Fragmentation and Services

We develop a model that explores the link between services and fragmentation. In our model components used in the manufacturing process are made with services and labor. Low foreign wages create an incentive to outsource component production (fragmentation). However, the importance of services in the manufacturing process can play a role in limiting fragmentation. Although advanced economies have higher costs of supplying simple services, because of the size of their home market they have a greater variety of services. As a result, their price of “aggregate services” tends to be lower than those of less developed economies. When services are not tradable advanced economies will tend to produce components that are service-intensive, and outsource the manufacturing of components that are less service-intensive (labor intensive) to developing countries. Complete free trade in services, however, eliminates the home market effect of the developed country, and in the absence of the Dornbush-Fischer-Samuelson type of comparative advantage will lead to complete outsourcing of components to the low wage economy. However, trade in services in the presence of transportation costs that are biased against the specialized services supplied by the home country may lead to reduced fragmentation of manufacturing. December 6, 2004 Filename: frag2004dec6.tex . Addresses: Long: Department of Economics McGill University 855 Sherbrooke St West, Montreal, Canada H3A 2T7 email: [email protected] Fax: 514-398-4938, 514-985-4039,Tel: 514-398-4844, 514-985-4020 . Riezman: Department of Economics University of Iowa W210 John Papajohn Business Bldg Iowa City IA 52242-1000, USA email: [email protected] Fragmentation and Services 2 FAX: 319-335-1956, Tel: 319-335-0832 . Soubeyran: GREQAM, Universite de la Mediterranee Chateau La Farge, Route des Milles,13290 LES MILLES, France email: [email protected] Fax: 33-4-42-93-09-68 Tel: 33—4-42-93-59-82