November 28, 2007
Distance still matters
VoxEU has an intriguing post by Keith Head, Thierry Mayer and and John Ries, about their work on distance effects in trade in services. Surprisingly, they find some.
Using theory and estimated distance effects, we are able to measure the extent to which geographic separation insulates local workers from foreign competition. The calculations reveal that, from the point of view of a London service purchaser, workers in Oxford can be paid 99% to 373% more than workers in Bangalore in productivity-adjusted wages and yet still be more attractive, once service-delivery costs are taken into account. This is because the Bangalore workers are 100 times more distant from London than the Oxford workers.
Those results indicate that geographic barriers offer high-wage workers substantial insulation from low-wage competitors based in remote countries. Distance has long acted as a serious impediment to international transactions. Unfortunately, most of what we know about the effects of distance on international transactions is based on studies of trade in goods. A consensus appears to be forming that freight costs cannot explain the strength and functional form of the distance effect for goods. Instead, physical distance seems to be picking up some combination of the barriers imposed by cultural differences, the continued desire for face-to-face communication, and the geographically-biased structure of social and business networks. These factors apply to services as well as goods. Thus, there are two senses in which Mankiw is right to say it does not matter whether imports arrive by ship or by broadband. First, there will be potential gains from trade in either case. Second, there will be distance costs that limit the realisation of those gains.
How much should high-wage workers fear competition from much lower paid workers in India and China? Our findings suggest that distance still provides significant protection. Since these estimates reflect averages across a range of services, there are surely services where competition is especially acute. Moreover, service delivery costs associated with distance appear to have fallen over the last decade to a level that is slightly below the level estimated for goods. Unfortunately, the data do not clearly indicate whether distance costs for services will continue their downward trend or level off. We suspect that persistent cultural differences, as well as locally-biased social networks, will maintain distance costs at a high enough level to forestall the small, flat world envisioned by some journalistic accounts.
It makes sense of course that cultural differences and social networks should affect costs in delivering services. What I find a bit more puzzling is that those effects should be significantly correlated with distance. Isn’t Britain closer in those dimensions to the United States or Australia, say, than it is to France? Well, maybe not.
