of trade does not lead to vigorous competition among foreign suppliers. In this case the foreign firm would be able to set prices above its cost of production but presumably below the current price set by domestic producers. If it did not set prices below those set by domestic producers, the foreign firm would not have much of a chance to gain a significant market share. The lack of competition thus will enable a foreign producer to extract undue profits, but the importing country is still better off than it would be in the absence of trade. The issue in this case, therefore, revolves around the distribution of gains from trade, not whether trade results in gains. Moreover, the remedy for an unequal distribution of the gains from trade is to pursue policies that would increase the number of potential foreign suppliers. 9 A more serious situation could arise if a dominant foreign supplier could eliminate weak competitors in the importing country, and with the competition removed raise prices higher than they would be in the absence of trade. In this situation, a country could actually lose from trade. The right remedy would be to pursue policies that would increase competition among potential foreign suppliers. An alternative course would be to provide enough support to the domestic industry to keep it in business as a viable competitor. The most contentious trade policy issues arise not over insufficient competition among potential foreign suppliers of services but over differences in the level of competition permitted in different countries. Government-imposed limits on competition, whether they affect the ability of new firms to enter the market or the ability of existing firms to expand, ipso facto reduce trade opportunities. Put another way, government-imposed limits on foreign competition are equivalent to a tariff or quota on trade, and such regulations are in practice the most commonly used tool for protecting services industries. The liberalization of trade between a country that allows open competition and another country that limits competition will enable the country with more limited competition to capture a greater share of the gains than it would be able to obtain with a more competitive regime. In fact, the economic outcome of liberalization of trade between two countries that allow different degrees of competition among suppliers is equivalent to a one-sided removal of tariffs on trade in goods. While it can be demonstrated that under a range of assumptions, a unilateral removal of tariffs can be in a country's economic interest, it could obtain even larger gains if other countries were to remove their tariffs as well. A country will therefore be better off by negotiating a mutual reduction of barriers, than by engaging in unilateral disarmament. Unilateral reductions of barriers, not surprisingly, are also difficult to sustain politically. The discussion up to now has focused on the absence of sufficient competition among suppliers. An issue could also arise with respect to inadequate competition among buyers. Lack of competition among buyers allows individual buyers to reduce their prices below free market levels by withholding purchases. This situation can arise whenever a government marketing monopoly that has the exclusive right to market certain services in the home market can choose among competing foreign suppliers. Competition among foreign suppliers will enable the government marketing monopoly to extract extraordinary profits from such transactions by shifting the terms of trade in its favor. In effect, the government marketing monopoly as a monopsonist can levy an optimal tariff on foreign producers through its power to determine the purchasing price. Now let us turn to a broad overview of the state of
competition in services, and the implication for the potential gains
from trade. Where the provision of services depends on the By virtue of its monopoly power, a foreign monopolist can charge higher prices in its own market than it could charge in a competitive market, and these monopoly profits could be used to subsidize exports to other countries. The important question therefore is whether a country that has competition in its own market can gain by allowing a foreign monopolist to participate in its market-that is, whether it can derive economic benefits by accepting imports from another country that does not permit competition. As noted above, a country that limits competition can shift the terms of trade in its favor. Firms that are protected from competition in their home market can also use the resulting monopoly profits to subsidize the sale of services abroad, displacing sales by nonsubsidized foreign suppliers operating in a competitive environment. Economies of scale could limit the number of firms that would survive under open international competition in segments of the telecommunications and transportation markets characterized by high overhead costs. Such segments of the industry could thus evolve toward a monopolistic market structure or an oligopolistic market structure with imperfect competition. Such a market structure would enable the surviving firm or firms to reap extraordinary profits. This possibility has provided the rationale for extensive regulation of both the telecommunications and the transportation sectors in most countries. In recent years there has been growing recognition that not all segments of these industries have economies of scale so large that they will necessarily evolve toward a monopolistic or oligopolistic market structure. There is wide disagreement among economists as well as policy officials, however, on the potential scope for competition in various segments of the market, and the evolution of thinking will very much depend on the outcome of deregulation in the United States and elsewhere. We have to conclude that neither the transportation nor the communications sector fits the ideal conditions assumed in the theory of comparative advantage, and that we cannot reach any conclusions with respect to potential gains from trade without a more detailed investigation of possible ground rules under which trade in these sectors could approximate the competitive market conditions necessary for mutual economic gains. In some countries, a number of services besides transportation and communications are provided through government owned or government-regulated monopolies. Financial services such as banking and insurance, for example, fall into this category, particularly in developing countries. The argument is made that the small size of the domestic market and the scarcity of domestic financial management expertise make it uneconomical to permit open competition among an unlimited number of small firms. The argument that the limited size of a domestic market requires government intervention to limit the number of competitors rests on a fairly weak theoretical foundation. If the market cannot sustain more than a certain number of competitors, enough firms will drop out through the normal operation of market forces. The problem in most countries that limit competition in banking and insurance is not too much competition, but rather too little real competition as a result of over regulation. It has become clear in recent years that an excessive centralization of financial institutions entrenches the economic status quo and limits the availability of financial resources for local entrepreneurs. Even the communist countries are moving away from a monopoly structure in the financial industry. Clearly, many governments in the past have underestimated the economic scope for meaningful competition-and the potential gains from competition. More competition can benefit such countries, whether such competition takes the form of more domestic competition or more international competition. In other service sectors, many governments have chosen to limit competition by regulating the number of participants, or by allowing industry associations to limit the number of practitioners through a licensing process. This is particularly the case with respect to professional services, where even developed countries like the United States allow the professional associations to exercise considerable influence or control over admissions to professional schools and the licensing of professional practitioners. In the same vein, professional regulations frequently prohibit advertising and discourage price competition. The argument is usually made that the quality and reliability of services provided in these sectors is more important to consumers than the prices at which such services are provided. Were unlimited competition allowed, it is argued, suppliers would' be forced to provide cheap services of poor quality and reliability, and consumers would not have the necessary information to make rational choices between price and quality. Moreover, it is argued, consumers themselves are in a poor position to evaluate quality, and it is therefore necessary to impose standards enforced by professional peers who are in the best position to judge quality. On the whole, these arguments for limiting competition tend to be exaggerated, and indeed they are employed by everyone who wants to justify limits on competition. Governments have a role to play in establishing standards, but there is little justification for explicitly limiting competition among potentially qualified professionals for the purpose of protecting quality. Any government-imposed limits on competition or government-sanctioned understandings among suppliers to limit competition ipso facto create barriers to trade in services. Such limits on domestic competition, however, do not constitute a sufficient economic rationale for restricting trade. In fact, negotiations aimed at the liberalization of trade in services may usefully force many governments to reevaluate regulations that limit domestic competition. Trade negotiations could thus become an important tool for domestic reform.
The nonmarket costs of trade are not paid by producers and consumers of services but are imposed on society as a whole. Trade in services, like trade in goods and like most economic activity, can result in adjustment costs for less efficient producers, and some of these costs are passed to the country as a whole through social assistance programs such as unemployment compensation, tax write-offs, and adjustment assistance programs. In fact, many of these programs are part of a broad social compact that redistributes some of the gains from trade to those who are adversely affected by them. A case can be made for limiting the growth of trade in services where a rapid increase in such trade imposes large adjustment costs on less competitive firms and workers. This is the case where the entry of a large number of temporary workers could create major unemployment in an area. International trade in services can also result in nonmarket social costs if it displaces domestic services industries that yield nonmarket social benefits. Some service industries, for example, could provide unique training opportunities for professional skills in demand in other sectors of the economy. A research laboratory could thus become the training ground for research scientists in related industries, or a software company could provide unique training opportunities for computer programmers in demand throughout the economy. Since firms that subsequently employ such individuals would not have to pay for the initial training, the market will tend to undervalue the economic contribution made by an industry that provided unique training opportunities. It would have to be demonstrated, however, that the training opportunities provided by a targeted services sector were in fact unique and would not be available otherwise. In such circumstances, a rational economic case could be made for limiting imports of the services involved or subsidizing the domestic production of such services. Trade in services based on an international movement of people can also generate other nonmarket social costs by placing an added burden on infrastructure facilities and social services. Where the stay abroad is very brief, the burden placed on such facilities is probably slight. Even short stays abroad, however, can overload public facilities if the number of people involved is very large, as perhaps best exemplified by the Olympics or the Haj to Mecca. In light of the burden placed on limited public facilities, a government under rare circumstances may well have rational economic grounds for limiting the number of people it is willing to admit in connection with trade in services. Trade in services, like trade in goods, can also impose more qualitative nonmarket costs on society. Trade leads to greater dependence on foreigners, and this can reduce the government's ability to exercise control over the available supply of services. In the case of war or in the case of an economic emergency, this greater dependence on foreigners could lead to a shortage of critical services. Every country must evaluate these risks on its own. It has to be said, however, that this risk is frequently exaggerated in public political debate. All human economic progress has been based on growing specialization and mutual dependence, both within countries and among countries. Temporary movements of labor also lead to disputes over taxation and access to subsidized services provided by governments. A temporary service provider most likely will pay income taxes in the home country, and not in the country importing his or her services. At the same time, such a person could make use of social services subsidized by the host government. It is sometimes argued that services such as transportation, communications, and financial services are more crucial to the functioning of society than goods, and that this makes it more essential to maintain national control over these industries. Moreover, it is argued that the reliability and quality of services are more important to national economic welfare than the cost of producing services, and that the inability of the government to 'control the quality and reliability of services produced abroad more than offsets what could be gained from the lower cost of services produced abroad. These arguments underestimate the ability of consumers to judge quality. In any case, consumers who can afford to buy services abroad are likely to be sophisticated enough to know what they are buying. On the other hand, services purchased from foreign suppliers in the home market of the consumer are subject to the full regulatory control of the home government. Claims to the contrary, claims that governments cannot exercise effective regulatory control over foreign suppliers established in the local market, are greatly exaggerated. Trade in services, like trade in goods, inevitably exposes a country to foreign customs and ideas. Countries that want to resist foreign cultural influences are likely to find trade in services more intrusive than trade in goods. After all, trade in services frequently takes the form of people moving across national borders, and these people inevitably bring along their foreign habits, outlook, and cultural values. In-other cases trade in services takes the form of an international flow of information, and inevitably facts and figures are mixed together with qualitative information that reflects different cultural values and a different point of view. The desire to preserve national culture and identity is understandable; yet, despite the growing influence of global mass media, many countries have seen a revival and renewed interest in ethnic culture. The vast expansion of communication channels in recent years has lead to an expansion of both global informational and cultural material and local and ethnic informational and cultural material. Instead of being viewed as a social cost, the cross-cultural exposure provided by trade in services could be considered a major social benefit. By offering a greater variety of cultural experience, it could enrich a country's social and cultural life. By increasing knowledge of foreign customs and culture, it can reduce international frictions due to an inability to understand each other and to communicate with each other. An expansion of trade in services thus can be a powerful instrument for ensuring peace in the world.
The discussion of comparative advantage in the last section showed us that trade in most services can lead to the better use of the existing resources of countries engaged in trade. In addition to these allocative or static gains from trade, we have to address possible dynamic effects of trade. Trade in services can affect the development of domestic resources over time, both positively and negatively. On the positive side, competition from foreign suppliers can stimulate domestic suppliers to undertake a more vigorous effort and to acquire new techniques by emulating foreign competitors. On the other hand, if foreign competitors are too strong, domestic firms may not survive to acquire the skills and economies of scale that would make them effective competitors in the long run. In other words, trade could prevent domestic suppliers of services from developing a potential comparative advantage.
The production of services, more than manufacturing, is a people business. The quality of the product and the efficiency with which it is produced are highly dependent on personal skills and capabilities, and the motivation of the individual worker to provide a high quality product. The organizational support and the advanced technological tools provided by the enterprise are obviously also important, but most of the technology and the capability to produce a highly competitive service usually reside in the individual service worker. Trade in services, whether based on an inflow of foreign experts, foreign information, or foreign investment, will expose domestic suppliers of services very directly to the skills and techniques employed by their foreign competitors. Multinational firms that want to sell or buy services abroad usually maintain regular contacts with their foreign customers and suppliers, and frequently they end up hiring and training local personnel in the skills and techniques employed by the firm. Once trained, these local employees can be hired by domestic competitors, or the more dynamic of these employees can start their own businesses. Trade in services, because it is so dependent on personal skills, can lead to a rapid transfer of the skills and techniques needed to produce a world competitive product. Foreign competition can also have a powerful effect
on the personal motivation to excel and to work hard. As we saw earlier,
there is a built-in tendency in many services to allow the industry
to limit the level of competition. Against this background, increased
competition from foreign suppliers can provide an important stimulus
to overcome the lethargy and indifference to customers that usually
accompanies a lack of sufficient competition. The rapid expansion of imports can also create dynamic
losses from trade by preventing domestic enterprises from developing
the necessary skills, experience, and economies of scale. In other
words, local firms may never get the chance to build on a natural
comparative advantage they might have as a result of cheap labor or
a favorable location because the development of such advantages might
take time, and strong competition from foreign firms could force them
out of business before they have a chance to build their strengths. Of these factors, the cost of labor and capital, and physical proximity, are bound by a country's current endowment of resources. The other factors-personal skills, organization, and institutional environment-can be acquired. A country that has cheap labor and can afford the necessary capital therefore may be able to develop a globally competitive industry. Putting together the needed personal skills, organization, and institutional environment, however, takes time, and local firms may not have the opportunity to develop these acquired skills if powerful foreign competitors can keep them from growing or can drive them out of business. Too much trade too soon could thus prevent a country from developing competitive strengths in a services industry in which it has potential strengths as a result of its plentiful supply of cheap skilled labor. This is the so-called infant-industry argument. Although ii has considerable validity, it is rarely applied intelligently in practice. A country that adopts a trade policy based on the infant-industry principle has to avoid a series of traps. The first trap is total protection. Even though less
foreign competition may sometimes give a domestic industry a better
chance to become more competitive, this does not mean that the elimination
of foreign competition altogether will create the most favorable environment
for the development of a competitive industry. If foreign competition
is removed altogether, the domestic industry is likely to decide that
the current way of doing things is just fine and that difficult decisions
can be postponed indefinitely. The third trap is comprehensive protection. It is easy to conclude that the infant-industry principle can justify the protection of all noncompetitive industries. This is wrong for two reasons. First, not all noncompetitive industries have the same potential for becoming world competitive, given an individual country's economic strengths and weaknesses. Second, every country has only a limited number of people with the skills needed to foster and facilitate the development of an industry, and the more industries are covered by infant-industry protection, the more the people with the critical skills are spread over too many industries. The scarcity of national resources thus imposes limits on the range of industries in which a country can develop a globally competitive position over a given period of time. The fourth trap is insufficient market size. The domestic market may not be large enough to provide the economies of scale needed to support the large-scale investment in research and development required to become competitive in a desired industry. If the domestic market is not large enough, no amount of protection for the domestic industry will make that industry competitive in either the short run or the long run. It can cost more than a billion dollars, for example, to develop the software necessary to operate a large public telecommunications switch efficiently. Obviously only a handful of countries with very large domestic markets could support the development of the necessary software, and it is doubtful that more than one or two countries could achieve success on their own. A country that falls into any one of the four traps associated with infant-industry protection ends up sacrificing both static and dynamic gains from trade without getting the dynamic gains it hopes to get from infant-industry protection.
International competitiveness in services is determined by the cost of labor, the knowledge and skills of local service workers and managers, the availability of data processing and communications equipment, the effective organization of service inputs required to deliver the services desired by customers, the institutional environment for the production of services, and proximity to the market. Developing countries can derive an important source of competitive advantage from their low cost of labor because labor constitutes the largest element of cost in most service industries. The critical handicap many developing countries face is the lack of the right skills, organization, and institutional environment, but these can be developed. Ultimately, the only real competitive disadvantage developing countries face is a relative scarcity of capital. One should therefore expect developing countries to do well in all service industries that require a relatively large input of labor and a relatively small input of capital. Developing countries should be able to develop a competitive advantage in an area such as data input and computer programming, which are labor-intensive activities, but not necessarily in computer processing or information services, which are machine- and capital-intensive activities. The crucial question developing countries must address is how they can best acquire the skills, organization, and institutional environment needed for the production of world-class services. The optimal strategy is likely to be one that offers foreign producers of services access to an increasing share of the domestic market and encourages them to establish local facilities for the production and distribution of services. By offering foreign producers access to a growing share of the market, a government can help assure a gradual increase in foreign competitive pressure on domestic producers and give foreign producers an adequate incentive to invest in the production and delivery of services to the local market. By encouraging foreign producers to invest in local facilities, a government can speed the transfer of professional and managerial skills, since the foreign producers will have to train local employees and by their presence will give domestic firms a role model to emulate. Foreign firms also tend to play a useful role inputting pressure on officials to modernize local laws and regulations, and in persuading the local industry to adopt more competitive business practices. One key problem of many developing countries is that their market is too small to support many firms that are large enough to obtain globally competitive economies of scale. This is perceived to be a bigger problem in services than in goods because it is difficult to export many services without sizable investments in service facilities in the importing countries. Protection is clearly not a solution to this problem, however, since protection cannot enlarge a market that is too small to begin with. Indeed, protection is likely to reduce chances of ultimate success by pointing the attention of management toward the domestic market instead of the international market. One way that service suppliers in small countries can compete successfully with large foreign firms in the international market is to ally themselves with large multinational firms and to use the international infrastructure of such firms for exporting their services. Such allied multinational firms can, in effect, provide the economies of scale otherwise unavailable to small firms. A highly protectionist policy in services is likely to be very costly for developing countries, not only by delaying the development of competitive domestic services industries with export potential, but by raising the costs of domestic manufacturing. Services constitute a large and growing input into the production of manufactured goods, particularly the production of high quality manufactured goods that have to compete in world markets. Increasingly, developing countries that seek to expand their exports of manufactured products have to acquire competitive inputs of services in such areas as engineering and design, software programming, communications and transportation, marketing and advertising, financing and insurance, documentation and training, and maintenance. In a highly competitive market, the price and quality of these service inputs can be crucial to competitiveness. Low productivity in services can also hamper economic development by absorbing too many manpower resources that would otherwise be available to expand manufacturing. While many of the poorest developing countries have not run into labor constraints, those that achieve a high rate of growth do run into labor supply bottlenecks. Beyond constraints on the development of manufacturing, it is a mistake to assume that a country's standard of living is not affected by the efficiency of the services sector. Services constitute a large portion of every person's budget, and the more inefficient the services; the more time is wasted in taking care of daily service needs. Many developing countries have protected the domestic services industry not only from foreign competition but also from excessive domestic competition. In some countries this policy has been motivated by a belief that an inefficient services industry can help assure full employment, and in other countries it has been motivated by a belief that competition would result in firms that are too small to achieve efficient economies of scale. As already noted, this is a particular concern in smaller developing countries. Whatever the rationale, these policies often end up inhibiting the development process rather than accelerating economic development.
In recent years a number of economists have begun to test whether the descriptive theory of comparative advantage could be used to explain the observed pattern of world trade in services. Two studies, in particular, have come up with some interesting results. The first study was carried out by Andre Sapir and Ernst Lutz (1980) for the World Bank. The second study was done by Nicholas Oulton (1984) for the Trade Policy Research Center in London. Both studies used balance of payments data published by the International Monetary Fund for trade in four categories of services: 1) freight and insurance services, 2) other transportation services (passenger fares and port services), 3) travel services (expenditures by travelers while abroad), and 4) other private nonfactor services (in other words all other services, not including interest payments and labor remittances). The period covered by the two studies is slightly different, 1967-1975 by Sapir and Lutz and 1959-1960 to 1979-1980 by Oulton. The major difference between the two studies, however, was country coverage. The investigation by Sapir and Lutz covered trade in services by both developed and developing countries, while Oulton's study focused exclusively on trade by developed countries. The study by Oulton showed some fairly consistent patterns of competitive strength by the countries studied in specific services, but not a very clear relationship to the underlying economic resource endowment of the countries involved. The study by Sapir and Lutz showed a clearer relationship between trade patterns and resource endowments. The difference in the results of the two studies is explained by the fact that differences in resource endowment between developed and developing countries are much more distinct than they are among developed countries. Sapir summarized the results of his work with Lutz in an article he published later in the Columbia journal of World Business (Sapir, 1982, p. 79). His conclusion is that the competitive position of a country in transportation (aviation) is determined by a relative abundance of physical capital, while its competitive position in insurance and other services is determined by the availability of human capital and research and development expenditures. He also found that the size of the country's market (scale economies) was an important factor in determining competitive strength in services more generally. Both Sapir-Lutz and Oulton were painfully aware of the overwhelming shortcomings of the data, which are highly aggregated, are aggregated differently in each country, and are of dubious quality overall. It is all the more interesting that Sapir and Lutz were able to show that the application of the descriptive theory of comparative advantage to trade in services yields results consistent with empirical observations, however poor the data. It is highly doubtful that an analysis of more detailed
data on trade in services, were such data available, would support
the validity of the Heckscher/Ohlin theory with respect to trade in
many services, particularly among developed countries. Competitiveness
in services is based more on human skills, the institutional environment,
and past success in building an international network for delivering
services than on resource endowments. These questions about the empirical
validity of the Heckscher/Ohlin theorem with respect to trade in services,
however, do not undermine conclusions about gains from trade in services
based on the normative theory of comparative advantage. The basic concepts of international trade theory can be articulated without any reference to what is produced and consumed and what is imported and exported. International trade theory is a logical construct that provides conclusions about market outcomes, no matter what is bought and sold in the marketplace. In other words the normative conclusions that can be drawn from international trade theory are as valid for shoes and oranges as for insurance and engineering. The real question is whether the underlying conditions specified in trade theory for the achievement of economic gains from trade are met in the real world. This question has been investigated at great length for goods. The process of carrying out an equally detailed investigation for individual service sectors has only begun, and the sectoral studies that have been carried out under the sponsorship of the American Enterprise Institute represent a major contribution to this effort. The analysis provided in the present overview can cover the subject only with the broad brush strokes of an impressionist painter. A considerable amount of basic theoretical and empirical work also remains to be tackled. While the similarities between trade in goods and trade in services are fairly apparent and the application of traditional trade theory to trade in services has been well explored, the unique characteristics of trade in services remain to be more fully explored. Areas where more work is required include the economics of trade in information services and intellectual property, the growth of specialized communication networks and trade in professional services, and the linkages between traditionally segregated policies in areas such as communications, transportation, immigration, and foreign investment. In short, the investigation of trade in services is a growth field that should provide material for many doctoral dissertations.
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