In summary, the anecdotal and the survey evidence as well as the econometric results demonstrating superior performance of foreign services providers suggest that service sector reform, and particularly foreign presence in these sectors, has left a positive mark on these industries. In the next section, we explore the implications of these changes for the manufacturing industries that rely on services inputs, which is the main objective of our analysis.

# **4 Empirical Strategy**

Our firm-level data include information on firms in 21 manufacturing industries.<sup>9</sup> As our measure of firm performance, we estimate the total factor productivity (TFP) for all manufacturing firms. The TFP is estimated as the residual of a three-factor Cobb-Douglas production function, with deflated values of labor, capital and material/services inputs as production factors. Nominal values of output are deflated using wholesale deflators specific to 3-digit NACE sectors, obtained from the Czech Statistical Office (CSO). Labor costs are deflated using the consumer price index from IMF’s International Financial Statistics. For capital, a deflator for tangible fixed assets, obtained from the CSO, is used.

As our objective is to assess the effect of services liberalization on firm performance, it is important to properly account for the usage of services inputs. While services inputs are not directly reported in the Amadeus data base, consultations with foreign accounting firms operating in the Czech Republic suggested that the data on the (combined) use of services and material inputs could be obtained by subtracting value added and extraordinary profit/loss<sup>10</sup> from the operating revenue. All three variables are reported in the Amadeus data base. In accounting terms, the material and services usage derived in this way is equal to the sum of (i) the cost of goods sold excluding wages, (ii) other operating expenses excluding depreciation,<sup>11</sup> and (iii) financial costs less financial revenues, excluding interest payments.<sup>12</sup> The value of material and services inputs is deflated using wholesale deflators specific to 2-digit NACE sectors (both manufacturing and services industries) weighted by the share of each sector in the provision of inputs taken from the input-output matrix. The use of this composite deflator gives us some confidence that we are taking into account changes in prices of services inputs.<sup>13</sup> We estimate the production function separately for 14 manufacturing sectors, using both ordinary least squares (OLS) and the semi-parametric estimation technique suggested by Olley and Pakes (1996).<sup>14</sup> The latter technique controls for a possible simultaneity bias arising from the endogeneity of a firm’s input selection, which will exist if a firm responds to productivity shocks unobservable to the econometrician by adjusting its input choices. Such behavior would lead to correlation between an explanatory variable and the error term in the estimation of the production function, thus violating one of the basic requirements for the validity of the OLS estimation. The Olley and Pakes estimator corrects for the possible bias that may result from this correlation by using the firm’s investment decision as a proxy for unobserved productivity shocks.<sup>15</sup> The estimated TFP is then related to the extent of liberalization in services industries.<sup>16</sup> Liberalization of services industries is measured in several ways. The first measure comes from the European Bank for Reconstruction and Development publication Transition Report 2004. The EBRD publishes indices of policy reform for banking, telecommunications, electric power, railway transport, road transport, and water distribution as well as an overall index for services sectors. We use the overall index

> 9 The petroleum sector (NACE 23) was excluded from the analysis because of a very small number of observations.

> 10 Extraordinary profit/loss pertains to items related to natural disasters and insurance claims.

> 11 Other operating expenses include insurance costs, depreciation, donations and penalties.

> 12 Financial costs include bank fees, interest paid and costs related exchange rate differences.

> 13 If changes in services prices do not fully reflect the improvements in services quality, these improvements will be captured by the total factor productivity. If they are a result of services liberalization, then they are part of the effect we intend to capture.

> 14 We group similar 2-digit sectors together to get a larger number of observations. See Appendix D for a list of groupings.

> 15 Details of the procedure are outlined in Olley and Pakes (1996), as well as in other papers that applied the procedure in the context of international trade and investment, such as Pavcnik (2002), Javorcik (2004) and Arnold and Hussinger (2005). The coefficients from the estimated production functions are presented in Appendix D.

> 16 Note that in Appendix E we demonstrate that our results are robust to using a one-stage approach, i.e. including variables of interest in the production function.

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