American Economic Association

Trade in Producer Services and in Other Specialized Intermediate Inputs

Author(s): James R. Markusen
Source: The American Economic Review, Vol. 79, No. 1 (Mar., 1989), pp. 85-95
Published by: American Economic Association
Stable URL: http://www.jstor.org/stable/1804775
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 Trade in Producer Services and in Other
Specialized Intermediate Inputs

By JAMES R. MARKUSEN*

Many producer services are knowledge-intensive,requiring a high initial invest-

ment in learning, after which the knowledgecan be provided to additional users at
low cost. A monopolistic-competitiontype model is developed to analyze these
producer services. Trade only in final goods is an imperfectand inferiorsubstitute
for trade in the specialized inputs, due to the complementaritybetween domestic
and foreign specialized inputs, or alternatively the gains from an increased
division of labor.

It has long been observed that over half of
international trade occurs in intermediate
goods. Much of this is in foodstuffs, raw
materials, and so forth, but much of the
trade in intermediates is also in produced
intermediate manufacturers. A rapidly grow-
ing category of trade in intermediates is pro-
ducer services, which include such areas as
management consulting, engineering consult-
ing, banking, insurance, marketing, and fi-
nancial services.
Many of the intermediate manufactures
and producer services that enter into inter-
national trade are probably characterized
by significant degrees of scale economies
and/or product differentiation. Factor-in-
tensity data suggest, for example, that inter-
mediate manufactured goods are on average
significantly more capital-intensive than final
manufactured goods (James Markusen and
James Melvin, 1984b). Many producer ser-
vices are both differentiated and knowledge-
intensive. Knowledge intensity in turn
suggests strong scale economies in that
knowledge must be acquired at an initial
learning cost, after which the knowledge-
based services can be provided at a very low
marginal cost (as in an engineering consul-
*Department of Economics, University of Western
Ontario, London, Canada N6A 5C2. Funded under a
grant from The Institute for Research on Public Policy
and the Department of Regional and Industrial Expan-
sion, Ottawa. The thorough and constructive comments
of an anonymous referee are gratefully acknowledged.
85
tant selling the same blueprints to different
firms).
The theory of international trade today
consists of a relatively small literature on
intermediate inputs (for example, Kalyan
Sanyal and Ronald Jones, 1982) and a litera-
ture on scale economies and imperfect com-
petition in final goods production (many ref-
erences are found in Elhanan Helpman and
Paul Krugman, 1985). The two are combined
in Wilfred Ethier (1982), Paul Romer (1987),
and Markusen (1988). These authors have a
simple model in which intermediate inputs,
produced with increasing retums to scale are
assembled to produce final output.
The purpose of this paper is to develop a
model of trade in differentiated intermediate
inputs along the lines proposed by Ethier. I
will be particularly interested in normative
issues not dealt with by Ethier (1979, 1982)
and Romer (1987). In the model, each of two
countries has a competitive sector (Y) and a
sector (X) which produces a composite good
from intermediate inputs or services (S).
The latter are produced with increasing re-
turns and are complementary in production.
The results demonstrate that allowing
trade in specialized inputs is superior to al-
lowing trade in final goods only in two dis-
tinct senses. First, free-input trade guaran-
tees that both countries will be made better
off relative to autarky while, due to the dis-
tortion between prices and marginal costs,
goods trade only does not guarantee that
free trade will be Pareto-improving. Free-

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86 THE AMERICAN ECONOMIC REVIEW
input trade guarantees that both countries
experience an expansion of production in
the distorted sector which has been shown to
be a sufficient condition for gains from trade
when price exceeds marginal cost (Markusen
and Melvin, 1981, 1984a). Free trade in final
goods only may result in the contraction of
this sector for the smaller or otherwise
" technically disadvantaged" country and
thus the sufficient condition for gains fails to
hold. Second, free-input trade is superior to
free trade in goods from the point of view of
the world as a whole, although not necessar-
ily from the point of view of both countries.
This result follows from the complementar-
ity of domestic and foreign specialized in-
puts in final goods production, or alterna-
tively from the increased division of labor
supported by trade. With free-input trade,
each country essentially confers a positive
technological externality on its trading part-
ner.
These results have a good deal of policy
relevance given the current discussions on
liberalizing trade in producer services. These
services generally face higher trade barriers
than do commodities since the former in-
trude on immigration and foreign invest-
ment policies which are in turn more restric-
tive than goods-trade policies.
I. ProducerServices,SpecializedInputs,and
the Division of Labor
Consider a two-sector general-equilibrium
model with a competitive sector Y. Good Y
is produced with labor (L) and sector-
specific capital (K) by a competitive indus-
try with constant returns to scale.
(1) Y=G(Ly,K); GI>O, G,,<O.
To keep things very simple, suppose that
production in the X sector consists of cost-
lessly assembling (as in Ethier, 1982) the
produced inputs S1,..., Sn. The identical
production functions for the competitive
firms in the X industry are given by
(2) Xi = XI(Sl,..* Sin),
where the Sj will be referred to as producer
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MARCH 1989
services or specializedinputs. The produc-
tion functionsin (2) have constantreturnsto
the S for a fixed n.
Each S is producedby a single firmand,
for simplicity, we assume that the produc-
tion of S. requiresonly labor. S producers
and X producersare disjoint,and the Sj are
producedwith increasingreturnsundertech-
nology and behavioral assumptions dis-
cussed below. Given constantreturnsin (2),
we can then aggregatethe individual firm
outputs to arrive at an industryproduction
function identical to (2) with the i subscript
deleted. In order to keep the problem
tractable,we assume that the S production
functions are identical and the S are sym-
metric but imperfectsubstitutesin produc-
ing X. Assume in particularthat the X in-
dustry productionfunctionis given by
(3) X- [s#]1 0 < p < 1.
Productionof S. uses only labor, and re-
quires a fixed cost plus a constantmarginal
cost. For simplicity,the marginalcost of S
is assumed to be one in terms of labor.
Letting Y be numeraire,the cost of produc-
ing Sj in terms of Y is then
(4) wSj + wF,
where w is the wage rate in termsof Y and
F is the fixed cost (in units of labor).
Let p denote the priceof X in termsof Y.
For a given p and w, the socially optimal
allocation in the X industry is found by
solving the followingprogrammingproblem,
equatingprice and marginalcosts.
(S) MaxvX= p [7.Sr] -2E(wSi +wF )
with respect to Si, n.
We can take advantageof the fact that the
symmetryof the S ensurethat each Si that is
produced will be produced in the same
quantity (implying that ESi = nSi, where n
is endogenous).' The first-orderconditions
IAs is common practice in the monopolistic-competi-
tion literature, the integer constraint on n is ignored.
 VOL. 79 NO. I MARKUSEN: TRADE IN PRODUCER SER VICES 87

relating to S and n are then given as follows. The first-order condition for Si is

(6) = (P/i)[n(Sj)"] (12) as, = q/32S-I w = O.

as aIS-W_w

=pn -w =; a=--(I - PVP The second-order condition holds since q

and w are viewed as exogenous. Free entry
of S producers results in zero profits, so
(7) an =(p/3)[n(SJ)"] S1
(13) qf3S/-wS,-wF= O.
-(wS, + wF) = 0
Substituting for q from (10), (12) and (13)
are respectively
= (p/li)naS,-wS,-wF =O
(14) pI3na-w=O;
Multiply (6) through by Si. Then subtract (6)
from (7). (p//3)n 3S, - wS, - wF= 0.

(8) ((1-, )/,B)pnaSj =wF. Multiply the first equation through by Si.
Combining the two equations in (14), we get
But from (6) we see that n= (w/p), so that the values of Si and n at the monopolistic-
the solution values are competition equilibrium.

A
(9) Si 1i F; n =( wlp ) /l (15) Si F;

Now consider the monopolistic-competi- n= (W/p3)#/('-").

tion equilibrium. The price faced by an indi-
vidual Si producer is the marginal product
of Si in producing X. Denoting this price as
ri (the same for all S producers due to
symmetry), this is given from (6) as
r= ( p3)
(10) n (Sj) ] aS-
- qI3Sf';
q pl-(P )n (S,) . economy's efficient production frontier.2
Suppose that there are many S producers,
such that we can assume relatively "competi-
tive" conjectures. Assume that S producers
view p as exogenous and also view X as
exogenous. Then the individual S producers
view q in (10) as fixed. An S producer's
programming problem is given by
(11) MaxT*= (qSJ-1))Si-wSi-wF
w.r.t. Si.
Compare the monopolistic-competition
values in (15) to the socially optimal values
in (9). Si is the same in both cases and
constant. The X industry expands via in-
creases in n and the market equilibrium
produces the optimal amount of any Si that
is produced. The former property implies
increasing returns to scale in X since X=
n"'IS (/B < 1). The latter property implies
that the market equilibrium will be on the
Comparing the values of n from (9) and
(15), we see, however, that the two equilibria
cannot be the same. For a given allocation of
2This result relies on the assumption that X is pro-
duced from the Si only. If other factors are used,
inefficient combinations of the latter with the Si will
generally result, leading to production interior to the
efficient production frontier. The algebra of the gains-
from-trade analysis is largely unaffected by this assump-
tion, but one result is dependent upon it. This is dis-
cussed in Section III below.

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88 THE AMERICAN ECONOMIC RE VIEW MARCH 1989

labor to the X and Y sectors, w and n are y

the same in the optimal and market situa-

tions. (15) and (9) therefore imply that p
must be higher in the market equilibrium by
T pI3=MRT
the factor P3.This result is the familiar dis-
tortion whereby the price ratio (p) will ex-
ceed the marginal rate of transformation
(MRT) at the market equilibrium. The MRT
is simply given by the ratio of the marginal
product of labor in Y to its marginal prod-
uct (MP) in Si.

MP _G1 MRT
(16) MRT - My p
MPX n a

where MPx is the "social" marginal product

of labor in X, given in (6). But the equilib- 0 T X
rium price ratio involves the private marginal
product of labor (MPx*), given in (11) and FIGURE 1
(14),

P= MPy GI The production frontier will be locally con-

(17) -
cave if the MRT is increasing in Lx; that is,
when (19) is positive. w' is positive and
Combining the results in (16) and (17), we increasing in X (G is strictly concave) but
have MPX'is also positive (we are referring to how
the MP of labor changes as we change n,
(18) p > pB = MRT. since S is constant in general equilibrium).
(19) can also be written as
The results in (18) combined with the ear-
lier result that the market equilibrium will be d(MRT) w [nw' nMP' 1
on the production possibility frontier is
shown in Figure 1. TT' is the production dLx nMPx L w MPx ]
possibility frontier, which may take on a
w
number of shapes. =M [nw*-?a],
Differentiating MRT = G,/MPx = w/MP, nMPx
and denoting derivatives with primes ('), we
have since MP, = ana-l, MPx= na, and where w*
w'/w denotes the proportional change in
d (MRT) MPxw'- wMPx w. The production frontier will be locally
( ) dLx MPx, concave if the concavity of G outweighs
scale economies so that (nw* - a) > 0.
- MPx] If Y is Cobb-Douglas, for example, Y=
=~ w w L7K1'- and w*=-G,,/G,=(1-y)/L,.
MPx MPx
(20) will be negative (TT' convex) in the
neighborhood of X = 0 (n = 0) but will
quickly become positive (TT' concave) as X
=MPx ('pPMPX) increases (n (1 - -y)/LY increases) if -y and a
are small (recall a = 1/ -1 approaches zero
w
since p, = MP as /B approaches 1). The production frontier
MPx will have the shape shown in Figure 1. For

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VOL. 79 NO. I MARKUSEN: TRADE IN PRODUCER SER VICES
the remainder of the paper, we assume that
a is sufficiently small, G is sufficiently con-
cave, and demand for X is sufficiently high
such that equilibrium occurs on the con-
cave portion of the production frontier in
Figure 1.
II. GainsfromTrade
Consider first a situation in which there is
free trade in goods only. Let subscripts g
and a denote quantities evaluated at the free
goods-trade and autarky equilibria, respec-
tively. Cy and C, will denote consumption of
goods Y and X, respectively. By the usual
revealed preference criterion, a country gains
from trade if
(21) Cyg+ PgCxg2 Cya+ PgCxa.
In autarky, we have market clearing, while in
free trade we have balance-of-payments
equilibrium.
(22) Cya= Ya, Cxa=Xa;
Cyg+ pgCxg= Yg+ pgXg.
Substituting (22) into (21), we have
(23) yg + PgXg > Ya + PgXa.
Now subtract the value of the factor endow-
ment at free-trade prices from both sides of
(23), and let k denote the return to Y-sector
capital,
(24) (Yg-wgLyg -kgK)
+ ( pgXg - WLxg)
> ( Ya- Lya- kgK)
+ (PgXa -
wgLxa).
The left-hand side of (24) is zero since both
industries make zero profits in equilibrium.
The first term on the right-hand side of (24)
is non-positive: the autarky factor propor-
tion (K/Lya) is not the most efficient way to
produce Ya at free-trade factor prices, hence
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89
profits would be negative from doing so. The
sufficient condition for gains from trade thus
becomes
(25) (PgXa-WgLxa)
= (Pg-wg(Lxa/Xa))Xa <?
iff (Lxa/Xa) ? (Lxg/xg).
This result is shown by first noting that
(pg - wg(L /Xg))=0 (zero profits). Since
X uses ony labor and since X = n7/S,
(LX/X) falls with increases in X and (25)
holds if and only if Xg Xa. The latter is a
sufficient condition for gains from trade.
The "product expansion condition" Xg >
Xa for gains from trade is by now familiar to
most international trade economists. Intu-
itively, with the price of X (private marginal
cost) greater than true social marginal cost,
there is a " Harberger trapezoid" associated
with changes in X output, (p - MC) X,
which is positive if A X> 0. In our case,
MC = w/MPx = p,, so (p-MC) = p(1-
i) >0.
It is also reasonably well known that this
condition may not hold in practice. Figure 2
shows a situation where the small home
country (superscript h) is at a cost disadvan-
tage relative to the large foreign country
(superscript f). Relative to autarky equilib-
ria at Ah and A1, country h could lose at the
free-trade equilibria Ch, Cf (consumption)
Qh, Qf (production) due to the distortion
between p and the MRT as shown in Figure
2 and as demonstrated by Markusen and
Melvin (1981, 1984a).
Now we consider free trade in specialized
inputs versus autarky, assuming countries
trade S and Y but cannot trade X. Note
with respect to (10)-(14) that free trade in S
equalizes the ri across countries. The fact
that the same number of inputs n = nh + nf
is available in each country at the same
prices implies that they are used in the iden-
tical relative amounts in each country. Con-
stant returns to the Si in X then imply that
the marginal products of additional inputs
are equal across countries and, from (10)
and (14), that the product price ratio p'=
r/na must be equal. Factor prices are also
90 THE AMERICAN ECONOMIC REVIEW MARCH 1989

nS
cf

Th B

nh
m

nh

u~~~h
p~~~~
f
a~~~~~~~~~~~
A

T T X 0 ff h f
? na nfm ns nf
FIGURE 2
FIGURE3

equalized (equal r imply equal w imply equal

k). The ability to trade X would be redun- zero since profits in both industries are zero.
dant. A discussion of the robustness of this We are left with the condition for gains from
and several other results is postponed until trade as
Section III.
The free-input trade (subscript s) is re- (29) O> (Yh-w,Lha- kKh)
vealed preferred to the autarky bundle if
+ (p- Ws(LLa/Xh )Xhh.
(26) Cys + PsCxs - Cyha xpsC,a.
The first term in (29) is negative as before.
The balance-of-payment and market-clear- Since inputs are freely traded at equal prices,
ing conditions are given by the average cost (Lix/Xi) depends only on
the number of inputs available. We can
Ch + p Ch =yh + rnhS;
demonstrate using Figure 3 and results de-
(27) rived below that nS n5 + n > ni (i = h, f)
-

under certain restrictions.Hence Lha/Xh >

chya =Yha-' Ch xha' ps/ws and both countries are assured of
xa
gains from free trade relative to autarky.
The proof involves the construction of re-
where rs is the free-trade price of a repre- action curves in (nh, nf) space. One simpli-
sentative service and S is the constant /BF/ fying assumption, not at all crucial to the
(1 -,B). Substituting (27) into (26), we have results, will be made in order to simplify the
exposition and to permit a clear, intuitive
interpretation of the results. I will assume
(28, {h?+ r nhS > yh + psXah
the absence of income effects such that the
price of X depends on the world output of
Subtracting the value of the factor endow- X: p = p(X). This can be generated by a
ment at free input-trade prices from both utility function of the form U(X, Y) = U(X)
sides of (28), the left-hand side will equal +Y, U,,<O.

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VOL. 79 NO. I MARKUSEN: TRADE IN PRODUCER SERVICES 91

Equilibrium in the domestic X industry is = -(p/X)(dX/dp). Finally note that

given by p (X)MPX = rh from the first-ordercondition
in (30). These results and definitions allow us
(30) p(X)MPx-r(nh) = 0, to express (33) as
X = Xh + Xf, dnh Ih
ax (36) ]
d[n
(31) p'(X)(MPx)-(dnf + dnh)
dn
1/(f) - (1/f - 1)
8MP
+ p(X) dn x(dnf + dnh)r'dnh = 0. 1/( B7e)(1/,-1)+ nrh

Note that nh and nf enter X symmetrically where

so that superscripts on n in (dX/dn) and
rh* rh'/rh > 0.
(dMPx/dn) can be dropped. The slope of
country h's reaction curve is then given by
The reaction curve may be either posi-
tively or negatively sloped. Of interest is the
(32) [-] case in which the slope is globally greater
than minus one. Restrictions which guaran-
-p'(X)(MP,)(dXX/dn)-p(X)(dMP /dn) tee this outcome are, from (36)
-p'(X)(MPx)(dX/dn)-p(X)(dMPx/dn)+ r'

Factor out p(X)(MPx)/n from both the (37) -1< (dnh/dnf) h<O
numerator and denominator of (32) and can-
iff r <17(1-3),
cel. This leaves

(33) dnf] (38) ? < (dnh/dnf)h

if 1/(1-/ )?1< and nrh* >(1/fB1).

p'(X)XndX nMP'
p(X) Xdn MP, With the restriction (37), both the numerator
p'(X)X ndX nrh'
and denominator of (36) are positive, with
nMPx'
the denominator larger in absolute value.
p(X) Xdn MPr p(X)MP+ With restriction (38), the numerator of (36)
give us is negative while the denominator is positive.
X-n17/S and MPx=n '1-1)
The reaction curve for country f is simply
d (MPx) -2 the inverse of (36). Thus
()-1/-1 ( n'l/#
an
(39) (dnh/dnf)f < -1
nd(MPx)
MPx d n 1 - iff ic<1/(1-3)

dX 1 (40) 0 < ( dnh/dnf )f _<o

(35) n-ni/3-S
if 1/(1- ,B) <?7 and nrf *> (1/ -1).
n dX
- =1/fl.
X dn We can summarize the results of (37) and
(38) as follows: sufficient conditions for the
Denote (minus) the elasticity of demand as slope of h's reaction function to be globally

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92 THE AMERICAN ECONOMIC REVIEW
greater than minus one are that either r1<
17(1-fl) or nri* > (1/-1). The same re-
strictions imply that the slope of f 's reac-
tion function is less than minus one or posi-
tive. The first restriction will be satisfied if
demand is sufficiently inelastic and scale
economies are sufficiently weak (1Bclose to
1), where we use the term "sufficiently" in
the tautological sense of values that satisfy
(37). The second restriction (38) was the
condition that the production frontier be
locally concave in the case of goods trade
only, as can be seen by referring back to
equation (20) (w* = r* since w = fir). Note
that, unlike the case of no input trade of
Figures 1 and 2, n = (n h + n f ) never ap-
proaches zero along the reaction curve, and
thus nrh > (1/fl -1) may hold globally over
the reaction curve.
Two sets of reaction curves satisfying the
restrictions in (37) to (40) are illustrated in
Figure 3. n h and nf are the autarky values
of n in countries h and f, respectively. n h
(n f ) is the n that country h(f ) would pro-
duce if country f(h) were constrained from
producing any n in the free-trade situation.
Positive demand for the other country dic-
tates that nh > nh (nf > nf).
The reaction curves, which give the opti-
mal n' for one country given the exogenous
ni for the other country, may be both down-
ward sloping or both upward sloping (or
combinations therefore, since r1is not a con-
stant). The reaction curves nhnh for the
home country and nf nf for the foreign
country illustrate the former case. The re-
strictions (37) and (39) imply that nhnh has
a slope between 0 and -1 in this case and
n nf has a slope less than - 1. Subject to
the economies being of similar size, the reac-
tion curves cross and produce a stable equi-
librium at A in Figure 3.
The reaction curves could both slope up-
ward as illustrated by n hn h' and nf nf' in
Figure 3. An equilibrium occurs at a point
like B, where one or even both countries
could be specialized (nhnh' becomes flat, or
nf nf' becomes vertical). Combinations of
these cases may occur, but the important
point for our purposes is that the slope of
h's reaction curve must be greater than mi-
nus one, and the slope of f 's must be less
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MARCH 1989
than -1 or greater than 0 under restrictions
(37) or (38).
These slope restrictions along with n h> n h
and nf > n f imply that the equilibrium
in Figure 3 must involve nS n + nf >
max(n nf ). More inputs are available with
free-input trade than in either country in
autarky. Since the average cost of labor in X
declines with n, and since ps and ws are the
free-trade values in both countries, the in-
equality in (29) must hold. Both countries
are assured of gains from trade.3
Now consider the comparison of goods
trade only with free trade in specialized in-
puts. Input trade is revealed preferred to
goods trade if
(41) CYh+ pCxh Cyhg+ psChg
By adding and subtracting the same terms,
the goods-trade balance-of-payments con-
straint can be written as
(42) + (pscxhg- psc)
Ch + pgCxhg
hxg)-
= yh + pgXh + (px h-px
Substituting this into (41) and replacing the
left-hand side of (41) with the input-trade
balance-of-payments constraint in (27), (41)
becomes
(43) Ys + rsnhS>yh/+p Xh
-
+(pg ps)( X-Cxg).
Subtract the value of the factor endow-
ment at input-trade prices from both sides of
(43) and the left-hand side will be zero as
before. The condition for superiority of in-
3If the restrictions in (37)-(40) fail to hold, the slope
of h's reaction function could be less than -1 and that
for f between zero and -1. The reaction functions
could cross at a value of nh + nf < max(n , n f )) so that
one country could be worse off. But such an equilibrium
is presumably unstable under some adjustment mecha-
nism, implying an equilibrium at n or nf in which
case the gains-from-trade result goes through. (37)-(40)
are thus not necessary conditions for bilateral gains.
VOL. 79 NO. 1 MARKUSEN: TRADE IN PRODUCER SER VICES 93

put trade becomes y

(44) 0(YhwLhg _ k Kh)

T
( -W h(Lh/Xh)) Xh $

(pg - ) ( Xgh- C .

The first term is negative as before: using

goods-trade factor proportions is not the
most efficient way to produce Y at input-
trade factor prices and hence profits in Y are
negative.
The third term in (44) is a terms-of-trade
effect. It states, for example, that if h ex-
ported X at the goods-trade equilibrium (Xg
> Cxg) and the price of X is higher at the
input-trade equilibrium, then the term is
negative and produces the desired direction
of inequality in (44). But note that a favor-
able terms-of-trade effect for one country
must be exactly matched by a negative
terms-of-trade effect in the other country.
Since the larger (as in Figure 2) and/or
more labor-abundant country is likely the
exporter of X in goods-trade equilibrium,
and since the price of X in input trade is
likely less than in goods trade (discussed
below), the larger/labor-abundant country
likely loses from the effect. Bilateral im-
provement at the input-trade equilibrium is
not guaranteed unless the volume of trade at
the goods-trade equilibrium is small.
The second-term in (44) is once again our
product expansion condition. Again, since
the average product of labor depends only
on the number of n available, this term will
be negative for both countries if ns h +n
- output of X in h becomes
> max(ngh, n f.)
The argument 'that n > (n , ngf) is made
with respect to Figure 4. Since both coun-
tries face the same producer prices (and
MRT's) in goods-trade equilibrium, we can
aggregate their production frontiers together
to arrive at the aggregate frontier TTg in
Figure 4. Assume also that countries have
identical, homothetic utility functions so that
we can aggregate their tastes. Given these
results, the goods-trade equilibrium at the
common price ratio pg will occur at a point
like G in Figure 4, where pgI3= MRT along
P9~~~P
o T9 TS X
FIGURE4
TTg as in the case for each country individu-
ally.
We can also aggregate the free-input trade
production frontiers to arrive at the world
production frontier TTs by virtue of the fact
that commodity and factor prices are equal-
ized in input trade. Indeed TTsin Figure 4 is
the world Pareto-optimum frontier. To see
that TT, lies everywhere outside of TTg ex-
cept at T, simply note that, holding ng and
nf (yh and Yf ) constant, each country could
exchange a portion (1- 8) of each of its ni's
for a portion 8 of each of the other coun-
h
tries n 's, whereSh = nhg(n+ nf) Inh/,g.
Trade balances under such a scheme. The
(45) Xh =
(ng)17"(8s)
= =
(nhIS) I(asS) >> Xh
(nh S
and similarly for country f. In general fur-
ther adjustments are optimal.
World income increases with service/in-
put trade over goods-only trade due to com-
modity and factor price equalization and the

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94 THE AMERICAN ECONOMIC REVIEW
increasing returns to n. Because consumers
are identical and face the same prices, the
aggregate preference map in Figure 4 is the
same as with goods trade. Third, the distor-
tion ratio p,8 = MRT holds along TTs as in
the case of TTg and the individual country
production frontiers. Finally, the slope of
TTs must be less at S than the slope of the
point on TTg directly below, G. The marginal
product of labor in Y must be less at the
former (Y, > Yg) and the marginal product of
labor in X greater (X, = Xg, but with less
labor in X at Xs, it follows that nS > ng and
hence MPXs> MPXg).The equilibrium along
TTs must then be at a point like S' where
Xs 2 Xg if X is non-inferior in consumption.
This last result implies that the total num-
ber of inputs produced in the input-trade
equilibrium must exceed the total produced
in either country in the goods-trade equilib-
rium. This follows from a simple argument
by contraction. If, for example, ng > n =n5
+ n f, then Xh> Xs (even ignoring output
from f ) whict contradicts the result that
Xg = Xf < Xs Thus n_ (n
The proof that nS ? (ng, ngf) is in turn all
that we need to prove that the second term
in (44) is non-positive. Except for the terms-
of-trade effect (the third term in (44)), both
countries are assured of gains at the input-
trade equilibrium relative to the goods-trade
equilibrium and one must prefer the former.
Note also if we add the inequality in (44) to
the corresponding one for f (identical homo-
thetic utility makes this meaningful), the
terms-of-trade effects cancel. The world con-
sumption bundle at the service-trade equilib-
rium is preferred to that in goods-trade equi-
librium.
III. Robustness of the Results
A few comments on the robustness of the
results may be in order before closing. None
of the results relies on the fact that the
number of specialized inputs exceeds the
number of goods in the relevant sector. The
X sector could be composed of many goods
with the total number exceeding the number
of inputs n. The result that free-input trade
is preferred to free trade in goods only for
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MARCH 1989
the world as a whole does, however, rely on
free trade in inputs equalizing commodity
prices and hence making trade in X-sector
goods redundant.
This will generally not be the case if the X
sector uses other scarce factors of produc-
tion that are unevenly endowed between the
countries. Non-constant returns in final
goods production would also result in non-
equalization of commodity prices. In these
cases, free trade in inputs only and free trade
in goods only each offers something that the
others do not. Free trade in inputs offers
higher technical productivity in final goods
production than free trade in goods. But if
free trade in inputs leaves commodity prices
unequalized, there exist unexploited gains
from the exchange of scarce factor services
embodied in final goods. Goods trade only
captures the gains from exchange but not the
technical productivity gains. In the general
case, it is impossible to say which of the two
second-best trade regimes dominates.
Restrictions implying commodity price
equalization from input trade only are used,
but not needed to prove the superiority of
free-input trade to autarky. p( X) in the
derivation of the reaction curves could refer
only to domestic price and demand. A spe-
cific factor in X that is unequal between
countries could be added to prevent the
equalization of r from implying the equal-
ization of p. The reaction curve analysis and
the expansion of n over autarky levels will
continue to go through. The revealed-prefer-
ence analysis culminating in (29) will need
modification for the additional factor but the
same result on X-sector expansion and gains
from trade will emerge. Unlike the case of
goods trade only, free trade in the special-
ized inputs in these circumstances cannot
result in disadvantaging the distorted sector
such that there is an inefficient contraction
of output. The assumption that there are
constant returns in X for fixed n is similarly
unimportant in this respect.
IV. Summary
The purpose of this paper is to develop
and analyze a model of trade in which trade
VOL. 79 NO. I MARKUSEN: TRADE IN PRODUCER SER VICES
occurs in differentiated or specialized inter-
mediate products produced with increasing
returns. I suggest that increasing returns
characterize both capital-intensive interme-
diate manufactures and knowledge-intensive
producer services. Many of these inputs are
differentiated and complementary to domes-
tic inputs.
As in the case of Ethier (1982), the model
adapts the Avinash Dixit-Joseph Stiglitz
(1977) characterization of differentiated
goods to differentiated inputs. These inputs
are produced with increasing returns and so
differentiation is limited by the extent of the
market, and increases with international
trade in specialized inputs or services.
Permitting trade only in final goods is an
imperfect and inferior substitute for per-
mitting trade in specialized services in two
well-defined senses. (a) Free trade in
inputs/services is Pareto-superior to autarky
while free trade in goods only may not be.
(b) Free trade in inputs/services is superior
to free trade in goods from the point of view
of the world as a whole, although not neces-
sarily the point of view of each individual
country.
These results have special relevance to
current discussions about the liberalization
of trade in services, particularly trade in
producer services. I suggest that these ser-
vices are very likely to have the complemen-
tarity property found in the model. Because
of the need to move people and/or establish
a foreign presence, trade in producer services
tends to fall under restrictions imposed by
immigration and foreign investment laws. In
most countries, these laws tend to be signif-
icantly more restrictive than barriers to trade
in goods. Combining this generalization with
the welfare results of the previous section
suggests the possibility of significant gains
from liberalized trade in producer services.
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95
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