Next Stop – the shift to the services Economy

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All aboard the relentless shift to services and the service economy!

We’ve come a long way from Adam Smith’s 1776 view that services are not wealth generators. Today we find many of our economies are 80%, and growing, based on services.

Why do we see this shift? And, further, what are the implications? Let’s find out!

Key take-aways

  • Services are the larger part of our economies (predicted to be 80% of US economy by 2050; already 79% of UK economy in 2017)
  • The shift from product- to service-based economies can be traced to:
    • Hierarchy of needs hypothesis – increases in wealth lead to increase in service usage
    • Deindustrialisation hypothesis – services fill the gap left by moving manufacturing to lower cost countries and trading
    • Cost Disease hypothesis
    • Exogenous Demand Shock hypothesis – structural changes in economies (such as moving from one-income to two-income families) increase service demand
    • A shift in societies view of non-ownership (e.g. hiring/renting/sharing economy)
    • The need to enhance products to distinguish offerings and avoid commoditisation
    • Growing acknowledgement of the value of data
  • The implications of this shift are…

The growing important of Services in our economies

Writing in 1776’s Wealth of Nations, Adam Smith considered products as the basis of creating wealth. Services he saw as a noble effort. But ultimately unproductive labour.

Jump forwards to 2017, and we find a different story. Food delivery service Just Eat’s revenue was £546Mn. Uber a revenue of $11.3Bn. Apple’s 2018 revenue from services was $37.2Bn (14% of overall revenue). Security services company Securitas had 92Bn SEK revenue. Handelsbanken – the best growing (bank) equity in history – had revenue of 41Bn SEK in 2017.

Hopefully we agree that services can no longer be seen the same way as in 1776. Nowadays services are wealth creators. They are a substantial, and growing, component of our economies. Let’s back this point up a little more. Back in 2000, the Organisation for Economic Co-operation and Development (OECD) was saying:

“manufacturing [is] slipping to less than 20% of GDP and the role of services rising to more than 70% in some OECD countries”

OECD, 2000

Later, in 2013, Chesbrough’s Open Service Innovation book was projecting that by 2050 the US economy would be 80% service based (Figure 1 is based on that data).

Figure 1: Growth of Services as Percentage of the Economy

Later still, in 2017, the UK reported its economy was already 79% service based (products: 14%, agriculture: 1%, and the remaining 6% was construction).

Figure 2: Breakdown of the 2017 UK Economy into component parts – services was 79%

If services are becoming so important, what are they?

What are services?

I have a whole article that explores what services are from definitions, attributes (marketing and economics) through to the modern interpretations of job-to-be-done and non-ownership. But in short my preferred definition is show in Figure 3.

Figure 3: My preferred definition of services

This definition covers all the services I can think of. Additionally, it recognises there is a continuum between products (or goods as marketing people will call them) and services.

Figure 4: The Goods-Services continuum

Simplistically, the shift to the service economy means moving along this continuum from left towards the right.

Why are we shifting to services economies?

We saw back in Figure 1 that economies shift from agriculture- to product-based (sometimes called manufacturing-based or industrialised). And subsequently shifting to being service based.

I see several reasons for this shift, including:

  • Passive and Active hypotheses from academia
  • A shift in societies view of ownership/non-ownership
  • The need to enhance products to avoid commoditisation
  • Growing acknowledgement of the value of data

Kim (2006) summarised the academic view on this shift from product- to service-based economies. She highlights two passive and two active reasons.

Figure 5: Four hypotheses as to why economies shift towards services as they advance

Shifting Passively

Economies can shift passively due to actions happening elsewhere in the economy. Kim (2016) looks at two passive hypotheses: Deindustrialisation and Cost Disease. We find the Deindustrialisation hypothesis observes that advanced economies move manufacturing to cheaper countries (and then trade). As a result there is a gap in the advanced economy. That gap is filled by services. Whilst sounding plausible, Kim discusses the evidence of deindustrialisation is not conclusive.

Baumol’s cost disease hypothesis, on the other hand, can be backed up with empirical evidence. However, it can feel a little counter intuitive. Here’s what it essentially says: salaries rise in industries that have no productivity increases in response to rising salaries in industries that have increased productivity. Baumol’s original work looked at why classical musician’s earn more today than in, say, the 19th century. Yet it still requires the same number of musician’s to play a classical tune. For us this translates as wage increases in product industry leads to increasing wages in services. And of course, rising wages attracts (service) workers and increases opportunities. Here is a good and further explanation!

Shifting Actively

The active reasons are the Hierarchy of Needs hypothesis and the Exogenous Demand Shock hypothesis. The hierarchy of needs is simple. As your income grows, so you start to want to have more free time and push of tasks to services. Thus the service sector grows as incomes grow. Kim mentions conflicting studies when trying to confirm this as fact.

Exogenous Demand Shock sounds complicated. But simplistically it means demand for services increases as a result of structural changes in the economy. What could these structural changes be? Kim references two examples. First the spinning out of manufacturing companies those services they used to do in-house. Now once hidden services become visible. Second, the change from one income families to two income families. Now time is right and so demand for services increases.

Shifting due to non-ownership

Remember when we looked at defining services we saw the following:

These together contribute, I believe, to the growth of services in an economy. Amazon cloud service is a good example. You can use Amazon’s computing power to host your businesses IT. You don’t own the servers. But rather than have to build a data centre yourself (large investment) you pay a more manageable monthly/usage fee (sunk cost).

But non ownership can also benefit in getting greater access to a wider range of assets. For example we can look at Spotify. Rather than owning a small number of CDs that I have bought, for a small subscription fee, I get access to millions of CDs.

Chesbrough (2013) also points out that services are growing due to making use of underutilized assets. Here we can include the sharing economy and the gig economy.

Shifting to enhance (product) offerings.

Products/manufacturing is becoming commoditized and harder to tell differences between companies’ offerings. A way out, according to Chesburgh (2013), is to enhance product offerings with services. We can take here examples such as digital twins. In particular how aircraft engine manufacturers such as Rolls-Royce now monitor engines in real time to provide additional services to airlines. This Harvard business school summary on this is interesting.

Shifting to, or because of, freeing data

We are collecting vast quantities of data. If we free that, then an explosion of services should occur. We well see this over the next few years as open banking api cores into force in the EU.

A shift to far?

Of course, things can go too far.  As we now know (and probably really knew all along) the world does not need a monthly subscription based juicing packs system!

Implications of the shift

The shift has limited impact…if we believe products and services are the same.

However, I don’t believe products and service are the same. As you can read here. It follows that innovating in services is different than innovating in products. If your economy is mostly service-based, why would you restrict yourself to just thinking about invasion in a product way? If you do, you probably recognise the innovation problem.

Examples of the product-service continuum and how we shift towards services over time
Figure 4: The shift towards services over time in various industries

But let’s not pretend the shift is simple. It comes with all the challenges we know from normal progress and economics. We can see this in the series of articles below:

  • [Add articles when completed]

Wrapping it up

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