production economies (top left quadrant) but also other services such as financial because consumers have a strong preference for bundling, irrespective of their technical capacity to provide these services (bottom) left quadrant. When there are neither production economies nor consumption externalities, manufacturers do not have a clear rationale to servitize.<sup>12</sup>

**_Table 1: Servitization is motivated by externalities in consumption and/or economies of scope in_** **_<u>production</u>_**

|||**Consumer preference f**<br>Yes|**or bundling by firms**<br>No|
|---|---|---|---|
|**Economies of**<br>**scope in**<br>**production**|Yes|Production and consumption driven<br>servitization (e.g. repair and<br>maintenance services);|Production driven servitization<br>(e.g. rental & leasing; IT)|
||No|Consumption driven servitization<br>(financial; professional services; retail<br>and wholesale; transport)|No clear rationale for servitization|

# **_Which firms servitize?_**

We focus on two key factors that influence a firm’s decision to servitize: _firm productivity_ and _exposure to import competition_ . Although economies of scope in production and consumer preferences are more likely to push certain industries towards servitization, not all firms within an industry servitize. Servitization is likely to require organizational changes that impose additional fixed costs of bundling services with goods (Gebauer et al, 2005). Given the large productivity differences across firms within narrowly defined industries (Syverson, 2011), it is likely that only the more productive firms servitize.

External competition can induce servitization by firms as a strategy to maintain their sales. With trade liberalization, for instance, firms adapt through quality upgrading, innovation or improving management to survive and even grow.<sup>13</sup> Breinlich et al. (2015) use firm-level data from the United Kingdom to show that servitization could be an additional channel of adjustment. The increase in servitization of UK manufacturing between the period 1997-2007 can be associated with the decline in import tariffs. In an attempt to flee competition, even firms for which it would not be otherwise optimal, such as low productivity manufacturing firms, may find it attractive to bundle their manufactured goods with services valued by consumers. Services that are either more protected from global competition or innately nontradable or both are natural candidates for such manufacturers. Foreign manufacturers find it harder to provide such bundles because trade costs are much higher for many services than goods. For example, the absolute level of ad valorem trade costs in services is estimated to be over 200 percent for India (Mirdout et al., 2013).

# **_3.2 Data sources_**

Given the dearth of firm-level studies for developing countries, we work with firm-level data for India. The firm-level data used in this paper is constructed from the Prowess database which is collected by the Centre for Monitoring the Indian Economy (CMIE). Prowess accounts for 60 to 70 percent of the economic activity in the organized industrial sector and the firms included in this data set contribute to 75 percent of corporate

> 12 Consumers clearly benefit from servitization  when they prefer the bundling of goods and services (Table 1, column 1). Consumers could also benefit when servitization is motivated by economies of scope in production, because quality-adjusted prices are likely to be lower.

> 13 See Khandelwal, 2010; Mayer, Melitz and Ottaviano, 2013; Bloom, Draca and Van Reenen, 2011; Bloom, Sadun and Van Reenen, 2010.

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