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July 27, 2010 / Lukasz Cerazy

Advance of the Service sector – Is it the Case of Being More Innovative or Simply Outcompeted in Manufacturing?

In the developed economies around the world, services contribute by far more to GDP than manufacturing does. Likewise, more people are employed in the tertiary sector, in the developed countries than in developing ones. In the EU services contribute by about 65% to GDP and even more so in the USA and Japan. The kind of production that was characteristic of the developed nations following the industrial revolution in the late 18th century has almost entirely been replaced by highly skilled labour and high value adding, capital-intensive production in the 20th century. Technological innovation often occurs in bursts or leaps, permanently transforming the economic landscape. Our path has followed three industrial revolutions: the fist starting in the mid 1700s with the invention of the steam engine and establishment of factories. The second industrial revolution encompassed the evolution of the engine, the art of metallurgy and the exploitation of crude oil and other natural resources. The third industrial revolution saw the birth of the computer and Internet age.

Our economic pathway has been dependant on technological innovations through centuries. It was, for example, through technological revolution in agriculture that mankind could avoid the Malthusian trap and become an advanced civilisation. Developing nations seem to follow a similar path of gradual steps of industrialisation and raising national incomes. This process has the effect of increasing worker’s wages over time and it therefore squeezes the manufacturing industries. There have been two responses to this external force by developed nations:

1) Transformation. The economy evolve into a knowledge-based economy, increasingly relying on services of various kind to employ individuals and either abandon the low-skilled manufacturing industries or protect them via subsidies to avoid job-losses.

2) Outsourcing. Companies have over the past four decades been engaging heavily in foreign direct investment to move their production activities to where labour is cheaper and only kept administrative, R&D and marketing functions in the home country.

This course has lead to the economic rise of countries like Russia, China, India and Brazil, where production is cheaper. There countries, and especially China, have – for that reason – been called the workshops of the world. This has in turn lead to healthy development and improved living standards in those economies. However, it poses challenges for the developed nations, like increasing the pressure on education, creating job opportunities for low skilled workers and future growth.

So to answer the question whether it is a pull or push mechanism that has driven the advance of the service sectors in the developed world, the correct answer lies somewhere in between. It has been pulled by the innovations and efficiency seeking, which has developed sophisticated service industries. On the other hand it has also been pushed by the increasing competitiveness of the less developed countries, which has eroded the old industrialised country’s manufacturing capabilities. This then poses another problem, because oddly enough only 9,2% of exports is commercial services, whereas manufactured good take up the bulk of exports out of the EU. There is therefore a significant risk that growth will not be as fast if trade in services is not expanded to a higher level. It is however not realistic that services will take up more of exports than goods in the near future as many barriers to this type of trade exist. These are: trade substitution via FDI that replaces otherwise servicing a market, differences in laws, language and cultural barriers. However, there is scope for greater harmonisation in synch with the degree of globalisation. Tearing down barriers is not the only way though. Policy-makers should focus on encouraging small and medium sized companies to exports their services by realising their potential. This is because these firms often do not realise their own possibilities and narrow their markets down to the distance a good could travel within a few days of standard delivery. But as these firms produce a service, that can reach the other end of the globe with the push of a button, the marketplace becomes global. So if patents and other intellectual property rights are any measure of the marketplace for ideas it has grown tremendously over the last decade. Those who hold ideas, not those who own machines, will generate greater profits in the economy of tomorrow. Furthermore a strategy that pursues increasing exports in services can realistically lift economic growth.

– By Lukasz Cerazy

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