The services economy: Comparing the manufacturing and service paradigms

The services economy: Comparing the manufacturing and service paradigms

Phuah Eng Chye (2 September 2017)

The share of the manufacturing sector has been falling and that of services has been rising for decades in many advanced countries. Services is the dominant sector in advanced economies. Yet the services sector is often treated as a poor relation to the productive manufacturing sector in economic planning. This is because of subconscious prejudice that industrial production is real because it is physical and durable while services remains an unloved enigma because it is intangible and ephemeral.

Hence, the mainstream policy mindset is to model, plan and manage economies as though they are still largely manufacturing economies. But the rules that apply in the manufacturing economy don’t work in the services economy. There are important contextual differences to the extent that the broad policy concerns, challenges and objectives for a service economy should differ from those used for a manufacturing economy.

But there is a policy vacuum; the relevance of the traditional paradigm is fading but there is no ready-made replacement. This void needs to be filled as manufacturing no longer seems capable to driving economic growth. The economic baton needs to be passed to the services sector and this implies an urgent need to develop unique policy paradigms that can be used to manage the services economy.

The starting point is perhaps to understand the stark differences in dynamics between manufacturing and services from a macroeconomic perspective. Last week, I featured the debate on Baumol’s cost disease which concludes rising service costs produces premiums that are needed to attract a crowd of investments, talent and customers to sustain service sector expansion. In contrast, manufacturing sector expansion is sustained by driving costs down to expand the consumer market.

Thus, there is a policy tension from the incompatibility between low-price manufacturing and high-cost services. This tension manifests in several policy areas. For example, countries can enhance their manufacturing export competitiveness through a weak currency and the use of low-cost labour (including immigrants). But this may backfire in a service economy where a strong currency is needed to cushion the deleterious effect of rising service costs. In a services economy, stagnating nominal wages combined with rising support costs can have harmful effects on small businesses, the consequences of income inequality and on the overall economy.

I am generalising a bit here but it is worthwhile observing that supply reactions to price falls may vary between the manufacturing and services sectors. In the mass market, when prices fall, manufacturers may react by increasing rather than decreasing output because (due to sunk costs) it is too expensive to allow a plant to idle.

In a services economy, labour may respond by rationing supply when wages fall. This may occur due to a variety of reasons such as the wage may be lower than the costs of going to work or due to work preferences relative to prices. A journalist may be willing to supply high quality articles at a certain price but would much rather do something else if the price falls. Thus, labour supply is perhaps more susceptible to rationing effects in the services economy.[1]

More broadly, some of the concepts used to guide policy-making in manufacturing are irrelevant in services. In the manufacturing sector, one of the most used concepts is productivity, usually defined as a ratio of output from inputs. Productivity provides critical insights into an economy’s cost efficiency but these insights loses relevance when manufacturing costs dwindle to a small percentage of GDP.

At the macroeconomic level, profits from asset price gains cannot be aggregated comfortably into a productivity framework that caters to physical output. In this regard, there is a decoupling of the relationship between physical output and labour wages with productivity gains ending up as profits rather than wages. This may explain why profit share of GDP tends to rise in tandem with service sector expansion and rising financialisation.

The irrelevance of the productivity framework may reflect that the influence of manufacturing is diminishing because the production question may have been largely solved. Higher output is desired but only because it creates jobs and income. Hence, a key aspect of the transition from manufacturing to services is that the growth drivers switch from production to demand or consumption.

If production lessens as an economic challenge, then it could be replaced by more suitable policy objectives in the services economy. One obvious candidate is the objective of equitable distribution. In the service economy, rising cost increases combined with stagnant wages are resulting in more services becoming unaffordable to a larger group of people and this is intensifying social dislocation pressures.

But resolving these distributional challenges is not easy. Scott Alexander illustrates the policy trade-offs: “The modern conflict between opponents and proponents of free college education is over how to distribute our losses. In the old days, we could combine low taxes with widely available education. Now we can’t, and we have to argue about which value to sacrifice…The conflict between the taxpayers and the teachers’ unions is about how to distribute losses; somebody is going to have to be worse off than they were a generation ago, so who should it be?”

The distribution challenge is made more acute by the impact of service sector employment trends on class structures. The transition to a service economy is often accompanied by a reduction in the size of the middle class and an enlargement of the pool of lowly-paid contractual and contingent workers. It is not just the changing relative sizes of the classes but also the contrasting optics and realities of the daily struggles of the army of servers and part-timers with the high-profile luxurious lifestyles of the handful of rich and famous that aggravates class polarisation.

Class polarisation is reinforced by the patterns of crowding in the service economy. Concentration and imbalances materialise between high-cost/high-wage and low-cost/low-wage locations (cities); and high-productivity/high-paying and low-productivity/low-paying firms. Hence, service sector growth is associated with urbanisation, corporate growth, high profits and stagnant wages. From whichever dimension it is viewed, inequality is worsening all around.

Another feature of the service economy is the acceleration in the financialisation process. This is not surprising as expenditures can be limited by the constraint imposed by physical production. This budget constraint or growth in the consumption of intangibles can only be overcome by an expansion of monetary assets (e.g. debt, market liquidity). Information-driven financialisation helps to transform intangible value into a form that can be monetised and exchanged.

Debt also works differently. In a manufacturing economy, loans are linked to production because they assist manufacturers to expand their plant capacity. Loans in a service economy tend to be linked to consumption (of goods as well as services such as education and healthcare). Therefore, the causation runs from debt which feeds into consumption which feeds into output rather than the way round.

In addition, the need for loans to finance plant expansion will decline in line with the shrinkage in the manufacturing share of GDP. Hence, expansion in corporate debt in the service economy will more likely be used to finance asset market transactions (property, takeovers, share buybacks). The impact of debt will also be different – household debt will have different dynamics and effects from corporate debt.

The dichotomy between the manufacturing and the services paradigms reinforce the point that the service economy requires its own unique paradigm. In my next article, I will review several key policy challenges for a services economy.

References

Phuah Eng Chye (12 August 2017) “The services economy: Macroeconomic overview.” Economicsofinformationsociety.com. http://economicsofinformationsociety.com/the-services-economy-macroeconomic-overview/

Phuah Eng Chye (26 August 2017) “The services economy: Revisiting Baumol’s cost disease.” Economicsofinformationsociety.com. http://economicsofinformationsociety.com/the-services-economy-revisiting-baumols-cost-disease/

Scott Alexander (9 February 2017) “Considerations on cost disease”. Slatestarcodex.com. http://slatestarcodex.com/2017/02/09/considerations-on-cost-disease/

[1] See Phuah Eng Chye (26 August 2017) “The services economy: Revisiting Baumol’s cost disease.”

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