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In the Wealth of Nations, Adam Smith compares agriculture and manufacturing and concludes that due to the reduced scope for specialization in the former as compared to the latter, those economies that relied on manufacturing would enjoy greater prosperity, a fact that seemed to be borne out in his day. In a similar vein, we have the essay and movie "I, Pencil", which extols the marvel of the market in allowing people from far-flung regions to cooperate in producing the humble pencil.

Along the same lines, I was just wondering what it would look like to compare manufacturing to services. What would a services version of "I, Pencil" look like? Can we say anything intelligent about the comparative scope for division of labor between manufacturing and services like Adam Smith did for agriculture and manufacturing?

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Firstly, love the reference to 'I, Pencil'; it remains one of my favourite poignant essays. Adam Smith did have an astute observation on industry and agriculture. However, the same comparison cannot be extended to manufacturing and services. In fact, it is the inability to trade services (although certain services in today's world can be traded) that hinders specialization through division of labour and enhanced productivity. Further, this is responsible for differences in price levels and thus, the real exchange rate. This answer is to elaborate on why collective prosperity is still a far-fetched idea.

Since goods can be traded, it is possible to disperse manufacturing across several countries and achieve division/ of labour. Consider the iPhone. The chips are made in Taiwan but the final assembly takes place in China thus leading to greater specialization and improved productivity.

Now, unlike manufacturing, services suffer from the Baumol Cost Disease leading to the Baumol effect (see https://www.mercatus.org/students/research/books/why-are-prices-so-damn-high). That owing to lower productivity and higher labour costs, prices in the services sector have seen a constant rise. It says that when productivity rises in certain sectors, it makes the prices in those sectors which haven't seen a productivity growth more expensive.

Why? Opportunity cost.

Think about a string quartet which performs Beethoven's String Quartet No. 14 (and extend the example to sectors such as health and education). Compared to the 1950s, it requires the same number of people to play the Quartet even today but since the opportunity cost of their performance is much higher today, it means that the price of their services will increase.

Why is the opportunity cost of their services much higher? This is because the other sectors (mostly manufacturing) have seen dramatic improvements in their productivity. And as per the marginal productivity theory of labour prices (price of labour = their Marginal Product), their incomes will naturally have increased. This explains the price differential between services and manufacturing in a particular country.

What does this mean for price levels in developed and underdeveloped countries? The Balassa-Samuelson effect thus extends this idea further. Since developed countries have seen dramatic improvements in incomes (in manufacturing owing to productivity rises, and in services owing to the Baumol Effect), it concludes that consumer prices in the developed world will be much higher than that of the underdeveloped/developing world.

Further, the TNT (Tradeable-Non-Tradeable) model tells us that since services cannot be traded, but goods can be, it implies that the real exchange rate will be dependent on the prices of the non-tradeable sector (i.e. services). This also partially explains the differences in the exchange rate between developed and underdeveloped countries.

However, this a rather simplistic take on the entire issue. Firstly, like I mentioned before, owing to technology primarily (think online classes and AI in healthcare), the Baumol effect can be controlled. That relative prices in the services need not surge as much. Second, since certain services (think banking and computing) can be done from any place in the world, it means that the price differential in services will not be as much (though the same services are still cheaper in the underdeveloped world).

These multiple factors when accounted for still leaves us with the conclusion of the TNT model. So, to connect to your larger question: yes, a similar version of I, Pencil can surely be achieved for services if there is free movement of labour (think migration laws are easy) and as barriers to free movement of services are reduced (think technology such as the internet). But [Rodrik's trilemma] tells us that such a day is still far away. I hope this gives you some insight. I leave the final connection of this puzzle to you.

Best.

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  • $\begingroup$ This is a pot pourri with lots of inconsistencies, e.g. "services cannot be traded" or "In fact, it is the inability to trade services (although certain services in today's world can be traded)" and misses the basic question about the potential for labour division in services. $\endgroup$
    – BrsG
    Feb 20, 2023 at 23:48
  • $\begingroup$ Also, a string quartet (=four musicians) performing a Beethoven symphony?! $\endgroup$
    – BrsG
    Feb 20, 2023 at 23:56
  • $\begingroup$ @BrsG, the point about services as non-tradables was simple: the economies of scale (and, therefore, productivity) that you can achieve with division of labour in manufacturing cannot be achieved in services. Trade-ability of goods and extensive supply chains help you achieve division of labour. If you read the last para carefully, I highlight under what conditions can such economies be achieved in the services sector. And of course, you have to give the caveat that certain services can be traded. The world is not a cute picturesque model like what the TNT model assumes it to be so. $\endgroup$ Feb 21, 2023 at 11:42
  • $\begingroup$ But, thanks for the comments. Helped me frame my ideas and draw the causal links more clearly. I have also modified the symphony example. $\endgroup$ Feb 21, 2023 at 12:08

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