Using a unique database, I estimate the costs of trading with European Union countries, relative to the costs of trading with the domestic market, for services and manufacturing firms located in the Basque Country region of Spain. I find that, despite the dramatic improvement in information and communication technologies, international trade costs for services are still much larger than for manufactures. Based on standard elasticities of substitution used in the literature, our results suggest that the tariff equivalent of international trade costs is between 50% and 60% larger for services than for manufactures.trade costs; exports; services; manufactures; firm-level evidence; Basque-Country

Minondo, Asier

English

Research Papers in Economics

1 
 
Are trade costs higher for services than for manufactures? 
Evidence from firm-level data 
 
Asier Minondo  
Deusto Business School, University of Deusto 
Camino de Mundaiz 50, 20012 San Sebastian, Spain. Tel:+34 943326600;  
E-mail: aminondo@deusto.es 
 
 
Abstract 
Using a unique database, we estimate the costs of trading with European Union 
countries, relative to the costs of trading with the domestic market, for services and 
manufacturing firms located in the Basque Country region of Spain. We find that, 
despite the dramatic improvement in information and communication technologies, 
international trade costs for services are still much larger than for manufactures. 
Based on standard elasticities of substitution used in the literature, our results suggest 
that the tariff equivalent of international trade costs is between 50% and 60% larger 
for services than for manufactures. 
 
JEL Codes: F14, F19, F23 
Keywords: trade costs, exports, services, manufactures, firm-level evidence, Basque-
Country. 
  2 
 
1. Introduction 
Services constitute the most important economic activity in the world. According to 
the Word Bank data, services accounted for 71 per cent of overall GDP in 2010. 
However, the share of services in world exports, around 25%, is much lower than its 
share in world GDP.
1 In contrast to manufacturing, where goods move, in a large 
range of services the supplier or the customer has to move. This proximity burden 
explains why services are less traded than manufactures (Francois and Hoekman, 
2010). 
However, during the last decades, the reduction in communication costs, and in 
particular the spread of the Internet, have increased the opportunities to exchange 
services across countries with almost no costs. In addition to that, trade liberalization 
and reductions in the cost of travelling have lowered the costs of supplying services 
overseas. As Jensen (2011) explains, these processes have led to a perception that 
services are becoming as internationally tradable as merchandises. The goal of this 
paper is to analyze the validity of this perception, comparing the costs that services 
and manufacturing firms face when trading with foreign markets, relative to 
domestic markets. 
Due to the inaccuracy and incompleteness of many direct costs measures for 
manufactures and, particularly, for services, we use a quantitative analysis to 
estimate relative trade costs in these sectors (Anderson and van Wincoop, 2004). To 
do so, we derive an econometric equation from a theoretical model with 
heterogeneous firms, where exports are function of firms' productivity and trade 
costs. I estimate this equation using a unique database of services and manufacturing 
                                                 
1 www.wto.org/statistics. 3 
 
firms operating in the Basque Country, a region located in the North of Spain. The 
use of firm-level data is particularly convenient for this analysis, because aggregated 
data might bias trade costs estimates (Helpman et al., 2008). To my knowledge, this 
is the first time that services and manufacturing firms' data are combined to estimate, 
and compare, international trade costs relative to domestic trade costs in these 
sectors. 
Our estimates show that, despite the spread of information and communication 
technologies, the cost of trading in international markets, relative to the domestic 
market, is still much larger in services than in manufactures. According to our 
results, and based on standard elasticities of substitution used by the literature, the 
tariff equivalent of international trade costs is between 50% and 60% larger in 
services than in manufactures. 
The rest of the paper is organized as follows. The next section presents the 
characteristics of the firm-level database. Section 3 explains how the econometric 
equation is derived. Section 4 comments the results of the econometric analyses, and 
section 5 concludes. 
 
2. Database 
Our database covers firms operating in services and manufactures in the Basque 
Country, a region located in the North of Spain. The firm-level database is built from 
different surveys carried out by the Basque Statistical Institute (Eustat). In services, 
Eustat surveys firms operating in accommodation and restaurants, business services 
and personal services. The database does not include firms operating in transport and 4 
 
storage, financial activities, education, health, and public administration activities.
2 
In contrast to services, except for oil refineries, the Eustat database covers all 
manufacturing activities. Surveys on firms operating in services are carried out every 
five years, and our database has information for services and manufacturing firms for 
the years 2004 and 2009. The database includes 4574 firms in services and 4435 
firms in manufactures. These firms cover 40% of services employees and 35% of 
exports, and 64% of manufacturing employees and 80% of exports. 
The database provides different firm-level variables, such as employment, wages, 
and investment. Along with these variables, the survey asks firms to report the 
amount of sales for two different destinations: sales to the rest of Spain (not 
including the Basque Country) and sales to the European Union. We use this 
information to identify exporters and non-exporters. 
 
3. The empirical model 
The econometric equation is derived from a theoretical model with heterogeneous 
firms and fixed trade costs (Melitz, 2003). The main characteristics of this model are 
that firms differ in terms of productivity, and have to incur in additional variable and 
fixed costs if they want to export. Due to these additional trade costs, only those 
firms with a sufficiently high productivity will obtain profits in foreign markets. 
In this model, once firms become exporters, the amount of sales abroad does not 
depend on the fixed costs of exporting. Analytically, the firm-level intensive margin 
of exports is determined by (Lawless, 2010):  
                                                 
2 Affiliates of Basque companies based in foreign countries are not included either. 5 
 
       
∈  1
∈
       
    
 
   
              1  
where xijt are exports of firm i to country j at time t, ∈ is the elasticity of substitution 
across products and services, which is assumed to be the same in all countries, Pjt is a 
price index in country j, ait is firm i's productivity index, c is the cost of labor in the 
country where firm i is located, and Yj is demand in country j.    denotes the variable 
costs of trading between the country in which firm i is located and country j. This 
variable captures different costs that a firm faces every time it supplies a service or 
sells a product abroad, such as transport and communication costs, tariffs and non-
tariff barriers, financial and legal costs. 
To derive the econometric equation, we take logs of equation (1), 
                                    1                 2  
where       1     
   
   ,          1        ,           1           
        , and eijt is the error term. The first right-hand side variable of equation (2) is 
captured by the constant term of the regression equation, and the second right-hand 
side variable by a time dummy. As we do not have data on the price index in country 
j at time t, we capture this variable with a time-specific destination fixed effect. This 
fixed effect precludes the introduction of other variables that are destination and time 
specific, such as the level of demand Yjt. Hence, the fixed effect captures all the 
effects that destination j has on firm i sales at time t. 
International trade costs are estimated with a dummy variable, EU, that takes the 
value of one when a Basque Country firm exports to the European Union, and zero 
when it sells to the rest of Spain. The coefficient of the dummy variable captures the 6 
 
additional trade costs (transport, communication, financial and others) that Basque 
firms face when selling their products or services to European Union countries, 
relative to the rest of Spain. Our database does not distinguish which European 
Union country Basque Country's firms export to. This limitation precludes the 
independent estimation of observable trade costs components' effect, such as 
distance, on the amount of firms' sales. 
 
4. Results from the econometric analyses 
To estimate correctly the additional variable trade costs that selling abroad imposes 
on firms, equation (2) should be estimated with a sample of firms that sell both in the 
rest of Spain and in the European Union. If we mixed exporting and non-exporting 
firms, the trade cost coefficient would capture the effect of trade barriers both on the 
intensive and the extensive margins of trade. The removal of non-exporters reduces 
the amount of firms in the sample from 4574 to 372 in services, and from 4435 to 
2115 in manufactures. 
Table 1 presents the results of estimating equation (2). First, we estimate the equation 
for firms operating in services (Column 1), and then for firms operating in 
manufactures (Column 2). Firms' total factor productivity is estimated following the 
Levinsohn and Petrin (2003) procedure.
3 As expected, the productivity coefficient is 
positive and statistically significant both for services and manufacturing firms. For 
services, we can see that the additional costs that firms face when offering their 
services in the European Union have a severe negative impact on exports. In 
                                                 
3 We also estimated the model with a total factor productivity measure computed with an OLS 
technique, and with labor productivity. Results do not change. 7 
 
particular, a Basque Country's exporter of services sells six times more in the 
domestic market than in the European Union (exp 1.71). For manufacturing (Column 
2), we also find that firms face additional costs when selling to the European Union. 
However, those costs have a lower impact on exports: the ratio of domestic sales to 
European Union sales drops to three. These results are in line with previous studies 
that use aggregated data to compare the ratio of international to domestic sales in 
services and manufactures (Anderson et al., 2011). 
 
Table 1. Results of the econometric analyses 
 1 
 
2 3 4 
Industry Services 
 
Manufactures Services  Manufactures
Productivity 0.68  (0.12)* 
 
1.08 (0.08)*     
EU  -1.71 (0.16)*  -1.16 (0.08)*  -1.71 (0.19)*  -1.16  (0.10)*
        
Adj. R-square  0.27  0.18  0.40  0.28 
Observations 744  4230  744  4230 
Firm+time fixed 
effects 
No No Yes  Yes 
Note: All regressions include time+destination and time dummies. Robust standard errors in 
parentheses. * statistically significant at 1%. 8 
 
If we assume an elasticity of substitution between 6 and 10, as standard in the 
literature (Anderson et al., 2011), the tariff equivalent of variable international trade 
costs, relative to domestic trade costs, would lie between 41% and 21% for services; 
in the case of manufactures, the tariff equivalent would lie between 26% and 14%. 
That is, the tariff equivalent of international trade costs is between 50% and 60% 
higher for services than for manufactures. 
To control for other variables that might influence the amount of firm' sales both in 
the domestic and the European Union market, in Columns 3 and 4, we estimate the 
equation with time specific firm fixed effects. The introduction of these fixed effects 
precludes the estimation of other variables, such as productivity, that are firm and 
time specific. As shown in the table, results are not altered.  
 
5. Conclusions 
This paper estimates whether the costs of trading internationally are larger for service 
exporters than for manufacturing exporters. To do so, we derive an econometric 
equation from a theoretical model with heterogeneous firms, where exports are 
function of firms' productivity-level and trade costs. We estimate this equation using 
a unique firm level data on services and manufacturing firms operating in the 
Spanish region of Basque Country. We find that the home-bias of Basque Country 
firms is much larger for services than for manufactures. Based on standard 
elasticities of substitution used by the literature, we conclude that the tariff 
equivalent of international trade costs is between 50% and 60% higher for services 
than for manufactures. This result points out that despite the dramatic improvements 9 
 
in information and communication technologies, and the spread of the Internet, it is 
still more costly to trade in services than in manufactures. 
 
References 
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on Canada's Services Trade", NBER Working Paper 17630, National Bureau 
of Economic Research, Cambridge, Massachusetts. 
Anderson, J.E. and Van Wincoop, E. (2004). “Trade Costs”, Journal of Economic 
Literature, 42, September, 691-751. 
Francois, J. and Hoekman, B. (2010). "Services Trade and Policy", Journal of 
Economic Literature, 48, 3, 642-692. 
Helpman, E., Melitz, M. and Rubinstein, Y. (2008). "Estimating Trade Flows: 
Trading Partners and Trading Volumes", Quarterly Journal of Economics, 
123, 2, 441-487. 
Jensen, J.B. (2011). Global Trade in Services. Fear, Facts and Offshoring. Peterson 
Institute for International Economics, Washington, D.C. 
Lawless, M. (2010). "Deconstructing gravity: trade costs and the extensive and 
intensive margins of trade", Canadian Journal of Economics, 43, 4, 1149-
1172. 
Levinsohn, J. and Petrin, A. (2003). "Estimating Production Functions Using Inputs 
to Control for Unobservables", Review of Economic Studies, 70, 2, 317-341. 
Melitz, M. J. (2003). “The Impact of Trade on Intra-Industry Reallocations and 
Aggregate Industry Productivity”, Econometrica, 71, 6, 1695-1725. 

Estimating Production Functions Using Inputs to Control for Unobservables&quot;,

Are trade costs higher for services than for manufactures? Evidence from firm-level data

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