The Rise of the Service Economy
By FRANCISCO J. BUERA AND JOSEPH P. KABOSKI
This paper analyzes the role of specialized high-skilled labor in the disproportionate growth of the service sector. Empirically, the importance of skill-intensive services has risen during a period of increasing relative wages and quantities of high-skilled labor. We develop a theory in which demand shifts toward more skill-intensive output as productivity rises, increasing the importance of market services relative to home production. Consistent with the data, the theory predicts a rising level of skill, skill premium, and relative price of services that is linked to this skill premium. JEL: O14, J24
Keywords: service economy, specialized skills, structural change, skill premium
Two of the most salient, interesting trends in the post-1950 U.S. economy have been the rising importance of the service sector and the growth in the skill premium in wages despite a large expansion in the relative supply of high-skilled workers. The growth of the service sector and the relative demand for high-skilled workers have been well studied in independent literatures, but theorists have not formally linked the two phenomena. This paper provides a theoretical framework for understanding the connection between skill accumulation and the growth of the service sector. Contrary to the conventional view, we argue that the growth in services is driven by the movement of consumption into more skill-intensive output. In doing so, we provide a new theory for the rise in the price and quantity of skilled labor, which is distinct from the common story of skillbiased technical change.
Several empirical trends involving services and skills motivate our analysis. First, the share of the service sector in value-added has grown steadily from 60 percent in 1950 to 80 percent in 2000, and it reflects disproportionate growth in both the price and real quantity of services. Second, this 20 percentage point increase is explained entirely by the growth of skill-intensive services: The output of high-skill industries increases by more than 25 percent, whereas the share of low-skill industries actually declines. Third, over the same period, the wages of college graduates rose from 125 percent to more than twice the wages of high school graduates, and the fraction of workers who were college educated rose from just 15 percent to over 60 percent.1 Finally, the growth in college-educated labor, the skill premium, the relative size of skill-intensive services, and the share of the service sector all accelerate around 1950.
Our key theoretical idea linking these three phenomena is that skills are specialized, and specialization plays an important role in the decision between home and market provision of services. Namely, the market allows the use of specialized skilled labor in production. This lowers costs relative to home production, since even high-skilled workers hold no specialty in most home production activities. This effect is greater, the larger the relative productivity of specialized high-skilled workers. With development, the increase in the consumption of more skill-intensive wants leads to a rise in the importance of market services, and an increase in the quantity and price of skills. The higher price amounts to a higher opportunity cost for home production, leading high-skilled workers to purchase an even wider range of services in the market.
We represent this idea using a stylized, static model in which a stand-in representative household faces a range of satiable wants that differ in their production costs. The household decides which wants to satisfy and whether to home produce or market purchase the services satisfying these wants. In addition, the representative household determines the fraction of members that are required to obtain specialized skills, and how high- and low-skilled members should allocate their time between home and market production. Market production has a cost advantage due to the use of more productive specialized skills, but home production is assumed to be more customized and therefore provides more utility. Furthermore, we assume that high-skilled workers have an increasing comparative advantage in the production of wants whose costs exceed a given threshold, and are therefore satisfied only at high incomes. Among the least complex wants, high-skilled workers have a constant absolute advantage.
To shed light on how these trade-offs shape the dynamics associated with development, we perform comparative statics with respect to a productivity parameter that is skilland sector-neutral. At low levels of productivity, and hence income, only the wants for which high-skilled workers hold a constant absolute advantage are satisfied. Thus, the margin between home and market production is independent of productivity, and the skill premium, the fraction of workers becoming high skilled, and the share of services therefore remain constant in the face of productivity increases. Above a threshold level of productivity, however, demand begins shifting continually toward services for which high-skilled workers hold an ever-increasing productivity advantage. The expansion of consumption into these services changes the mix of services optimally produced in the market relative to the home.
Beyond this threshold, the higher is productivity, the greater is the importance of specialized high-skilled labor at high levels of productivity, which leads to the rise of the service economy. That is, it leads to growth in the range of services that are market produced relative to those home produced, and ultimately to growth in the relative quantity and relative wage of high-skilled workers. In the limit, as productivity increases, the share of services in consumption converges to one, though the share of services in value-added is bounded below one. Moreover, the growth in the real share of services is also accompanied by growth in the relative price of services: the rising relative wage increases the cost and price of market services relative to goods, since the former are more skill intensive in equilibrium.
We relax the stylized assumption that home production is centrally produced by a stand-in household, and we highlight additional factors contributing to the growth in services by simulating an economy in which individual agents perform their own home production. In this case, the opportunity cost of home production is higher for highskilled workers who therefore consume a higher fraction of their services on the market. Thus, when productivity grows, the rising fraction of high-skilled workers increases the overall share of services. Moreover, the rising relative wage resulting from productivity growth also increases the opportunity cost of home production, leading to an even greater shift toward market services.
We show, using a panel of nine countries with comparable data, that the rise in the skill premium is tightly related to increases in per capita income after controlling for time effects, which provides suggestive evidence in favor of our demand-driven story for the rise in the quantity and price of high-skilled labor.
The rest of the paper is organized as follows. We conclude this introduction with a review of related literature. Section I then establishes the facts that motivate our analysis. The model is laid out in Section II, while Section III describes the theoretical results and Section IV presents an alternative model. In Section V, we discuss the relationship between the theory and the motivating facts, together with additional testable implications. Section VI concludes.
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