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 need for services in the manufacturing process can play a role in limiting fragmentation. Although advanced economies have higher costs of supplying simple services, the size of their home market offers a greater variety of services. As a result, the price of aggregate services tends to be lower than in less developed economies. When services are not tradable, advanced economies will tend to produce components that are service-intensive, and outsource components that are less service-intensive and more labor-intensive to developing countries. Complete free trade in services, however, eliminates the home-market effect, and, in the absence of the Dornbush-Fischer-Samuelson type of comparative advantage, will lead to complete outsourcing of components.