An empirical model of services in the U.S.

The rapid growth of services in the U.S. has raised concern, captured by Baumol\u27s analytical model (1969) with its stylized facts: services have a relatively constant or growing share of total output and productivity growth occurs in manufacturing but stagnates in the services. They imply a larger proportion of the economy\u27s resources going to services and the cost-disease, as competitive labor markets compel services to match productivity-based wage gains in manufacturing, passing the higher costs onto consumers. Are the generalizations underlying such pessimistic analyses congruous with the actual economic behavior of the services, which embrace a wide range of dissimilar activities? This study examines the economic behavior of the services at a more detailed level than before to answer this question. A disaggregate review of services shows that the nature of the needs behind their demand and the potential substitutability of services by goods in consumption differentiate the services in terms of the sensitivity of demand to income and relative prices. On the supply side, labor productivity statistics for many services suggest negative growth in total factor productivity and a trivial role for capital, implications inconsistent with the rapid rate of investment in equipment capital, various case studies on new production technologies, and the observed improvement in labor quality. The analysis of the degree of mismeasurement of service output and the flaws in the associated deflators links the direction and magnitude of the bias to the method for the derivation of proxy data, the movements of the omitted variables, and the degree of adjustments to price data for quality changes. An econometric model of services is constructed and developed to capture their behavior in output, employment, prices, wages, investment, and link them to the rest of the economy. Model simulations for different scenarios in long-term growth show the increasing importance of intermediate services and also their sensitivity to business fluctuations, contrary to the general belief in their resilience. A simulation of higher wage rates, Baumol\u27s cost disease scenario, yields dissimilar responses reflecting the complex set of demand and supply forces behind service growth