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Federal Reserve of Cleveland June 15, 1986 ISSN 042H-1276 The Emerging

by Patricia E. Beeson and Michael F. Bryan

"I wish you wouldn't squeeze so, " said the Dormouse, who was sitting next to Chart 1 Real by Sector Chart 2 by Sector her. "I can hardly breathe. " Billionsof 1982 dollars Millions "I can't help it, "said Alice very meekly, 2400 66~------~ "I'm growing. " "You've no right to grow here, " said-the Dormouse.

"Don't talk nonsense, r s said Alice more boldly, "you know you're growing too." "Yes, but I grow at a reasonable pace, " said the Dormouse, "not in that ridicu- lous . " -Alice's Adventures in Wonderland

Alice and the Dormouse in Lewis Carroll's classic story offer a lesson about nature that can be ap- 1955 1960 1965 1970 1975 1980 plied to our economy. 800r------••...••• Change often produces uncertainty 600 1955 1960 1965 1970 1975 1980 and anxiety. When the economic envir- onment changes, our anxieties are fre- quently reflected in political and legis- 18~ lative action. 1955 1960 1965 1970 1975 1980 ~ So it is with the emerging service 13 1955 1960 1965 1970 1975 1980 economy. Over a long period of time, ;o~man,ufact~red ~ood~ the U.S. economy has become increas- l ingly oriented towards the 1955 1960 1965 1970 1975 1980 4 1955 1960 1965 1970 1975 1980 and employment of services, while SOURCE: U.S. Department ofCommerce, SOURCE: U.S. Department ofLabor, moving away from more traditional Bureau ofEconomic Analysis. Bureau ofLabor Statistics. -producing industries. As the transition continues, legislative policies designed to protect goods producers I Wish You Wouldn't Squeeze So In 1950, total employment in the U.S. have become more popular. Since 1945, our economy has undergone was 48.5 million workers. By 1984, it This Economic Commentary exam- some dramatic changes; total employ- had almost doubled to 91.1 million. Vir- ines the expanding ment has nearly doubled and real out- tually all of the increase (90 percent) and suggests that its is not put has increased almost threefold. was in the service-producing indus- something to be feared. Rather, service While there have been increases in both tries. The majority of the remaining sector growth reflects a natural-and output and employment in all three employment gains occurred in manu- inevitable-response to rising wealth. major sectors of the economy (manufac- facturing, with only slight gains in turing, non goods, and nonmanufactured goods employment services), the largest gains occurred in (, , and construction). the service sector (charts 1-2).

Patricia E. Beeson, a visiting at the The views stated herein are those 0/ the authors Federal Reserve Bank 0/ Cleveland, is on leave and not necessarily those 0/ the Federal Reserve from the University 0/ Pittsburgh, where she is Bank 0/ Cleveland or 0/ the Board 0/ Governors 0/ assistant professor, department 0/ economics. the Federal Reserve System. Michael F. Bryan is an economist at the Federal Reserve Bank 0/ Cleveland. The authors would like to thank Katherine Barnum lor her assistance. industries showing above-average real Changes in the types of goods the since they represent a higher-order of than food, which is a Chart 3 Shares of Gross National output growth rates include , economy produces have also increased Table 1 Output and Employment Growth by Service wholesale , and other services the for intermediate services. Average Annual Percentage Change, 1950-1985 basic, low-order consumption item. Percent (primarily and business Increased incomes and expanding However, gains were services). Employment growth in servi- markets have resulted in more product Industry Output (1982 dollars) Employment most prominent in the farming sector, ces has been paced by the health care differentiation that, in turn, has All services 3.7 2.5 rising at an average annual rate of 4.8 and business service fields, and has increased the importance of services in percent over the same 38-year period. been above average for the , the design, production, advertising, and Communications 6.7 (1) 1.8 (6) Nonfarm productivity rose at a lesser insurance, and real estate industries. of these goods. Because of Utilities 5.5 (2) 1.4 (7) 1.9 percent per year. As a result, the :~I55 1955 1960 1965 1970 1975 1980 the gains from specialization and econ- Other services 4.4 (3) 3.3 (1) substitution effect probably encouraged Wholesale trade 4.3 (4) 2.1 (4) the growth of farming relative to non- 30 omies of scale in the provision of these I Can't Help It, I'm Growing services, proportionately more of these FIRE* 3.7 (5) 3.2 (2) farm businesses. Trade 3.0 (6) 2.3 (3) Overall, the income and substitution We can identify a number of likely services are being provided by special- Government 2.3 (7) 2.1 (5) sources of service-sector growth: the ized firms in the service sector rather Transportation 1.7 (8) 0.4 (8) effects in the farming sector tended to growth in the demand for services in the than being provided in-house by firms *Finance, insurance and real estate. offset each other. Nonetheless, the sub- production of goods, increases in U.S. in the goods-producing sector. SOURCE: U.S. Department of Labor, Bureau of Labor Statistics. stitution effect in this case was likely wealth, relative adjustments be- While increases in the demand for to be weaker than the income effect, tween goods and service industries, and intermediate services have contributed since it is commonly believed that the changes in labor force demographics. to the increased service-sector activity, simply, consumption of most goods and are thus encouraged by influence of relative on food con- Many service industries produce so- exact figures concerning their contri- services increases in response to a pro- lower prices to consume proportion- sumption is very small." called intermediate services. These are bution to the overall growth of the ser- ductivity improvement, but there is ately more produced The evidence from farm output is services used for the prod uction of vice sector are not available. Based on also a shift in this consumption toward by industries that have the largest pro- consistent with the story outlined goods, such as computer, , an examination of input-output tables an increasing proportion of luxury ductivity gains and to consume propor- above. Generally, since 1947, real U.S. SOURCE: U.S. Department of , legal, , and advertising ser- of the U.S. for 1947-1977, however, we goods and services. tionately less goods produced by indus- farm output has risen, in an absolute Bureau of Economic Analysis. vices. Over time, the of interme- estimate that only about 15 to 20 per- The distribution of necessities and tries with low productivity growth. sense, by about 1.1 percent per year. diate services as a percent of the value cent of the overall growth of the service luxuries is probably not even between call this the "substitution But real output by nonfarm businesses of goods has been increasing, rising sector during this period can be attrib- goods-producing and service-producing effect" of a productivity change. rose, on average, at a 3.4 percent Similarly, almost 70 percent of our from 29 percent in 1947 to 37 percent in uted to an increase in intermediate ser- industries. For example, the goods pro- The effect that productivity annual pace. As a result, the share of increased production since 1950 has 1977.2 In much the same way, the rela- vices. While this represents a signifi- duced in agriculture, construction, and advancements have on the distribution farming to total U.S. business output occurred in service industries. The tive growth of the manufacturing sec- cant increase, other factors, namely mining can probably be categorized as of national output by industry depends was reduced by more than 50 percent goods-producing sector, far from stag- tor during the changes in U.S. productivity, are prob- those that satisfy basic, lower-order upon the combined influence of the in the postwar period, dropping from nant, however, nearly doubled its out- was partially the result of shifting the ably more powerful explanations for needs. Manufacturing industries, how- income effect and the substitution about 5.6 percent in 1947 to only 2.4 put, primarily in U.S. manufacturing. provision of farming inputs from the growth of the service sector. ever, are typically thought to produce effect. If the production of higher-order percent last year. As a result of this growth, our econ- farmers to manufacturers." As a nation's average productivity goods that satisfy a somewhat higher goods occurs in industries that are Income and substitution effects may omy has been transforming-from one When the for specialized busi- rises, it becomes wealthier in the sense order of needs; consequently, we expect experiencing the greatest productivity also explain the changes in the distri- where two of every five workers were ness services was small, these services that it can now enjoy more goods and these industries to develop after the gains, this industry will unambigu- bution of national output between ser- employed in the goods-producing sector, were either provided in-house by firms, services for the same amount of nonmanufactured goods industries. On ously increase its share of a nation's vices, manufactured goods, and non- to one where only about one of every or they were not produced at all. Growth resources. Economists call this pheno- balance, it would seem that service output. If, however, the most signifi- manufactured goods since 1950. Again, four workers are presently employed by of the U.S. economy expanded the bus- menon the income effect. Increased industries represent production that cant productivity gains occur in lower- the economy enjoyed a prolonged in- goods-producing industries. The compo- iness and professional services market productivity changes consumption satisfies an even higher order of needs, order, goods-producing industries, then crease in national wealth over this per- sition of U.S. production has also and encouraged the development of patterns and, hence, output. and that a blossoming service sector is the income effect and the substitution iod, as output per man-hour increased changed, though less dramatically firms specializing in these activities. The effect of rising productivity on characteristic of a nation (or individ- effect will tend to offset each other. at an average annual rate of 2.1 per- (chart 3). The share of total output For example, at one time the major- the behavior of a nation is not unlike ual) which or who has experienced a For example, consider U.S. farming cent. This income effect should have produced in the service sector has in- ity of accounting services were pro- the effect of an income increase on the prolonged improvement in wealth. since 1947. Between 1947 and 1985, encouraged the growth of most indus- creased from 58 percent in 1950 to 66 vided in-house by firms in the goods- behavior of individuals. Low-income The impact of the income effect on business productivity increased at an tries, but particularly the growth of the percent in 1984. Most of these gains producing sector. As the demand for nations, like low-income , the distribution of a nation's output is average annual rate of 2.3 percent. service sector. That is, the income ef- have been at the expense of the non man- these services grew, specialized consume proportionately high levels of complicated when productivity growth That is, on average, the fect would probably have tended to de- ufactured goods sector, with little or no accounting firms developed. Over time, necessities, or so-called lower-order does not occur evenly between all economy was able to produce 2.3 per- crease the relative growth of manufac- change in the share of total output pro- goods-producing firms purchased more goods. As incomes increase, we con- industries, which rarely happens. cent more per year for the same level of turing output and, to an even greater duced in the manufacturing industries.' of their accounting services from inde- sume more of all normal goods and ser- Industries that experience the largest labor expenditure. This represents a degree, the relative growth of nonmanu- The service economy has been grow- pendent accounting firms that are vices, but the rate of growth of luxury productivity gains should experience a significant increase in wealth for the factured goods output (such as farming). ing, but output and employment included in the service sector. Even had (or higher-order) goods consumption is relative decline in the cost of produc- nation. In theory, rising wealth should growth has not been even for all service there been no increase in the demand greater than that of necessities.' More tion and, consequently, a relative have encouraged the growth of most industries (see table 1). Indeed, real for accounting services, the specializa- decline in the prices paid by consumers. U.S. industries (the income effect), but output growth has been greatest in the tion of accounting firms would have should have encouraged relatively more communications field. Other service been reflected as a measured increase growth for nonfood goods and services, in service sector activity.

1. See Michael F. Bryan, "Is Manufacturing Dis- 2. These figures reflect both the direct and indio 3. Fuchs (1968) and others have noted that while 4. The consumption of some goods may actually de- 5. Goods and services for which the substitition appearing?," Economic Commentary, Federal rect service- sector requirements of the goods- there has been a shifting of function from the cline as incomes rise. These goods, typically effect is small, that is, where Reserve Bank of Cleveland, (july, 1985). producing sector and were calculated from the goods-producing sector to the service sector, there called "inferior goods" by economists, are special changes have little impact on consumption, are input-output tables of the U.S. economy. These has also been some shifting of functions in the op- (and uncommon) cases. The origins of the applica- called "price inelastic" goods by economists. The tables are not available after 1977. posite direction. For example, the production of tion of income effects as applied to industrial de- opposite case, goods and services for which the pharmaceuticals has been shifted from being pri- velopment come from Fisher (1935)and Clark (1957). substitution effect is proportionately large, are marily in the service sector (drugstores) to being called "price elastic." primarily conducted in the manufacturing sector. Chart 4 Total Shares of Chart 5 Average Annual Growth Rate of Output per Hour Employment Percent 75r------~ All business

Manufacturing

Nonmanufactured goods

Services

SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis. 1955 1960 1965 1970 1975 1980

After 1960, however, productivity The nonmanufactured goods indus- growth for non manufactured goods try has also assumed a less important industries began to slow. The offsetting role as an employer, as relatively fall- 25 influence of the substitution effect was ing output and about-average produc- considerably less during the 1960-1985 tivity growth indicate relatively fewer period than in the 1950's. Consequent- workers are necessary in these indus- ly, the relative importance of non manu- tries. Finally, the service sector has factured goods industries plummeted become a more important source of over the past 25-year period, from 19.6 employment, as the relatively high rate Nonman ufactured goods percent of total real GNP in 1960 to of this industry's output growth and only 10.7 percent in 1984. relatively low rates of productivity The experience of the manufacturing growth require these industries to 5 a...... ~lo.:'-95.•..5~19Lo60-...... 1o.:'-96.•..5•.•1.••9Lo70..•••.•19o.:'-7.•.5•.•1.••9Lo80...... l economy has been somewhat different, absorb an increasing share of the SOURCE: U.S. Department of Labor, probably because the growth in manu- national force. Bureau of Labor Statistics. facturing productivity, and hence the The issue of the relocation of substitution effects, have helped this employment and other productive sector maintain its share of national resources is complicated by demogra- However, the distribution of national output. Between 1960 and 1985, produc- phic changes occurring in the labor output remained relatively constant tivity in manufacturing industries rose force since 1950. Namely, the emer- between 1950 and 1960. Only after 1960 at an average annual rate of 2.7 per- gence of women and secondary family did service-sector production signifi- cent, compared to only 2.0 percent for workers in the labor market has proba- cantly increase its share (chart 3). nonmanufactured goods industries and bly contributed to the relative growth Further, the post-1960 service sector only 1.7 percent for service industries. of the service economy in terms of out- emergence has come primarily at the Where resources are directed, put and employment. If the growth in expense of the nonmanufactured goods depends upon where the growth in out- the labor force has occurred primarily sector, as the share of national output put is occurring relative to the produc- among laborers with a comparative represented by manufacturing tivity of resources in those industries. advantage in the production of service remained largely unaffected. For example, because output in manu- output, this would have a depressing The reason for the behavior of these facturing has tended to maintain a sta- influence on service industry share shifts, it would seem, has to do ble share of national output in the and prices, and would further encour- with the offsetting substitution effects. postwar period, but productivity in age the growth of the service economy." Between 1950 and 1960, the nonmanu- manufacturing has exceeded that of the factured goods industry enjoyed a very average U.S. industry, we would expect large relative increase in productivity, that manufacturing industries would Don't Talk Nonsense about 5.0 percent per year, on average employ a decreasing share of the work Critics voicing popular fears claim that (chart 5). This was almost twice the force. This has indeed been the exper- the emerging service economy cannot average business productivity gain of ience of manufacturing workers, who support itself, that relative declines in 2.7 percent. A strong substitution effect have represented a smaller proportion goods output is a consequence of for- in this decade may have allowed the of total employment virtually through- eign , that the growth in nonmanufacturing sector to completely out the past 35-year period (chart 4). the service economy implies a slow- offset the depressing influence of the down in the growth of national wealth, income effects over the decade. and that redistributions of wealth may eliminate America's middle class.

6. Disproportionately large increases of service workers into the labor market may also account for some of the relatively slow rates of productiv- ity increase in these industries. And what about the fears that we will It is often assumed that since some decline can be attributed to the shifting Economic fallacies rarely die, how- Chart 6 U.S. Trade Balance-Goods and Services (NIA basis) reduce the growth of national wealth? high-paid manufacturing workers are of employment into the service sector. ever, they just lay dormant for a time. Billions of 1982 dollars As discussed earlier, the growth rate of forced to accept lower paying service In fact, he found that the greatest . Echoes of the Physiocrian theory can 80 productivity in the service economy has sector positions, there has been a gen- reduction in middle-income jobs was in still be heard in 1986. It would be been less than that of the goods- era I lowering of the standard of living the goods-producing, not service- unfortunate if the transition toward a producing economy throughout the for Americans. To be sure, the standard producing sectors. He suggests more relatively greater reliance on service postwar period. Some believe that shift- of living for some displaced manufactur- likely explanations for the shrinking production brought with it its own ing of resources into an industry with a ing workers is reduced. But the average middle class, namely, an increase in the forms of protective legislation, such as relatively slow productivity growth is standard of living in the U.S. must be number of part-time workers, and industrial policies and protectionist responsible for the nation's lower rate greater, since it is an increase in aggre- changes in the age and skill composi- trade . A careful examination of of productivity growth in recent years gate wealth that has primarily brought tion of the work force. the reasons for the relative growth of and, therefore, is responsible for slow- about the growth of the service economy. the service economy make the policies ing the growth of the economy. The problems of displaced workers designed to prevent its emergence seem -80 A number of studies, however, have are important ones that public policy Curiouser and Curiouser ill-advised-or, as Alice would say, "curiouser and curiouser." -100 examined the extent to which growing may wish to address. But policies The uncertainties associated with an service industry employment has con- aimed at discouraging the service tran- economy in transition create a great -120 tributed to the slowdown in productiv- sition by "protecting" goods-producing deal of anxiety, such as those which -140 ity growth in recent years, reaching es- employment threaten to reduce the accompanied the Industrial Revolution. References -1601:..-_.1.- __ --l ...L.. L- __ .....1. .1.- __ ---L...J....L...JL...... L.J sentially the same conclusions: standard of living for the entire econ- In the mid-18th century, for example, 1. Clark, Colin. The Conditions of Economic Pro- 1950 1955 1960 1965 1970 1975 1980 productivity growth has been uni- omy. If we choose to address the poten- just prior to the industrial revolution, a gress. New York: St. Martin's Press, 1957. a. Real service trade excludes factor income. formly lower in all industries in recent tial inequities associated with economic French school of thought called Physio- 2. Denison, Edward. Accounting for Slower Eco- SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis. years, the contribution of the intersec- transitions, policies designed to spread cracy held that all wealth arose from nomic Growth: The United States in the 1970s. torial shifts in production have con- the burden of the transition, such as farming. Only the earth, they said, Brookings Institution, 1979. tributed very little to the overall pro- job retraining or other wealth redistri- yields more than is put into it, from 3. Fisher, Allan. The Clash of Progress and Secur- Whether or not the service sector can virtually all of the increase has been ductivity slowdown and, to the extent bution schemes, should be less costly, which surplus the "sterile" efforts of ity. London: Macmillan, 1935. support itself, however, hardly seems a related to rising petroleum imports that intersectorial shifts have contrib- and certainly more effective. industrialists and others are supported. relevant concern given that output in (chart 6). U.S. exports of real non- uted to the slowdown, it has been Finally, some believe that "the once- The problems of the industrial revolu- 4. Fuchs, Victor R. The Service Economy. New York: National Bureau of Economic Research virtually all goods-producing industries petroleum goods actually favored U.S. caused by the shift away from agricul- solid middle tier of American jobs has tion, they believed, were that a growing and Columbia University Press, 1968. continues to increase. Even the real goods producers at an increasing rate ture, not from manufacturing." been undermined" by the shift of industrial economy could not support it- output of nonmanufactured goods between 1967-1980.7 Only after 1980, Ignoring the evidence to the contrary, employment into the service sector self, that the movement of resources into 5. Fuchs, Victor R. "The Service Industries and industries is declining only in a relative did dramatic increases in the value of suppose for the sake of illustration that which has a smaller portion of middle- the industrial sector would cause star- U.S. Since War II," sense, that is, as a share of total the dollar result in a decline in net the emerging service economy were tier jobs." While the evidence here is vation, and that the redistribution of in Economic Growth or Stagnation: The Future of the U. S. Economy. Indianapolis: Bobbs- national output. To be sure, the econ- nonpetroleum goods export, and a non- somehow responsible for a slowdown in not conclusive, Robert Lawrence of the wealth from farmers to industrialists Merrill Educational Publishing, 1978, pp. petroleum goods trade deficit since U.S. productivity growth. Would this in Brookings Institute contends that was in some sense "unfair."!" Similar omy is producing more goods today 137-156. than ever. For example, goods produc- 1983. However, even the rather dra- some sense be bad for the economy? while the 'middle class' has shrunk sentiments in the U.S. gave rise to a tion has risen about 30 percent since matic turnaround in real net U.S. non- Probably not. In a broad sense, the only from 50 percent of all workers in 1969 complex series of legislations designed 6. Kutscher, Ronald E. and Jerome A. Mark. 1969. But because of productivity petroleum goods exports in recent years way that we can measure the productiv- to 46 percent in 1983, very little of this to protect the of farmers. Phy- "The Service-Producing Sector: Some Com- mon Perceptions Reviewed," Monthly Labor increases in goods industries, this out- has not been associated with a decline ity of resources is in terms of how effi- siocracy, however, had a rather meteor- Review, Vol. 106, No.4, April 1983, pp. 21-24. put has been generated using only in the share of U.S. goods production cient they are in satisfying our desires. ic life, fading in part due to the popular- about 5 percent more labor. which remain fairly constant during Clearly, there are no gains in to ity of the teachings of . Another common misconception is the 1980s (chart 3). Moreover, real net be had by producing in industries that that the emerging service economy rep- service exports have been increasing have a high growth rate of output per resents an erosion of U.S. goods produc- since 1970, yet the magnitude of real hour if these industries are producing 9. AFL-CIO pamphlet " and 10. The fears such beliefs arouse have, at times, tion by foreign competition. Supposedly, service trade gains have been negligible goods that we don't want. the Two Tier ." Cited by R. Kirkland, Jr. provoked very misguided (but predictable) policy the U.S. is replacing goods output with relative to the general growth of the Our economy is devoting more re- Are Service Jobs GoodJobs? Fortune (june 10 prescriptions. Between 1811and 1816,one group imports and is exporting proportion- U.S. service industry. sources to the production of services be- 1985). pg. 38. of English radicals, called Luddites, set out to ately more services. If this were true, Overall, while international trade cause we now prefer to consume propor- destroy industrial machinery in the name of jobs however, we would expect that our real flows may have been important factors tionately more , health care, creation. trade balance of goods would have in the relative decline of some goods in- and information processing, to name Federal Reserve Bank of Cleveland BULK RATE declined over time, while the real trade dustries during the postwar period, the but a few growing service industries. Research Department U.S. Postage Paid balance of services has increased. relative decline of the aggregate goods- Suggesting that we stem the growth of P.O. Box 6387 Cleveland,OH While it is true that real imports of producing sector appears largely unrelat- services in the name of national wel- Cleveland, OH 44101 Permit No. 385 goods from abroad have risen relative ed to international trade considerations. fare is akin to arguing the U.S. should to real goods exports throughout most have remained a nation of farmers, of the postwar period, a closer exami- because output per worker grew faster nation of the trade flows reveals that in agriculture than in manufacturing.

7. Real petroleum trade data are not readily 8. For example, see Denison (1979), Kutscher and available prior to 1967. However, given the size of Mark (1983), and Fuchs (1978). petroleum imports relative to total goods imports Material may be reprinted provided that the Address Correction Requested: Please send prior to 1967, it is unlikely that earlier data source is credited. Please send copies of reprinted corrected mailing label to the Federal Reserve would substantially alter this analysis. materials to the editor. Bank of Cleveland, Research Department, P.O. Box 6387, Cleveland, OH 44101.