Why are Services Cheaper in the Poor Countries? Author(s): Jagdish N. Bhagwati Source: The Economic Journal, Vol.

94, No. 374 (Jun., 1984), pp. 279-286 Published by: Wiley on behalf of the Royal Economic Society Stable URL: http://www.jstor.org/stable/2232350 . Accessed: 01/07/2013 12:09
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The Economic Journal, 94 (June 1984), 279-286 Printedin GreatBritain

WHY ARE SERVICES CHEAPER POOR COUNTRIES?*

JagdishN. Bhagwati
I. THE EMPIRICAL PHENOMENON

IN THE

In their important work on international comparisons of national incomes and of comparative price structure, Kravis, Heston and Summers (i982, p. 8) have noted that 'services are much cheaper in the relative price structure of a typical poor country than in that of a rich country'. This phenonomen has been documented now fairly systematically by the data, gathered under their guiding hand, of the United Nations International Comparison (ICP) which covers 34 countries. Table I reproduced from their work (I982), and Fig. I based on rows3 and II-13, indeed show this tendencyfor the relationship between relative service prices and real per capita GDP in this Kravis-Heston-Summers 34-country 6-group sample. The tendency is strongly evident except for the intermediate groups III and IV.
II. THE KRAVIS-HESTON-SUMMERS INTERNATIONAL PRODUCTIVITY EXPLANATION: DIFFERENCES

An explanation of this phenomenon was provided by Kravis-Heston-Summers as follows: As a first approximation it may be assumed for purposes of explaining the model that the prices of traded goods, mainly commodities, are the same in different countries. With similar prices for traded goods in all countries, wages in the industries producing traded goods will differ from country to country according to differences in productivity- a standard conclusion of Ricardian trade theory. In each country the wage level established in the traded goods industries will determine wages in the industries producing nontraded goods, mainly services. Because international productivity differences are smaller for such industries, the low wages established in poor countries in the low-productivity traded goods industries will apply also to the not-so-low productivity service and other nontraded goods industries. The consequences will be low prices in low-income countries for services and other nontraded goods (I982, p. 2I). This is an interesting explanation and indeed is to be found also in Balassa
(i 964) and Samuelson (I 964) and, as Kravis has pointed out to me, in a splendid

early analysis in Harrod (1933, chap. IV). Kravis et al. explore it further and insightfully. But it does raise, within the parameters of its own approach, the
* Thanks are due to the National Science Foundation for partial support of the research underlying this paper. Alan Deardorff, Robert Feenstra, Irving Kravis, Paul Samuelson, Kar-yiu Wong, an anonymous referee and the Editor made useful suggestions.

279

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280

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[JUNE

100
90 80 p 70 60 50 * Relative to commodity price V x Relative to GDP deflator

VI

40 30 20 10I 0.1 02 03 0.4 05 06

II

07

08

0.9

1.0

Real price of services Fig.

i.

Relative price of services and per capita GDP for six country groups,

1975.

Table I and form of services of GDP in the Nominal andrealper capitaabsorption by realpercapitaGDP group,1975 andpriceindexes, commodities,
Income group I
i.

III 6
15-29.9 23-1

III 6
30-44.9

IV 4
45-59-9 524

V 9
60-89-9 760o

VI
I

Number of countries

8
0-14-9 9-0I

Real GDP per capita (U.S. = i oo) 2. Range 3. Mean

go and over
100-0

37.3

Per capitaexpenditures converted at exchange rate 1211 3,7 4. GDP (U.S. = ioo) 5-0 15.2 5. Commodities (U.S. = ioo) 8-i 6. Services (U.S. = ioo) 2-0 28-4 22-2 7. Share of services

24.2 311 15.5 274

38.7 50o6 234

82.3
92.7

25-6

69-I 36-8

100-0 100-0 100-0

43-9

Per capita quantity indexes (based on PPP-conversion of expenditures) 53-8 37.5 8. Commodities (U.S. = ioo) 234 8-8 49-2 370o 22-7 9-4 9. Services (U.S. = ioo) 30-3 31-8 31.7 io. Share of services 33.8 Price indexes (U.S. = i oo) i i. GDP I2. Commodities I3. Services
14. 13/12 40.6 57.2 20-7 0-36 51.7 65.9 34.1 0-52

77-4
73-0

000
100-0 32.3

31P2

64-7 83-1
412 0?49

73*5
94?0 46.3 0?49

I07-5 II9-0 94.6 0 79

100-0 100-0 I00-0 I00

Line 2 (expenditure in domestic currency/population) . purchasing power parity 100. GDP in U.S./U.S. population Line 3 Simple average of values within each income class. (expenditures in domestic currency/population) -exchange rate Line 4 GDP in U.S./U.S. population x I00. Lines 6, 7, 9, I0 and 13 include public consumption as well as household expenditures. Lines 11-13 purchasing power parity--exchange rate x Ioo. Source: Kravis-Heston-Summers (I982).

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i984]

CHEAPER

SERVICES

IN POORER

COUNTRIES

28I

question whether we cannot formalise it in general equilibrium, also extending the formalisation beyond the excessively limiting Ricardian framework of a single factor, labour, so that we get closer to a more realistic and meaningful formulation. This can indeed be done, drawing on two elements of general-equilibrium analysis as practised by international trade theorists: (i) the use of the Lerner diagrammatic technique relating goods to factor prices, as used to advantage in analysing technical change in the 2-good case by Findlay and Grubert (I959) and the pattern of comparative advantage and the Heckscher-Ohlin theorem in the many-good case by Bhagwati (I972) and Deardorff (I979); and (ii) the notion that we can go beyond the single-factorRicardian theory by taking multifactor production functions with Hicks-neutral productivity differences internationally, this generalisationhaving been proposed in Bhagwati (i964).'

0 u co

XR

XXP

(X>1)

XSR

SP Factor L

o
Fig. 2

Then, to formalise the Kravis-Heston-Summers argument in a general equilibrium, 2-factormodel, take Fig. 2. X and Y are two 'traded' commodities; S is the non-traded service. SuffixesR and P referto the Rich and Poor countries prorespectively. Assume the standard restrictionson constant-returns-to-scale duction functions in each activity. Putting a wage-rental price line, w),tangent to the corresponding isoquants then defines, as shown by Lerner, the correI

Thus, if I and 1I are countries, and X and Y are two activities using factors K and L, let XI = bI(Ko,L,) and XII = A '(K., Li).

If A > I, country II has Ricardian-style neutral productivity advantage in producing good X. The Ricardian theory of comparative advantage is then reformulated in Bhagwati (I964) in terms of comparative A differences across trading countries.

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sponding goods price vector. Evidently, XR will exchange for YR and each, in turn, for SR, in the Rich country.' The Kravis-Heston-Summers argument assumes that in the Poor country, if the same traded-goods prices prevail due to free trade and productivity is indeed lower by A in the traded sector, AXv exchanges for AYpyielding, of course, the same X: Y price ratio. But the service sector is equally productive as in the Rich country. Hence, AXp exchanges for AYp but for Sp. Hence, trade will link the Rich and the Poor countries but lead to SR = ASp(A > I), yielding therefore the observed phenomenon that the relative price of the service sector is lower in the Poor country. This theoretical, general-equilibrium2 formulation of the Kravis-HestonSummers argument is based on a more satisfactory notion of 'productivity' advantage than simply labour productivity and is fully rigorous. But it does also imply at least two other unrealistic consequences: that the wage-rental ratio, co, is equal across countries and that K/L ratios are also equal across countries within each activity. One couldweaken some of these implications by, for example, parametrically shifting the Xand Yisoquants for the Poor country to the right, to allow for the observed fact that Poor countries seem to have lower K/L ratios procedure. in each activity than Rich countries. But that would be surely an adhoc Besides, it is not evident to me at all that the non-traded sectors do have 'productivity' parity in the proper theoretical sense (as against simply looking at labour productivity differences) whereas the traded sectors are technologically inferior, in the Poor countries relative to the Rich countries. It is arguable that technology diffuses fairly substantially through sale of technology, direct investment, etc. in the traded sectors and that this implies that the A parameter in Fig. 2 is not important. On the other hand, services today are not by any means technically stagnant and hence there is probably a not insignificant A in the services sector in favour of the Rich countries. Can we therefore build an explanation of the observed phenomenon of real resorting to a particular price of services being lower in Poor countries without specification of comparative-productivity ranking between countries in their traded (commodity) and non-traded (services) sectors, while also explaining the labour-productivity rankings? I believe it is indeed possible to do so, as shown immediately below. In fact, I propose to develop an explanation which, while altogether ignoring differential ('true') productivity differences across sectors between countries, manages to 'explain' simultaneously a number of related empirical observations in Kravis, Heston and Summers (i982) as also the fact that groups III and IV in Table I do not conform to the central phenomenon being discussed in this paper.
1 Evidently, since they are tangent to the same factor price line, P, XR = PyYR = PSSR(= wOQ worth of wages). Therefore p,.jpy = YR/KR, etc. 2 A conventional demand side can be readily added to the model to close it. Evidently, the configuration of demand and factor endowments must be such that, within each country, the wage-rental ratio is the same, as in the argument formalised via Fig. i. With presumably the relative endowment of labour higher in the poor countries, this implies that the argument permits demand there to be skewed more in favour of services. Line io in Table i, and private conversation with Kravis, suggest however that the share of services in total expenditure is not differentially greater in the poor countries. Demand differences have been discussed also by Samuelson (1 964) in the context of the purchasing power parity doctrine.

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1984]

CHEAPER III.

SERVICES

IN POORER

COUNTRIES

283

AN ALTERNATIVE

EXPLANATION

Consider then the same basic model as in Fig. I. But now assume, as in Fig. 3, that the Rich and Poor countries have identical production functions in each sector: 'productivity' differences are thus assumed to be non-existent. Let -R be the wage-rental ratio obtaining in the Rich country, implying that XR exchanges for YR for SR. If, however, the Poor country were to have this wage-rental ratio, its overall endowment ratio (K/L)p for all employment would have to be spanned by OA and OC, with AOC (not drawn) constituting the McKenzie-Chipman diversification cone. But if, as in Fig. 3, (K/L)p lies outside this diversification cone, O0R iS

0
C.)

SR

SP Factor L

o
Fig. 3

not feasible and the Poor country, being so abundantly endowed with labour, would have to have a lowerwage-rental ratio such as up. The consequence is that production of Xis no longer possible at the goods price ratio XR = YRgiven from the Rich country, whereas Yp will now exchange, notfor SP but for Sp, the choice of K/L ratios being OE and OD respectively in the Poor country. The new diversification cone defined by EOD, of course, spans (K/L)p. This immediately means that the relative price of services is cheaper in the Poor country, since SP > SP. But, aside from yielding the central phenomenon to be explained, my construct also shows that one may find that labour productivity in services relative to labour productivity in commodities is higher in consequence in the Poor country. For, at up relative to 0R) these are twoeffects lowering K/L ratio in commodities (and hence lowering the labour productivity in them) whereas there is only one effect

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lowering it in services.The two effectsin commodities are: (i) the elimination of X, the most K-intensive good, from production; and (ii) the substitution effect from B to E in Y-production.The one effectin servicesis simply the corresponding substitution effect from C to D.1 This argument is further reinforcedif we explicitly allow for trade, such that there is a third traded commodity Z which the Poor country will produce more cheaply and export to the Rich country which will produce commodity X more cheaply and export it, in turn, to the Poor country- with commodity Y equally Z, and hence an isoquant ZR tangent also to aR between B and C in Fig. 3 and another, 4p, tangent to up between E and D. Then, it is clear that the Rich country will produce X and Y (with Z being too expensive to produce) and the Poor country will produce Y and Z (with X being too expensive to produce) while each country will be producing its own nontraded Services, of course. The Rich country will thus necessarily export X and the Poor country will necessarily export Z, if each country consumessome of each good. Hence, the Rich country alone will be producingcommodity Xwhich is the most K-intensivegood whereas the Poor country alone will be producing commodity Z which is the least K-intensivetraded good: thus only reinforcingfurtherthe effect (i) distinguished earlier in the preceding paragraph.2 It is, in fact, remarkablethat this is preciselywhat Kravis,Heston and Summers (I982) report: Kuznets' own work relating first to I950 and later to I960 and the independent work of Chenery and Syrquin (I975) summarizing the period I950-70 show clearly that the productivity of the service sector relative to the commodity sector tends to be inverselyrelated to the income level of the country. This finding is confirmed when sectoral productivity indexes, circa I975 are regressedagainst realpercapita GDP for the 20 ICP Phase III countries for which data for such indices were available. In the following regression, productivity in the service industries (SP) relative to productivity in the commodity industries (CP) of each country is taken as the dependent variable and the ICP estimate of I975 real per capita GDP (r) is the independent variable (standard errorsare shown in parenthesis):
l Yet another reinforcing explanation, resting on inter-activity technological differences, could be that the elasticity of substitution in (traded) commodities is higher than in (non-traded) services. Theoretically, one might argue that technical change, which is faster historically in commodities, tends also to be capital-using and hence may be simultaneously imparting greater flexibility in choice of techniques and hence may imply a higher elasticity of substitution. Recent empirical evidence does not seem primafacie to support this, however. Thus, Dale Jorgenson tells me that his 1978 work on postwar U.S. data shows that manufacturing, services-trade-communications, transportation, and agriculture*, 1o09, 0-17 and 0-35 mining-construction have substitution elasticities between capital and labour of I respectively. Careful splicing of this work to the Kravis-Heston-Summers classifications may however turn out to be consistent with the hypothesis advanced in this footnote; so may other econometric evidence for other countries and periods. 2 By introducing a range of traded commodities and allowing the wage-rental ratio to vary downwards, the argument in the text can be extended to successessive pairs of countries without difficulty. Note also that, while Fig. 3 shows only one commodity (Y) to be produced in common by the Rich and Poor countries, this is not a necessary outcome. The number of such commonly-produced commodities can be expanded as greatly as desired.

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i984]

CHEAPER

SERVICES =

IN POORER

COUNTRIES

285

ln (SP/CP)

7-3988 -o 3 Ioo ln r I?2 =o 6i8 S.E.E. = OI98 (0o4349) (0o0550)

n
=20

The coefficient of r is negative and highly significant. The higher the country's per capita income, the lower its service sector productivity relative to its commodity sector productivity. My explanation also implies that, as K/L endowment ratio rises, and therefore GDP per capita increases, the wage-rental ratio would tend to rise and hence for K/L ratios in each sector to rise. I.e., in Fig. 3, the (K/L) ratio at OE in the Poor country is exceeded by those at OB and OA in the Rich country; also, that at OD is exceeded by that at OC. This again is observed statistically by Kravis, Heston and Summers (Table I2): Table 2

Ratios* Capital/Labour
Income group I
II

Commodities 439
9-24

Services 2-48
51i6 6*2I 6-32 9*44 Io096

III IV
V

5 64
6-9I i6*27 2 IP94
* $Iooo

VI

worth of capital per man-year.

Finally, it is clear that these effects, both the central phenomenon of the relative service decline with GDP per capita and the associated comparative labour productivity observations between- sectors and within sectors across countries, depend in my construct on the fact that, for the pair of countries being compared, their comparative factor endowments are sufficiently apart so as not to permit them to be at the same wage-rental ratio and hence to be in the same diversification cone. If therefore two countries or groups of countries are close together, in GDP per capita, we would expect that the several correlative phenomena explained in this paper would also be correspondingly weak. And this seems more or less to be so. Thus, if we examine Table 2, it is evident that the capital/labour ratios in the two 'sectors' (commodities and services) are not substantially changed between country groups II-IV. This would suggest that these lie more or less within the same diversification cone and hence we would not expect to observe substantial change in the relative price of services within the range ofper capita GDP variation defined by these groups. It is therefore somewhat remarkable that, as Table I and Fig. I show, the relative price of services is indeed fairly constant over groups J1-IV! My explanation, therefore, seems yet additionally compelling.'
1 Kravis has kindly drawn my attention to Kravis and Lipsey (I983) where a 'factor proportions' explanation, consonant with that advanced in this paper, is stated.

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IV. CONCLUDING

REMARK

This paper has thereforeformulatedin general equilibrium the Kravis-HestonSummers explanation of the observed phenomenon that services are cheaper in the poor countries. It has also provided another, alternative general-equilibrium explanation that altogether abstracts from the Kravis-Heston-Summers focus on comparative productivity differences among sectors across countries but focusesinstead on comparative endowments. This alternative explanation is also demonstrated to fit additionally other associated phenomena noted by these distinguished authors.' The explanations provided are 'stylistic' rather than in the form of econometric estimations.In this,they conformto the explanationsprovidedin Bhagwati (I 977), again drawingon general-equilibriumproductiontheory in international economics, of the well-known statistical observation by Chenery (I960) and other authors that the share of manufacturesin national income generally rises with per capitaincome. Columbia University Date of receipt offinal typescript: September 1983
REFERENCES

Balassa, B. (I 964). 'The purchasing-power parity doctrine: a reappraisal.' Journalof Political Economy, vol. 72 (December), pp. 584-96. JOURNAL, vol. 74 Bhagwati, J. N. (I964). 'The pure theory of international trade: a survey.' ECONOMIC (March), pp. I-84. (I972). 'The Heckscher-Ohlin theorem in the multi-commodity case.' Journalof Political Economy, vol. 8o (September/October), pp. 1052-5. (I977). 'Comment on: transitional growth and world industrialisation by Hollis B. Chenery.' Activity.London: Allocation of Economic In B. Ohlin, P. Hesselborn, and P. Wijkman. TheInternational Macmillan. Chenery, H. (I960). 'Patterns of industrial growth.' AmericanEconomicReview, vol. 50 (September), pp. 624-54. 1950-1970, London: Oxford University Press. and Syrquin, M. (I975). Patterns of Development Deardorif, A. (I979). 'Weak links in the chain of comparative advantage.' Journal of International Economics, vol. 9 (May), pp. I97-209. Findlay, R. and Grubert, H. (I959). 'Factor intensities, technological progress and the terms of trade.' Papers,vol. II (March), pp. I I I-2I. OxfordEconomic Economics.Cambridge Economic Handbooks. London: Nisbet & Harrod, R. F. (I933). International Cambridge University Press. Kravis, I., Heston, A. and Summers, R. (I982). 'The share of services in economic growth' (mimeoEssays in Honor of Law-enceR. Klein (ed. F. G. Adams and Bert graph). In Global Econometrics: Hickman). Cambridge: MIT Press. Kravis, I. and Lipsey, R. (I983). 'Toward an explanation of national price levels.' Princeton Studies in International Finance, No. 52. and Statistics, Samuelson, P. A. (I964). 'Theoretical notes on trade problems.' The Reviewof Economics VOl.46 (May), pp. 145-54. 1 My Fig. 3 paradigm rationalises the relative cheapness in poor countries of labour services and of non-tradeables that are of especially high labour intensity. If all non-tradeables, taken as a whole, were of average or higher-than-average capital intensity, my paradigm would not also rationalise the principal Kravi3-Heston-Summers finding - namely that national income comparisons based on crude exchange rate calculations exaggerate twofold the superiority of per capita real incomes in the affluent regions compared to the poor regions. I kill two birds with one stone if it is realistic to expect that being of high labour intensity predisposes a good to be relatively immobile in international trade.

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