How to Make the Service Economy Really Deliver

(Bloomberg View) -- When we think about productivity, we often have a bias towards physical goods -- things we can touch and feel, like iPhones or suits. But over the past century, as the economic historian Stephen Broadberry has shown, services, not manufacturing, have been key to explaining which countries are moving up or down the international productivity league table. And yet advanced economies are moving away from the one productivity booster in this area that has been proven to work.

Services represent around 80 percent of both the U.K. and U.S. economies, with France and Italy not far behind. Even in Germany, the historic home of cars and chemicals, services account for almost 70 percent of gross domestic product. That’s bad for productivity.

How to Make the Service Economy Really Deliver

The McKinsey Global Institute calculates that overall, the shift from manufacturing to services has knocked 0.2 percentage points off annual U.S. productivity growth since 1987. In the U.K., and since 1948, labor productivity growth in services and manufacturing has averaged, respectively, 1.48 percent and 2.78 percent a year. Improving overall growth prospects and productivity hangs on improving service-sector productivity. And yet this requires overcoming two problems.

First is “Baumol’s disease.” According to the late economist William J. Baumol, services are inherently more labor-intensive when compared with industry, so productivity growth is harder to achieve. Attempts to economize on labor costs by demanding more from service sector workers --from journalists to care-industry workers --eventually reach their limits. Services then become an expanding (in employment terms) and yet stagnant (in productivity terms) part of the economy. According to Baumol, this helps explain why goods like college tuition and health care have tended to become more expensive over time relative to food and TVs.

Second is the problem of competition. Competitive pressures tend to be somewhat limited in services, especially cross-border, in part due to regulatory differences and occupational licensing requirements. This lack of competitive pressure can further hamper productivity growth (as anyone who relies on the train services in Britain knows well).

How to Make the Service Economy Really Deliver

Complicating matters, however, the service sector cannot be treated as a homogeneous whole. It consists of two very different worlds, one in which productivity growth is low and generally local and another in which productivity growth has been more rapid and the market has become more monopolistic. In the second, companies have deployed new technologies more rapidly and effectively. Industries such as retail, finance and media were transformed by technological advances in the 1990s and early 2000s, with the most successful firms increasing their market shares. In this second part of services, the challenge will be to maintain productivity growth alongside the increased concentration.

But a growing part of the labor force is employed in the low-productivity type of service. Areas such as education, health care and personal services, from hairdressing to elder care, have seen much lower productivity growth. Unfortunately, an increasing proportion of the workforce in countries like the U.S. and U.K. are in parts of the service sector where productivity growth is low, especially in sectors such as elder care, beauty services and food and accommodation.

Between 1980 and 2005, according to David Autor and David Dorn, the share of labor hours worked in low-skilled service sector occupations increased by 30 percent, bucking the decline in other low-skilled occupations. The combination of a fiercely competitive local marketplace in this low-paid part of services and limited technological improvement leads to a greater focus on labor costs. Unfortunately, the resultant low wages only serve to undermine incentives to raise productivity, creating a low-wage and low-productivity-growth trap.

Fostering greater international competition in low-productivity services, and thereby encouraging diffusion of best practice methods, could help to raise productivity and wages alongside, offering a way out of the trap. Some of the largest productivity gaps between economies can be found in low-wage parts of the service sector, leaving lots of “catch-up” potential if barriers to international competition were to be eliminated. As a result of market liberalization measures introduced since the 1990s, the share of services in world trade has increased to around a quarter of all global trade today from a meager 10 percent in the early 1970s.

By focusing on non-tariff barriers such as regulation, the European Union has sought a level playing field in services, including in finance and, more recently, port services. However, there is still plenty of room to expand cross-border service trade, including through further addressing regulations and by tackling barriers in the form of occupational licensing.

The service sectors experiencing the most rapid productivity growth in recent history have been those that have been most exposed to international competition, according to research based on the British economy by PWC. They point to three reasons why. Internationally competitive firms are more specialized and so develop expertise more quickly. Access to bigger markets for the most productive service-sector firms lead to benefits from economies of scale and the elimination of less-efficient firms. And, third, these firms have increased incentive to innovate and absorb best practices. Where practical obstacles limit the international tradability of services (you don’t get a lot of international competition in hairdressing or dentistry), free movement of capital and labor can act as a substitute. The result may be improved quality of service and range of offerings, even if not significant productivity improvements.

Tackling the slowdown in productivity growth alongside addressing concerns about inequality will require a greater focus not only on what’s happening in the service sector, but, more particularly, on the divergences occurring within it. The key to unlocking faster productivity growth across services is to reduce regulatory barriers to trade and enable increased international competition. Unfortunately, that seems opposite to the direction in which we are presently moving.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Victoria Bateman is a fellow and lecturer in economics at Gonville and Caius College, Cambridge University.

To contact the author of this story: Victoria Bateman at

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