The Growth of Service Industries: The Paradox of Exploding Costs and Persistent Demand

Citation

Jallat, F. (2002), "The Growth of Service Industries: The Paradox of Exploding Costs and Persistent Demand", International Journal of Service Industry Management, Vol. 13 No. 2, pp. 202-205. https://doi.org/10.1108/ijsim.2002.13.2.202.1

With The Growth of Service Industries Thijs ten Raa, Associate Professor of Economics at Tilburg University, Ronald Schettkat, Professor of Economics at Utrech University, and their colleagues cover an important, difficult, and interesting topic in modern services economy.

Economists are puzzled by the interplay of slow service and fast goods productivity growth and wonder why the demand for services is so persistent.

Indeed, problems arise if budgets for services are held constant whilst prices rise. The authors argue that the price of commodities is linked to demand and price increases would therefore seem to threaten the very existence of these services. The puzzle for economists is that services do not become more costly because their provision is less efficient. The service sectors of advanced economies are surprisingly vigorous – the employment of an ever increasing share of the labour force is one phenomenon. The paradox of these services is that in spite of their exploding costs, demand persists.

Based on a research project supported by The Netherlands Science Foundation, the Department of Economics and Policy Studies of Utrecht University, and the Department of Econometrics of Tilburg University, a small number of experts from Europe and North America has been invited to address this complex and somewhat paradoxical question: why, in spite of their exploding costs, does demand for services persist?

What are the facts? Do services really suffer from a “cost disease” as stated by William Baumol (1967), professor at New York University, in his seminal article? Is the contribution to the economy in terms of employment, income, or output nonetheless stable? If so, how can one explain the persistence of the services in modern economy?

In order to organize the analysis of the services, all contributors to this volume received a list of potential resolutions of the service paradox.

In an article entitled “Paradox of the services: exploding costs, persistent demand”, a very lucid introduction to the cost disease and the persistence of the services is provided by William Baumol in Chapter 1.

For Thijs ten Raa and Ronald Schettkat, the two editors of this volume, the possible explanations of the service paradox range from accounting issues to supply and demand economy effects and are presented in their article “Potential explanations of the real share maintenance of the services”.

Three possible explanations are conceptual, involving the appropriate measurement of the service productivity and the service share. The remaining four explanations are economic‐behavioural. The first effect is a supply effect: the capacity of the service sector to absorb labour that is surplus to the manufacturing sector because of increased automation. The second is related, but takes into account international trade. Technological progress abroad may shift the domestic comparative advantage to the services. Last, but not least, there are two demand effects. The income effect, a preference for the services by richer consumers, may tilt advancing economies towards the services despite the fact that they are becoming costlier. The substitution effect, the replacement of services by manufactures, would seem to predict a reduction of the service share, but this trend may not last as consumers reach saturation point.

The supply‐side reasons for employment shifts in the services sector is addressed in part 2 of the book. In their article “Employment growth, structural change and capital accumulation”, Esra Erdem, a junior economist at Oxford University, and Andrew Glyn, a senior lecturer at the same institution, state “to some degree service sector employment appears to have acted as a sponge – it has persistently expanded more where labour supply has been plentiful, to an extent apparently not dependent on capital accumulation within the sector” (p. 60).

In another article entitled “Technology and international skill demand”, Stephen Machin, Professor of Economics at University College London, looks at the relative demand for skilled workers, both describing the key trends, and evaluating the explanations underpinning the observed changes. The key factor seems to be technological change that is biased in favour of skilled workers and it is this, rather than increased international competition, that has boosted their relative labour demand.

Part 3 investigates the cost disease of the services for the USA (in the article “Will the new information economy cure the cost disease in the USA?” by Joe Mattey, a senior economist at the Federal Reserve Bank of San Francisco) and Canada (in an article by Pierre Mohnen, Professor of Economics at the University of Quebec in Montreal, and Thijs ten Raa entitled “Productivity trends and employment across industries in Canada).

Part 4 focuses on demand‐side reasons for services persistence. In their article “Are prices unimportant? The changing structure of the industrialized economies”, Eileen Appelbaum, the Research Director of the Economic Policy Institute in Washington, and Ronald Schettkat explore the relationship between demand analysis and the service paradox.

An interesting further twist is given in an input‐output framework by Giovanni Russo, Assistant Professor of Economics at Utrech University, and Ronald Schettkat in their research “Structural economic dynamics and the final product concept”. The ultimate test for demand effects to explain the persistence of the services is developed by Joachim Möller, Professor of Economics at the University of Regensburg in Germany, who looks at income and price elasticities in different sectors of the economy through an analysis of structural change for Germany, the UK and the USA.

As the editors state in their preface “what is fascinating about the above analyses of the services is that the results all point to the same resolution of the service paradox. The use of appropriate productivity and share measures may soften the coexistence of the cost disease, but not by much. International trade has the potential to explain the persistence of the service share, but this line of reasoning is not conclusive either. However, demand, and particularly income effects, are important and resolve the paradox” (p. xiv). Their concluding chapter, “Light on the mystery of service sector growth” extracts a useful list of stylised facts about the modern service sectors. The new perspective provides a clear understanding of the coexistence of the cost disease and the persistence of service demand.

A substantial number of stylised facts can be grouped under the heading “conceptual frame and measurement error”, which affects both the input and output side of service production. A second group of stylised facts may be classified as “final demand shifts” with a domestic and an international demand component.

The interpretation of the data by the authors, which leads to widely believed “facts”, is affected by a multitude of conceptual and measurement issues: output measurement (labour versus total production factors), the appropriate definition of the production unit, theoretical concepts about the relative importance of price and income effects. All these issues may affect our perception of the “facts”.

Mismeasurement of both the output and the input of service industries may affect the perceived productivity trends and may lead to a downward bias in service sector productivity and an upward bias in manufacturing productivity. Measurement bias can be caused by difficulties in determining the real output of service industries, but it can also be related to conceptual problems concerning productivity measures and the definition of industries.

This book is intended to address both readerships and serves as a useful introduction to service productivity analysis. The research illuminates the “mystery of the service sector”, which attracts a rising share of nominal output even though relative prices of services are rising. High productivity growth manufacturing industries decline everywhere in employment, while service industries suffering from William Baumol’s “cost disease” expand.

The works presented in this volume investigate the various hypotheses and mysteries ranked around the development of the service sector. Complex theoretical issues and measurement problems are involved in evaluations of the development of the service sector and, not surprisingly, the views on these fundamental questions are extremely heterogeneous in the literature. Therefore, a clear picture emerges from the collected contributions in this volume, despite the fact that they use different methodology, different data sets and include various countries. All the chapters point to a product market explanation: income effects have diminished the demand for manufacturers, which broadly speaking became a satiated market, whereas the expansion, especially of personal services, suffers from rising relative prices.

Overall, the main benefit of The Growth of Service Industries is that it deals with one of the key issues in the modern economy. Policymakers struggle with the problematic question of whether to limit public service budgets as costs for their provision rise. Economists are perplexed by the interplay of slow service and fast goods productivity growth and wonder why the demand for services is so persistent. In that respect at least, The Growth of Service Industries is intended for use by both policymakers and economists and serves as a useful introduction to service productivity analysis.