7 Myths About Services

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Australian Services Roundtable

10

Seven Myths about

Services

Andrew McCredie and Darryl Bubner


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Seven Myths about Services

That for some time now the services sectors cover just about everything that counts in modern

economic growth has been obscured by a number of pervasive myths.

1

We have to erase thesemyths in order to achieve sound evidenced based policies. The seven most dangerous myths are

the subject of this paper.

1 Services are non-productivethey dont create wealth

2 Essential services must remain public services

3 The expansion of services in the economy is a result of reclassification, not substantive

changes in our economy

4 Service sector jobs are low skill and low wage5 The expansion of the service sector drives down productivity growth

6 Service sector innovation investment is low

7 Public sector innovation cant be measured

Most of these myths have persisted long after their expiry from the economic literature and the

weight of evidence should have expunged them.

Even though services now account for two thirds of Australias national economic activity2, myths

get in the way. The growth in services is a statistical artefact; the real economy has not changed.

Services privatisation, regulatory reform and trade liberalisation are framed by ideological debates

rather than economic analysis. Services are low wage and low skills, and services productivity

growth is non-existent or unmeasurable. Policies and programs that support services industry

growth and innovation are simply picking winners and rent seeking an extension of bad

agricultural and manufacturing policies.

In recent years new and more accurate national account structures have been developed. They

have been implemented in the US, endorsed by the UN and the OECD3 and are likely to be

implemented in many countries. Analyses based on these new structures and data sets are now

solving mysteries about growth productivity that long puzzled economists. But weaknesses in the

previous structures led to measurement errors that generated the puzzles and fed and sustained

the myths.

Even while the effects of old measures live on; new more ambitious measurement frontiers are

being been opened up. These frontiers focus on the relation between economic measures and

wellbeing. There are active work programs at the OECD and in the US and the EU on improving

GDP as a measure of national wealth and welfare, and on accounting for a new range of

intangibles such as the value of innovation, impacts on the environment, societal conditions and

1For a definition of services see the end notes.

2 ABS, 1301.0 - Year Book Australia, 200910, Derived from Table 15.1 INDUSTRY GROSS VALUE ADDED AND

GROSS DOMESTIC PRODUCT3Dale W Jorgenson (Ed) 2009 The economics of productivity Edward Elgar Publishing Ltd 2009


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dimensions of wellbeing including employment, equity, health, leisure, security and happiness.4

These activities and the changes to national accounts are instances of emerging and significant, if

little noticed, service innovations.

Despite the myths it is increasingly understood that the 21st Century will reward those countries

with the most dynamic, productive and internationally engaged services sectors; and a rush of

countries in our region including India, China, Malaysia, Singapore and Korea are developing

policies reflecting that belief.

The increased value of services in the global economy is of enormous potential benefit to

Australia. We have long had sophisticated services sectors such as architecture, education and

engineering. Leading practitioners from these sectors are known and respected internationally.

The tyranny of distance for services is less significant; Australias Asian time zone and regional

people-to-people linkages are a real advantage. It is time to dispel the myths that are preventing

us from taking action to secure and strengthen Australias place in the Asian region and the global

services economy.

4The OECD has aGlobal Project on Measuring the Progress of Societies, there is a staff report from the US Bureau of

Economic Analysis onGDP and Beyond: Measuring Economic Progress and SustainabilityApril 2010, In 2007 Francecommissioned Joseph Stiglitz to lead an international research projectReport by the Commission on the Measurement ofEconomic Performance and Social Progress, 2009
http://www.oecd.org/pages/0,3417,en_40033426_40033828_1_1_1_1_1,00.htmlhttp://www.oecd.org/pages/0,3417,en_40033426_40033828_1_1_1_1_1,00.htmlhttp://www.oecd.org/pages/0,3417,en_40033426_40033828_1_1_1_1_1,00.htmlhttp://www.bea.gov/scb/pdf/2010/04%20April/0410_gpd-beyond.pdfhttp://www.bea.gov/scb/pdf/2010/04%20April/0410_gpd-beyond.pdfhttp://www.bea.gov/scb/pdf/2010/04%20April/0410_gpd-beyond.pdfhttp://www.stiglitz-sen-fitoussi.fr/documents/rapport_anglais.pdfhttp://www.stiglitz-sen-fitoussi.fr/documents/rapport_anglais.pdfhttp://www.stiglitz-sen-fitoussi.fr/documents/rapport_anglais.pdfhttp://www.stiglitz-sen-fitoussi.fr/documents/rapport_anglais.pdfhttp://www.stiglitz-sen-fitoussi.fr/documents/rapport_anglais.pdfhttp://www.stiglitz-sen-fitoussi.fr/documents/rapport_anglais.pdfhttp://www.bea.gov/scb/pdf/2010/04%20April/0410_gpd-beyond.pdfhttp://www.oecd.org/pages/0,3417,en_40033426_40033828_1_1_1_1_1,00.html


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1. Services are non-productive they dont create wealthThe idea that the production of goods contributes to national wealth while services are ancillary

and, more often, frivolous and insubstantial; dates back at least as far as Adam Smiths Wealth of

Nations. He wrote, decisively and without qualification:

The labour of some of the most respectable orders in the society is, like that of menial servants, unproductive

of any value.... The sovereign, for example, with all the officers both of justice and war who serve under him,

the whole army and navy, are unproductive labourers. In the same class must be ranked, some both of the

gravest and most important, and some of the most frivolous professions. Like the declamation of the actor,

the harangue of the orator, or the tune of the musician, the work of all of them perishes in the very instant of its

production5

Smiths assertions reflected the dominant thinking of his time, but aspects of this thinking

continue to influence public discourse and public policy, even though the importance of intangible

resources in modern knowledge based economies is widely reported.

On this subject Smiths logic was flawed. For example, accepting for the sake of argument his

proposition that the performance of music leaves nothing of value; how could it be that the

production of a musical instrument creates wealth when the only use of the instrument is to

perform music? The very significant economic impact of the intangible is well illustrated by Adam

Smiths primary contribution to economic thought, the concept of the invisible hand in the

operation of markets. His concept has made a greater and more lasting contribution to global

wealth than the work of scores of production workers.

The supposedly non-productive/non-wealth creating attributes of services was also a feature of

the early 20th

Century Economic Base Model, which combined the view of services as being

unproductive with a heavy dose of mercantilism. In its original form this theory postulated that the

wealth of a nation was entirely a result of the competitiveness of its goods exporting industries

and that economic activity within the region, especially consumption of services, merely reflected

the wealth created through the export activity. Never accepted by mainstream economists on

theoretical grounds6; economic base theory attained adherents in regional planning and

geography, with an active literature continuing into the late 20th

century. More modern variants

accepted that export services could be included as part of the wealth creating base, but continued

to insist that the bulk of services activity was consumption and non-productive of wealth.

Economic base thinking also influenced international aid and economic development policies for

poor nations. Until recently, poorer nations were urged to focus first on developing their

agriculture sector, then their manufacturing sector and the services sectors last if at all.

Inefficient, labour intensive services were accepted, if not valued, for their role in job creation. The

contemporary understanding of the link between the productivity of the services sectors and

national wealth and welfare is only beginning to be reported in the development literature.7

5Adam Smith, An Inquiry into theNature and Causes of the Wealth of Nations Book II, Chapter III, Of the Accumulation ofCapital, or of Productive and Unproductive Labour, 17766A number of empirical studies further debunked the theory. See Andrew C. Krikelas, Why Regions Grow: A Review of

Research On the Economic-Base Model, Economic Review, Federal Reserve Bank of Atlanta, July/August 1992, pp. 16-29www.rri.wvu.edu/WebBook/Schaffer/Chapter%203%20S11%20for%20WVA.pdf 7See for example, Ghani, Ejaz and Homi Kharas (2010), Service LedGrowth in South Asia: An Overview, in Ejaz Ghani

(eds),The Service Revolution in South Asia, Oxford University Press, India.
http://www.rri.wvu.edu/WebBook/Schaffer/Chapter%203%20S11%20for%20WVA.pdfhttp://www.rri.wvu.edu/WebBook/Schaffer/Chapter%203%20S11%20for%20WVA.pdfhttp://www.oup.co.in/search_detail.php?id=145346http://www.oup.co.in/search_detail.php?id=145346http://www.oup.co.in/search_detail.php?id=145346http://www.oup.co.in/search_detail.php?id=145346http://www.rri.wvu.edu/WebBook/Schaffer/Chapter%203%20S11%20for%20WVA.pdf


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Although departed from academic research, economic base theory continues to influence public

policy, providing a rationale for some ofAustralias annual industry assistance which the

Productivity Commission estimates at over $17 billion in gross terms.8 This influence is but one of

many examples of lags and overhangs in economic activity, research and policy making that feed

the myths exposed in this paper. In this case, industry assistance policies shaped by the economic

base theory thrive long after the theory has been discarded and virtually forgotten.

Christopher Lovelock in his 2004 review of the economic history of services notes that: by the

mid-twentieth century, most economists... tended to dismiss the distinction between productive

and unproductive labour as irrelevant and obsolete. In particular, economists came to see the

ultimate end of economic activity as consumption rather than capital formation, thereby

validating the economic contribution of services that could be sold at a price because they offered

consumers value-in-use.9

The importance of services to national wealth is illustrated by economic historian Stephen

Broadberry (2006) in his analysis of the comparative economic performance since the 1870s of

Britain, the United States and Germany. He shows that it is differential trends in service sector

productivity, not manufacturing, that explains most of the movement in comparative

performance.10

In particular he shows Britain was economically ahead of the US and Germany in 1870 only

because of its lead in services. By 1890, the US had caught up economically and subsequently

forged ahead through improved services productivity. According to Broadberry the US gained and

grew its lead in services productivity over Britain through the more rapid uptake of new

management and organisational methods11

, exemplified by Henry Fords production line.

Errors of interpretation have arisen in analyses of economic growth and productivity as a result of

limitations associated with the length of the periods analysed, even for periods spanning several

decades. Broadberrys findings are significant because of the long 150 year period that he studied.

Later in this paper we challenge myths about service productivity and innovation with recent

evidence of the real levels of service productivity and the potential for continuing productivity

growth. But even as service sector productivity grows, levels are likely to remain lower than for

the manufacturing sector. Services will always seem inferior if productivity alone is taken as the

ultimate measure of wealth. The question is whether productivity and GDP per capita should be

the ultimate measures.

The price of cars, clothes, furniture and home electronics have dropped significantly as a result of

productivity gains in manufacturing. A growing number of consumers are satisfied with the goods

that they have. They gain little marginal benefit from buying more, or better, goods and prefer

to spend their money on services ranging from fast food, fine restaurants, online dating, gambling,

investments, travel or education. Whether consumers invest in improving their human capital or

their financial capital or in entertainment and leisure, the shifts in consumer spending remind us

that productivity is not the ultimate measure of what consumers and citizens want. When

material needs are met sufficiently well; services, supported by technology and manufacturing,

become the focus on consumer interest and the main source of economic value and growth.

8Productivity Commission 2009, TRADE & ASSISTANCE REVIEW 2007-08

9Christopher Lovelock, Evert Gummesson 2004 Wither services marketing? In search of a new paradigm and fresh

perspectivesJournal of Service Research7 (1), 20-41.10

Stephen Broadberry 2006, Market Services and the Productivity Race, 1850-2000: British Performance in InternationalPerspective, Cambridge University Press11

Chandler, Alfred 1990, Scale and Scope: the dynamics of industrial capitalism, Harvard University Press, Introduction


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The belief that services are not-productive may be rooted in a deep awareness that food, water

clothes and shelter are vital necessities of life. However given healthy economies the broader

question is not whether services are productive but what mix of economic activity consumers

want and value, and how resource availability12 will impact on those wants and needs.

A related question is what people as citizens, members of communities and societies, want. The

issue of attending to ends as well as means and the links between productivity and wellbeing, has

attracted serious attention in recent years. Perhaps the biggest challenge in these areas, whether

one is measuring service productivity, innovation or the links between economic activity and well-

being; is the task of developing elegant measurement models, enabling efficient and cost effective

data collection, analysis and reporting. Joseph Stiglitz had made a major contribution and focused

international attention on the issue as Chairman of the Commission on the Measurement of

Economic Performance and Social Progress, set up by the French President.13

In his report Stiglitz provided a framework and an agenda for improving the statistical information

on the links between economies and societies. One of his central themes, and a theme of thispaper, is that we should not only measure what is easy to measure, things that have a monetary

value, but also measure what is most important for our economic wealth and social wellbeing.

Stiglitz suggest several ways of dealing with the deficiencies of GDP as an indicator of economic

performance; including more use of well-established indicators.14

He also discusses quality of life

measures under the headings of health, education, personal activities, political voice and

governance, social connections, environmental conditions, personal security and economic

security. Services have a major role and contribute to our wealth in all of these areas.

12The potential impact of peak oil, dramatic rises in the price of fuel, transportation and travel expected within a decade as

demand for oil outstrips global supply, is one of a number of major factors bearing on economic and service sector policies.13

Commission on the Measurement of Economic Performance and Social Progress Draft Summary June 2, 200914

For example he proposes net national disposable income, and net rather than gross, domestic product ibid, pp. 11- 13


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2. Essential services must remain public servicesA major trend over the past thirty years has been privatisation of public services coupled with a

loosening of the rules controlling service delivery deregulation. Functions formerly delivered by

government are now delivered by business; and changed regulations encourage competition byproviding businesses with greater operational flexibility and freedom to innovate.

Virtually none of the essential services in Australia have been immune to this trend, eg power,

water, education, health, finance, communications, transport, housing, culture, law and security.

The task is not complete, the Productivity Commission estimates that the further reform dividend

from competition policy and red tape reduction per year could add a further $17 billion or 1.8 per

cent to the Australian economy.15

Many of the proponents of privatisation and deregulation (eg Thatcher and Reagan) were

motivated by an ideological belief in the virtues of smaller government, the inherent superiority of

private enterprise and the importance of personal freedom and individual responsibility. Critics of

this ideology point to a steady erosion of social cohesion as competition and the naked pursuit of

self-interest invade more and more of our social life, with obvious winners and losers.16

The weaknesses of these old ideological positions are apparent. For example, why might garbage

collection be more essential than the supply food and clothing? Were more jobs created with the

tax payers money used to protect the shrinking textile industry over the pat twenty years? What

value was there in keeping engineers confined to public works departments serving highly cyclical

regional markets? Australia is now home to half a dozen international engineering firms in the

global top 100, largely founded by ex-public works engineers. Yet ideology rather than evidence

still frame public debates around services considered to be essential.

Australian businesses are growing and exporting health and education services, even though most

markets in these sectors are dominated by government. Indeed the role of the Australian

government in establishing an appropriate market, payment systems and incentives for a range of

public and private institutions to attract foreign students has been a major factor in the success of

Australian international education. Australia leads the world in this business as proportion of GDP.

In many countries, education institutions cannot charge sufficiently high fees and/or retain a

sufficiently high proportion of those fees to provide much of an incentive to attract foreign

students.

The financial sector is often caricatured as the exemplar of excessive greed and extreme

capitalism, and the global financial crisis has given credence to this image. There is evidence that

the speed of globalisation of financial markets had outpaced regulation and the crisis had drawn

attention to the moral hazards17 that were always present. But it is important to view this industry

in context. The overturn of the medieval strictures against usury in Europe that culminated in the

financial revolution of the 17th century in Holland and the UK created capital markets with interest

15Gary Banks 2008, Riding the third wave: some challenges in national reform, opening plenary session of the Melbourne

Institute Economic and Social Outlook Conference, New Agenda for Prosperity, Melbourne, 27 March 200816

Quiggin, J. (1997), 'Economic rationalism', Crossings, 2(1), 3-12.17

Moral hazard occurs when a party insulated from risk may behave differently than it would behave if it

were fully exposed to the risk
http://www.uq.edu.au/economics/johnquiggin/JournalArticles97/Econrat97.htmlhttp://www.uq.edu.au/economics/johnquiggin/JournalArticles97/Econrat97.htmlhttp://www.uq.edu.au/economics/johnquiggin/JournalArticles97/Econrat97.htmlhttp://www.uq.edu.au/economics/johnquiggin/JournalArticles97/Econrat97.html


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rates almost an order of magnitude lower than had previously existed.18 This spurt of European

financial innovation was developed by business, preceded the industrial revolution, and arguably

was as significant as the revolution itself.19

In part as a result of Australias success in weathering the global financial crisis, a bipartisan view

has emerged that a sound regulatory framework is essential for the efficient operation of financialmarkets. This suggests a less ideological, more empirical approach to the operation of essential

services markets.20

The focus on the role of ideology in services privatisation and deregulation in the 1980s and 1990s

also has tended to obscure the enabling role of new technology.21 For example, the establishment

of electricity markets was in a practical, efficient sense not feasible until the 1990s. Looking ahead,

when consumers have better means, such as smart meters, to vary their consumption in relation

to price signals, the major theoretical benefits of electricity markets are likely to be achieved.

The Australian Governments agreement on health and hospital funding with most of the States

and Territories - to introduce activity based funding, the use of the Independent Pricing Authority,and the funding relationship with local hospital networks is in line with recommendations made

by the Productivity Commission for the greater use of the market in the structural reforms of our

health system. The development of ehealth systems, such as electronic personal health records

will facilitate greater use of the market in delivery of health services in ways that previously would

not have been cost effective. How a greater role for the market is to be introduced into the

delivery of health services is a current debate.

18Productivity Commission modelling suggests for every 1 per cent decline in the productivity of financial

services, and 1 per cent rise in its cost, global output would be 0.5 per cent lower than otherwise (equivalent

to $350 billion), Gary Banks, Back to the future: restoring Australias productivity growth, Presentation to

the Melbourne Institute Economic and Social Outlook Conference, The Road to Recovery, 5 November

200919 Niall Ferguson, The Ascent of Money: A Financial History of the World. New York: Penguin, 200820

The general issue of government regulation was explored in depth at a conference in 2008, published in

Government and Markets: Toward A New Theory of Regulation eds Edward Balleisen, David Moss Harvard

University, Massachusetts, November 200921

Robert Reich writes: They *neoliberals+ did not cause the shift; at most, they legitimised it p12

Supercapitalism: the transformation of business, democracy and everyday life Scribe Publications 2008.


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3. The growth of services contribution to GDP is a result ofreclassification, not substantive changes in the real economy

A further persistent myth is that the observed growth in the services sectors is, in effect, artificial

resulting from statistical reclassification.

The fact that the services parts of the economy have become more important in generating wealth

was rarely considered until recently in the economic and business literature. As shown in the

Appendix, the growth and changing nature of services has changed the structure of the economy,

the way we do business and the methods recently developed to measure economic activity.

Proponents of the reclassification view point to the growth in outsourcing of services related to

goods production. For example, manufacturing companies over the last twenty years have

increasingly outsourced functions such as accountancy, cleaning, security, marketing to specialist

services company firms. They consider that a number of large companies such as Dell and

Billabong that national statistics offices define as wholesalers (a services sector) should be

classified as manufacturers. Some have argued that correcting such classifications could account

for most of the reported rise in the services sectors share of the economy.

The magnitude of undertaking this reallocation task and the definitional complexities makes this

an essentially untestable proposition, but more fundamentally it is the wrong proposition.

The key issue is why these services functions have increasingly become performed separately from

manufacturing (and agriculture and mining) functions, and what this indicates about the nature of

the contributions the sectors to which they have shifted to the value adding process of varioussupply chains. A European economic study detailing the sources of productivity growth in the

business services sector is included in Appendix 1 because it explains the changes.

Several manufacturing sectors illustrate this point. Music publishing used to be classified in

national accounts as manufacturing - originally the manufacturing cost was greater than the

services component payments to authors, distribution and marketing, and so on. With records

becoming CDs and then migrating to iTunes and other internet delivery modes the manufacturing

dimension from music publishing has largely disappeared. As a result this economic activity is now

increasingly located in the Information Media and Telecommunications Industry Division of ANZSIC

2006, and not the Manufacturing Division. With the rise of Kindles and iPads the same process isoccurring in book publishing. The reclassification involved is not artificial; the manufacturing

component has simply withered away.

Pharmaceuticals are another manufacturing sector that illustrates the increased contribution from

services to the value chain. Most of the profit and turnover of the large pharmaceutical

companies comes from the drugs on which they hold exclusive patent rights to produce. In turn

the success of these drugs is dependent on the companys R&D effort, its product assurance and

efficacy testing, its regulatory approval and pricing negotiations, its marketing and distribution and

its management of product liability issues. The manufacturing value-add and cost dimension of

most modern drugs is a relatively small part of the total value chain.

These points are well illustrated by the smiling curve used by Acer Computers CEO Stan Shih to

convince Taiwans President Chen Shui-bian to permit Acer laptops to be manufactured in China.


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Figure 1 Source:Business Week International online extra, May 16, 2005, Stan Shih on Taiwan and China

Mr Shih said: Hollowing out of tangible things is not critical. Hollowing out of intangible things is

really critical.22

The value chain of Apples iPod has been well analysed, and illustrates Stan Shihs curve. Every

iPod sold for $299 in the US increases the reported trade deficit with China by about $150 the

factory cost of the iPod plus the cost of shipping. Yet the value added to the product through

manufacture and final assembly by a Taiwanese manufacturing services company operating inChina is $3. The $299 handed over by each customer is shared between Apple ($80) and US retail

and distribution ($75), with the Japanese, Taiwanese and Korea component suppliers gaining

between then margins totalling around $44 above the $100 cost of inputs (labour and goods),

including the $3 for assembly.23

The increased contribution of services to business is also illustrated through the recent history of

IBM which has transformed from being a predominantly manufacturing company to being a

predominantly services company, with the combined value of services and software reaching 78

per cent of IBMs worldwide revenue in 2008, see graph overleaf.

22Business Week International online extra, May 16, 2005, Stan Shih on Taiwan and China

http://www.businessweek.com/magazine/content/05_20/b3933021.htm23

Greg Linden, Kenneth L Kramer and Jason Dedrick; Who Captures Value in a Global Innovation Network? The Case ofApples iPod VOL. 52 No. 3 March 2009 COMMUNICATIONS OF THE ACM
http://www.businessweek.com/magazine/content/05_20/b3933021.htmhttp://www.businessweek.com/magazine/content/05_20/b3933021.htmhttp://www.businessweek.com/magazine/content/05_20/b3933021.htm


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0

10

20

30

40

50

60

70

'90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08

Percent

Year

Figure 2: IBM Worldwide Revenue - by Segment

Source: IBM Financial Reports

Hardware

Services

Software

Other

57%

16%

64%

19%14%

21%

6%3%

Services & software accounted for

78% of IBMs revenue in 2008

Software revenue exceeded

hardware revenue for the first

time in 2008

The debate about whether companies like Dell, CISCO, Apple, Li & Fung24

and Billabong are actually

manufacturing companies (even though they do not for the most part manufacture any of their product)

also misses the essential point that these firms success is not related to manufacturing value-adding, but

rather to a range of services activities.

Trends in our mining industries are generating changes in some areas that have yet to be reclassified as

professional services rather than mining. The professional work of Australias mining companies is

increasingly located overseas or associated with overseas projects.25 26

This trend has intensified over the

past decade; for example, ASX-listed companies are now managing 928 overseas mining projects.27

As work

on overseas projects is not associated with goods produced in Australia, it can be appreciated that an

increasing proportion of the high skill, high wage jobs provided by the Australian mining companies would

be more accurately classified as professional services.

24Li & Fung Group is a Hong Kong based multinational group of companies with three core businesses - export sourcing,

distribution and retailing. The group provides another example of how value adding has shifted up the supply chain from

manufacturing to serviced sector activities. Li and Fung produces more than two billion pieces of apparel, toys andother consumer items every year and owns great brands including Toys R Us.

Yet Li & Fung does not own a single factory. Instead it is a network orchestrator. It manages global supply chains

involving more than 8,300 suppliers served by over 70 sourcing offices in 40 countries and territories. The company

indirectly provides employment for more than two million people in its network of suppliers, but less than 10,000 of

these are on Li & Fungs payroll. With a lean structure, each of the companys employees generates about US$1 million

in sales, earning a return on equity of more than 38 precent per year. From: Victor K. Fung, William K. Fung, and Yoram

(Jerry) Wind COMPETING IN A FLAT WORLD: BUILDING ENTERPRISES FOR A BORDERLESS WORLD.

25Oliver Mapongaa and Philip Maxwell 2000; The internationalisation of the Australian mineral industry in the 1990s

Resources Policy, Volume 26, Issue 4, December 2000, Pages 199-210.26

An indication of the significance and scale of Australian offshore mining investment is provided by the UNCTADsWorld Investment Report 2007: Transnational Corporations, Extractive Industries and Development whichreports employment associated with the foreign affiliates of Australian mining companies as being 322,000 in 2002;

total Australian mining employment was around 85,000 in 2002 (ABS6203.0)27

DFAT 2010 Review of Australias Relationship with the Countries of Africa, Submission to the Joint StandingCommittee on Foreign Affairs, Defence and Trade, Inquiry into Australias relationship with the countries of Africa, 17

March 2010, http://www.aph.gov.au/house/committee/jfadt/africa%2009/subs/Sub%2046.pdf
http://www.unctad.org/en/docs/wir2007_en.pdfhttp://www.unctad.org/en/docs/wir2007_en.pdfhttp://www.unctad.org/en/docs/wir2007_en.pdfhttp://www.unctad.org/en/docs/wir2007_en.pdf


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4. Most service sector jobs are low skill and low wageAs the services sectors provide jobs for 84 per cent of Australians in employment, it is true that

these sectors provide many low skill and low wage jobs. Its role at the low skills end of the

spectrum attracts attention because of the importance of increasing participation in employment.It is less well known that the service sectors provide most of the high wage and high skill jobs; see

table 1. In 2009, 93 per cent of Australians with qualifications equivalent to a university degree or

above were employed in the services sectors.28 The better salaries and employment outcomes

achieved by university graduates in Australia (which have been sustained despite the substantial

growth in the proportion of Australians with degrees) primarily reflects the increased demand

over the past twenty years by the services sectors for their skills.

Table 1

Australian Workforce and Graduate Distribution, and average salaries by industry, 2009

Industry

Workforceproportion of all

industries

(percent)

Graduate plus

grad dip. orabove in

industry

workforce

Average

Weekly Salary

Agriculture 3.3% 6% Not surveyed

Mining 1.5% 21% $ 1,999

Manufacturing 9.2% 14% $ 1,199

Electricity, Gas, Water and Waste Services 1.2% 27% $ 1,482

Construction 9.0% 7% $ 1,380

Wholesale Trade 3.9% 15% $ 1,213

Retail Trade 10.9% 11% $ 950

Accommodation and Food Services 6.8% 9% $ 905

Transport, Postal and Warehousing 5.2% 10% $ 1,238

Information Media and Telecommunications 1.9% 35% $ 1,476

Financial and Insurance Services 3.7% 41% $ 1,433

Rental, Hiring and Real Estate Services 1.7% 18% $ 1,258

Professional, Scientific and Technical Services 7.6% 50% $ 1,466

Administrative and Support Services 3.4% 18% $ 1,233

Public Administration and Safety 6.2% 36% $ 1,338

Education and Training 7.6% 64% $ 1,288

Health Care and Social Assistance 11.1% 36% $ 1,236

Arts and Recreation Services 1.8% 25% $ 1,107

Other Services 4.1% 11% $ 1,038

All Industries 100.0% 25% $ 1,277

ABS 6302.0 - Average Weekly Earnings, Australia, Nov 2009; 6278.0

Several services sectors lead in terms of both rates of pay and employment of university trained

staff. These sectors include Information Media and Telecommunications, Financial and Insurance

Services, and Professional, Scientific and Technical Services, which in total employ 13 per cent of

those Australians in employment and over a quarter of all graduates.

28ABS 6278.0 Education and Training Experience 2009


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Manufacturing in Australia is a relatively low paid and low skill sector. As shown in table 1, both its

level of pay and employment of university graduates are well below the average for all industries

and the average for services industries. It provides jobs for 9.2 per cent of those Australians in

employment.

Mining is the industry sector with the highest rate of pay, but it is a relatively small employer withjust 1.5 per cent of Australians in employment. Many of the jobs in the mining sector are difficult,

dangerous, dirty and remote; attracting high salaries even though the formal skill level is lower than

most other sectors.

The high salaries in the mining sector are also related to the increased proportion of graduate and

above degree people in the mining workforce. At 21 per cent it is three times that of construction

which might be thought of having similar workforce needs, and a third higher than manufacturing.29

Technical mining professionals with degrees are among Australias highest paid professionals,

commonly attracting salaries above $150,000 in positions advertised on the My Careers website.

29By comparison the proportion of graduate and above employment in the US mining sector is 18%, which is half the all

industries average (36%), similar to construction (13%) and a third less than manufacturing (27%) US Census Bureau

Educational Attainment in the United States: 2009.
http://www.census.gov/population/www/socdemo/education/cps2009.htmlhttp://www.census.gov/population/www/socdemo/education/cps2009.htmlhttp://www.census.gov/population/www/socdemo/education/cps2009.html


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5. Expansion of the service sector drives down productivity growthTHE MYTHMAKER

In 1967 economists William Baumol noted that the productivity of a string quartet was the same as acentury before and that it was difficult to think of ways to improve its productivity.30 He argued that,

in contrast with manufacturing sectors, which he called progressive, labour intensive services were

stagnant because their potential for productivity gains was very limited.31 He predicted that as the

service sectors share of the economy increased, prospects for economy-wide productivity gains

would diminish. His model and hypothesis, which became known as Baumols disease,seemed to

explain the productivity slowdown in the 1970s and early 1980s.

In 198532 Baumol strengthened his case by revising his model and classifying services as progressive,

stagnant or asymptotically stagnant. In doing so he acknowledged that some service sectors, such

as telecommunications, achieve high and spectacularly high productivity growth, while continuing to

argue that most are stagnant. He contended that high productivity growth was possible in

telecommunications precisely because no personal contact was involved.

He labelled services such as R&D, that use some inputs (computers) from the progressive sector

and some inputs (the intellectual work of researchers) from the stagnant sector as hybrid and

asymptotically stagnant33. In 2007 he rounded out his revised model by forecasting that the growing

costs of R&D labour will eventually reduce demand for these services34

. Baumol still considers health

and education to be low productivity growth sectors because the work of teachers, academics,

doctors and nurses is characterised by the handicraft attributes of personal contact

35

. Hecontinues to promote his hypothesis and it in turn exercises a wide influence on the thinking of

columnist, economists and policy makers36. For example, in a recent Age article John Legge wrote:

The possibility of raising the productivity of many activities, including many services, is limited.

Manufacturing, on the other hand has unlimited potential. Legge continued: It is misleading to talk

about a move from manufacturing to a service economy: what has really been happening is the rise

of software37.

Baumols model appeals to common sense and has cast some light on productivity growth trends for

half a century. One cannot dispute that the labour involved in string quartet performances,

academic research and in the personal service fields of child care, teaching and nursing either shouldnot be, cant be or cant easily be automated. As a result, the productivity growth resulting from

many decades of automation of agriculture, mining and manufacturing (capital deepening) is not

30Baumol, W. 1967, Macroeconomics of unbalanced growth: the anatomy of urban crisis American Economic Review, vol. 57, no. 3, pp

415-26.31

This brings to mind the scene in Notting Hillwhen Bernie the gauche friend of the Hugh Grant character commiserates about the worthy

nature of acting and poor pay with the Julia Roberts character, Anna. Bernie: What's the pay like in movies? I mean, last movie- how much

did you get paid? Anna: 15 million dollars.32

William J. Baumol (with Sue Anne Batey Blackman and Edward N. Wolff) "Unbalanced Growth Revisited: Asymptotic Stagnancy and NewEvidence," American Economic Review, Vol. 75, No. 4, September 1985, pp. 806-81733

Ibid page 811 Examples in brackets were inserted by the writers.34

William J. Baumol, On Mechanisms Underlying the Growing Share of Service Employment in the Industrialized Economies, Chapter3in Mary Gregory, Weimer Salverda, and Ronald Schettkat, eds., Services and Employment: Explaining the U.S.-European Gap, Princeton,

NJ: Princeton University Press, May 2007 Preface, page 1035

Ibid page 936

Baumol quoted by Herszenhorn, D. M.; For Ailing Health System, a Diagnosis but No Cure, The New York Time, 17 January, 2010.prescriptions.blogs.nytimes.com/2010/.../an-economist-who-sees-no-way-to-slow-rising-costs/37

John Legge Without support for industry, were no more than a quarry The Age p 21 Friday August 13 2010


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matched in these service sectors. Developments pointing to capital deepening and automation of

these services are discussed later in this paper.

The first problem with Baumols formulation is that, aided and abetted by input, output, price, and

therefore productivity measurement errors, his model misleads with deceptively simple and

persuasive explanations. The second problem is that it leads directly to the view that is nothing that

can be done in terms of policy to foster productivity growth in the stagnant service sectors.

Baumols construction ignores the accelerating impact of new knowledge, embedded in human

capital (skills) and technology (hard tools and soft methodologies) on services. For example, the ICT

revolution has made it possible to significantly lift the productivity of a string quartet, disproving

Baumols original example. A real world example is provided by the band that plays every Saturday

at the Melbourne dinner dance restaurant, Rasputin. Three performers, a singer and drummer and a

pianist, who also plays a small computer sitting on his keyboard, generate the sound equivalent to

that of a ten to fifteen piece orchestra. Todays music lovers can also choose from a global store of

digital music. Such online retailing illustrates the dramatically increased productivity of the

distribution service sector.

Poincare wrote that "Science is (made of) facts, just as houses are made of stone....but a pile of

stones is not a house, and a collection of facts is not necessarily science."38 Baumol has made

significant contributions, particularly to our understanding of entrepreneurs and innovation, but his

service productivity model is more like a house than a collection of stones, but in the field of

economic growth research it is a dominating house with a strikingly attractive facade that belies

shoddy workmanship, structurally weaknesses and crumbling foundation stones. Its an old house

that needs either demolition or renovation from the ground up.

SERVICES, INTANGIBLES, KNOWLEDGE AND PRODUCTIVITY

Over the last 35 years there has been a dramatic decline in the contribution of manufacturing labour

productivity growth to total productivity growth in Australia. The contribution dropped from 82% to

42% while the contribution of services sector labour productivity growth grew commensurately by

40%.39 There are similar if less dramatic trends in Europe and the US.40 However contributions are

not only a result of productivity; they are also, and in this instance, mostly, a result of the relative

size of each sector. With services now accounting for around 75% of economic activity across OECD

countries, these changes are not surprising. However, trends and improvement in measurementmethods are gradually narrowing the manufacturing services gap.

To understand why the manufacturing-services productivity gaps have bolstered the myth for

decades we need to identify and measure drivers of productivity and growth at the sector level.

Doing this (at any level) is rather like unscrambling a dish of scrambled eggs. We may not be able to

physically unscramblethe dish but we can define the component parts, get a sense of their relative

importance and the way they interact and work together.

38Poincare, J. H. (1903)

La science et l'hypothese[The science and the hypothesis]. Paris: E. Flammarion.

39Own calculations based on data from Bart van Ark and Pieter Woltjer (Eds) The EU KLEMS Productivity Report Issue No2 2008 Groningen Growth and Development Centre University of Groningen .40

For example studies of US ICT using industries showed that since 2000 the major contribution to productivity growth hasshifted from manufacturing to services and has been concentrated in just eight service and trade sectors. Similar trends

and concentrations were found in France, Germany, the Netherlands and the UK, but the levels of investment in ICT and

the rates of growth were lower in the mainland European countries. See Jorgenson D (Ed) Economics of Productivity 2009


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A service is defined by what it is not an intangible product that is not a good. Services and service

characteristic elude easy classification41 because; after agriculture, mining and manufacturing, they

make up all other economic activity. The definition of service in the UN System of National Accounts

2008 while accurate is anything but simple and straightforward.42

An intangible is also defined by what it is not - something that cannot be touched, that is not solid.The term also refers to things that cannot be easily grasped, defined, measured or assessed; a point

that explains some of the difficulties measuring services. Valuable intangibles that are owned, used,

bought and sold are called intangible assets.43 They are of growing importance. Since 1960 the ratio

of intangible capital of total capital in Australian public companies grew from 10% to over 22%.44

In essence the defining characteristic of services; the thing that truly distinguishes service sectors

from goods producing sectors, is the intangibility of their output. In accounting, intangible assets are,

by definition, stocks while their use, for example in service production and delivery, is measured as

flow. The significance of intangibles, measured as the ratio of book to market value has long been

recognised in the finance and investment community. In recent decades quite detailed frameworks

for measuring intangibles have been proposed and used to augment financial accounts.

45

In nationalaccounting systems, measuring the outputs of services is difficult; and has not yet been mastered.46

As the result there are large gaps in the data needed for estimating service productivity.

Nevertheless, the impact of intangibles has been estimated at industry sector and national levels.

Knowledge is the common and core element of intangible assets and of most services.47

Knowledge

is the major element in all but five of the twenty nine intangible assets listed by the US Financial

Accounting Standards Board in SFAS 141.48 Knowledge can be in forms including data, information,

brands and reputation, legally recognised and protected intellectual property, skills, proprietary

knowhow, formal intellectual property and contracts.

Knowledge is what we know, think and believe. Its made up of fact and belief.49 Knowledge is the

core ingredient of skills or know-how; the major components of human capital.50 While ultimately

all knowledge originates from people; a quantum remains embodied in each person. Even so;

41The variety of services is so great that one can easily find flaws attempts to list service characteristics. For example,some writers claim that (1) no transfer of ownership takes place when services are sold, and that services (2) cannot be

stored or transported, (3) are instantly perishable, and (4) come into existence at the time they are bought and consumed.

However, when a builder builds a house for me, I take ownership of the completed house, which is (hopefully) anything but

instantly perishable. Data in databases and e-books can be moved around the world at what seems like the speed of light.

Finally, an accounting report can be read and re-read for years after the accounting work is completed and paid for.

42UN SNA 2008 , Section 6.1743 Lev notes that an intangible asset is a claim to future benefits that does not have physical or financial (a stock or a

bond) embodiment. Lev, B. Intangibles: Management, Measurement, and Reporting. Brookings Institution

Press, Washington, D.C., 200144

Webster Elizabeth THE WEALTH OF NATIONS: WHERE DOES IT COME FROM? Talk at the Clever Collections Conference, November 2007The actual period was1960 to 199745

The models are summarised in Thomas A. Stewart Intellectual Capital The New Wealth of Organisations Doubleday 199746

The key problem is that while price data is easy to collect, service volumes are difficult to establish.47

For example, knowledge dominates educational and government services, but shares a place with tangible inputs andoutputs in the construction sector and in the hotel and restaurant sector.48

Knowledge is not or may not be central in five types of contract based intangible assets: licensing, royalty, standstillagreements, lease agreements, construction permits, operating and broadcast rights and finally, use rights such as drilling,

water, air, mineral, timber cutting, and route authorities.49One of the major debates in the field of epistemology concerns the ultimate sources of knowledge in black and white; are we bornwith some innate knowledge or do only we come to know things through observation? Regardless of where the balance lies its a fact that

people create and produce knowledge and that they have been doing so for centuries. We might speculate as to whether the ratio of fact

to belief can and does change, and if so whether we should be optimistic or pessimistic about evidence based policy. 50

Human capital is the health, strength, education, training, and skills that people bring to their jobs, hereafter, skills. In growthaccounting Human Capital is currently treated as a component improving labour quality, rather than an independent factor of production.

Education levels which are measurable are used as the main indicator of useful knowledge in economies.


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knowledge is most commonly recognised in its seemingly more tangible form, as the contents of

books and publications and databases. Knowledge is also embodied in goods through their design,

constituent materials and production processes.51 At a fundamental level, there are tangibles and

intangible components in both products and services. Services are not pure intangible and

agricultural, mining and manufactured products embody and store knowledge. However, with this

caveat, the intangible content of services is far, far greater than that of goods.

Economic growth involves reallocating resources tangible and intangible in ways that are more

valuable. Growth occurs when economies become smarter and more efficient; as distinct from

simply expanding because more people work longer (increasing labour input) and consume more

(increasing GDP). Productivity growth is a result of increases in the productivity of labour, capital and

other factors, primarily but not only new technology.

We want to keep technical language to a minimum, but will spell out these factors. The most

common measure of labour input is hours worked. Labour productivity growth is the result of people

working harder (but not longer) and smarter, aided by smarter tools and methods. The contribution

of human capital, the skills that educated people bring to their work, which is not picked up in hoursworked, is now is recognised in standards and can be measured as quality adjusted labour input.

Capital input is a measure of the rate at which investments in land, plant, machinery and equipment

is used, and used up. In accounting the using up rate is measured as depreciation. Capital

productivity is a measure of the efficiency with which the capital is used to produce goods and

services. Capital productivity is a result of the interaction between investment levels (more

investment leads to capital deepening), contributions from new technology in new vintages of

capital, economies of scale, capacity utilisation and labour inputs. In oversimplified terms, if a

worker uses a machine for more (less) hours over a period of time, the capital productivity of the

machine increases (decreases). During the last 25 years increasing labour costs have led to

reductions in labour inputs and increases in capital inputs, triggering declining capital productivity.

Labour and Capital by themselves do not explain productivity growth. To cover the remaining

influences economists use the somewhat misleading term Total or Multiple Factor Productivity

(TFP/MFP) the intangible influences on labour productivity, such as new ways of organising,

improvements in efficiency and new technology.52 TFP growth results from:53

firms applying new knowledge available in science and technology publications;

firms copying what other firms do, including the best practices of leading firms

the leakage ofvaluable knowledge and ideas from one firm to other firms through staff

movement and informal contacts;

imitation of innovations by firms through reverse engineering and simply stealing ideas

commercial technology transfer;

all training and learning-by-doing that occurs in firms

network effects or externalities. For example, an Internet user stands to benefit as an

increasing number of their friends start using and communicating on the Internet.

These examples illustrate the fact that knowledge can be spilt-up, copied, carried and moved around

both in formal commercial contracts and informally by people; such as when managers from

different firms or agencies swap information over lunch. The movement and leakage is called

knowledge spillover because valuable knowledge, unlike indivisible goods, gets used in many ways

outside its original intended use. The very existence of cities demonstrates the power of knowledge

51Production here covers agricultural production, mining and manufacturing.

52Michael J. Harper, Bhavani Khandrika, Randal Kinoshita and Steven Rosenthal Nonmanufacturing industry contributions to multifactor

productivity, 19872006 BLS Monthly Labor Review June 201053

This list isbased on John Revesz, Harvey Anderssen and Dr Lee Boldeman Productivity growth in service industries DICITA Occasi onalEconomic Paper, April 2005


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spillover. Why do people live together in expensive cities when they could live on cheap land in the

country? Because the knowledge spillovers that can take place when people are concentrated in

cities is the intangible glue that leads to significantly higher productivity54 that makes living in cities

more rewarding.

TFP measures the contribution of free floating knowledge and economies of scale, in contrast tothe knowledge that is embodied in capital and labour. TFP is generally seen as a broader measure,

covering more than labour productivity. Over the long term labour productivity and TFP trends tend

to track each other.

WHY HAS THE MYTH LIVED FOR SO LONG First, it takes a long time to fix mistakes

Conclusions, derived from theoretical models built with flawed assumptions and metrics and

populated with limited data fostered the prevailing view that service productivity is doomed to lag

behind productivity in other sectors. Economists were often puzzled as to why predictions based on

their models were proved wrong. An equally intriguing puzzle is why some economists continued to

use flawed approaches for so long. The answer involves accounting at all levels: a combination of

out-dated accounting standards developed during the industrial era that still fail to treat intangibles

correctly; path dependence,55

with the growth model developed in 1957 by Robert Solow an

overpowering influence on the (thinking) path taken subsequently by economists; insufficient

attention to the significance of the principle of requisite variety,56 and data and measurement errors

in national level accounts errors that while not especially significant in national snapshots of

national economic activity become so when used in models to explain service productivity trends.

Solows model elegantly linked three inputs: capital, labour and another unexplained residual

factor as the causes of productivity and economic growth.57The unexplained or residual factor was

considered to be completely outside of the economic activity covered by the models and thought to

be the rate of technological progress. Essentially, technological progress is not hostage to the limits

to economic growth imposed by the diminishing returns from all physical inputs to economic

activity. Diminishing returns reflect the fact that there are limits to the ability people to work harder

and faster, and to the capacity and working life of machines and equipment. As physical resources

are used more and more over a period of time the returns from the resources diminish. This was

expressed succinctly and even proposed as an economic law, by one of the founders of neo-classical

economics, Alfred Marshall: ... while the part which nature plays in production shows a tendency to

diminishing returns, the part which man plays shows a tendency to increasing returns.58

Several real world factors affect model building. There can be lags of a decade or more before new

technology delivers benefits; and economic cycles and shocks affect productivity and growth trends.

National accounts data, collected primarily for the purpose of calculating GDP, is aggregate and not

sector level data. Consequently it limits the study of activity at sector level, and within and between

54Not all of which is measured.

55Decisions and mistakes made in the past influence subsequent decisions; the historical hangover can be long lasting and inefficient.

56In its original form, a complex system can only be regulated by an equally complex set of controls. W. Ross Ashby, "An Introduction to

Cybernetics" Chapman and Hall, London 1956 Despite being highly influential, Ashby is not as well-known as other thought leaders in the

field of systems theory and science.57

Technological progress was a factor entirely beyond the parameters of economic models and as a result these models became known

as exogenous models that recognised a factor entirely beyond economic activity; as seen through the economists models. Later modelsthat incorporated technological and other change are known as endogenous models) . His influence is demonstrated by the fact that hisless than intuitive term for technological progress, Total Factor Productivity or TFP is still used to describe the rate of technological

progress.58Marshall, A. Principles of economics (8th Edition), Macmillan and Co., Ltd. 1920 Book 4, Chapter XIII, Paragraph IV.XIII.11 Retrieved1/8/2010 from,http://www.econlib.org/library/Marshall/marP1.html Clearly, his followers picked up on some but not other parts of his

thinking and writing.
http://www.econlib.org/library/Marshall/marP1.htmlhttp://www.econlib.org/library/Marshall/marP1.htmlhttp://www.econlib.org/library/Marshall/marP1.htmlhttp://www.econlib.org/library/Marshall/marP1.htmlhttp://www.econlib.org/library/Marshall/marP1.html


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sectors. Finally, even when these factors are addressed, errors in defining and measuring labour and

capital at constant prices over time remain.

As with all research, economic research gradually builds and improves our knowledge of the world.

But not only do lags occur; wrong turns and flawed paradigms long lasting world views can

limit the horizons of researchers for decades. (Following Karl Popper, all research outputs, even

those with the strongest evidence, might be regarded as work in progress.) These factors have

affected economic model building, testing and thinking; and contributed to the myth for decades.

Just a few years after Solows 1957 paper some economists sounded warnings about the difficulties

of and effects of measurement problems; and they have been sounded, with ever increasing

frequency, by an increasing number of leading economists, ever since.59

During the 1960s other economists, particularly Griliches and Jorgenson completed productivity and

growth studies using better measurement constructs but, as shown in Table 2 overleaf, despite their

advocacy and warnings of others,four decades passed before their approach was taken up bynational and international statistical and accounting bodies. The early appeal of the models of Solow

and also Kuznets (applied to past and emerging data they seemed to made sense at the time) lured

economists into studies limited by poor measurement concepts and data, even as real world growth

diverged from the rates forecast by the models. As a result, economists such as Professor Peter

Robinson, writing the DIISR study of Innovation Metrics,60

warns policy makers of the limitations of

the models and findings based on the models.

Unfortunately, flawed theories and models show up in bad policies and the policies become difficult

to change. Garry Banks, citing successful tariff reforms as an example of the policy benefits of sound

analysis and robust statistics mentioned that there were entrenched opposition to the reforms.61

59Freeman, C Continental, national and sub-national innovation systemscomplementarity and economic growth Research Policy 31

(2002) 191 211 In this paper Freeman praises Stanford economist Irma Adelman for her foresight and courage in identifying the

problems in 1963. Leading economists from the US BEA, BLS and Federal Reserve Board, the Australian Productivity Commission, the EC

and OECD have written about the problems.60

DIISR, 2009 DIISR Innovation Metrics Framework Project , 2009, Part 261

Ibid pages 9 and 17


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Table 2 Major growth accounting studies and models of economic growth; and related improvements in national accounts62

Tinbergen 1942 Found that growth in capital and labour inputs accounted for about 75% of growth in outputs, with

productivity or efficiency accounting for about 25% in the US during the 35 year period, 1870-1914.

His findings were at odds with and were completely overshadowed by later studies by Solow and Kuznets

Solow 1957 Highly influential paper providing conceptual clarity and sophistication. It integrated data and modelsfrom Douglas (1948), Tinbergen (1942), Abramovitz (1956) and Kendrick (1956) in a model (called Total

Factor Productivity or TFP and later renamed multi-factor productivity or MFP by the US Bureau of Labour

Statistics) that retained capital and labour as the productivity inputs and also identified technical change

as the other factor contributing to productivity and economic growth.

Solow measured output as NNP, labour as hours worked and capital input as real capital stock.

Dennison 1962,

1967

Used constant quality measures of labour input (age, sex & education as well as hours) in his pioneering

1967 paper Why growth rates differ. Quality is the term used by economists to describe the

composition, with a connotation of value, of input factors.

Griliches

andJorgenson

1967 Explained productivity change using the cleaner concept ofGNP rather than NNP as the output

measure; constant quality measures of both labour and capital inputs and a new concept of theproduction possibil ity frontier replacing the aggregate production function. They also used constant

quality price indices.

They found that changes in quality adjusted capital and labour inputs accounted for 85% of growth during

1945-65, with only 15% accounted for by TFP growth. Their work supported Tinbergens findings for the

earlier period that he studied. In 2009 Jorgenson, who has a chair at Harvard, wrote that the their use of

constant quality measures altered, irrevocably, the modelling of the interaction (substitution) between

labour, capital and technical change (Introduction xiii )

Solow

Kuznetz

1970

1971

Two papers published independently within a few months of each other reinforced the earlier work of

Solow and seemed to reinforce each other. The approach presented in the papers came to dominate

growth accounting, the study of economic growth, for decades. The conceptually stronger measurement

concepts of Griliches and Jorgenson were ignored.

Bureau of

Labour

statistics

1983 This US government agency introduced a new productivity measurement framework using GNP rather

than NNP as the output measure and a constant quality index of capital inputs. However it retained

retaining hours as the sole measure of labour input.

Jorgenson, et

al

1987 Seminal book reporting industry-level analysis of productivity growth in the post-war US economy.

Bureau of

Labour

statistics

1994 The Bureau updated its framework by incorporating constant quality measures of labour and a constant

quality price index. The Bureaus 1994 estimates of MFP overturned findings of Solow and Kuznets, but

more than a decade was to pass before the measures and framework were progressively prepared,

endorsed and applied in international standards..

OECD 2001 Published Measuring Productivity the first multinational standard, based on the BSL framework.

EU KLEMS 2004 EU funded KLEMS productivity measurement project begins using and extending the OECD measurement

methods. The data bases enable measures of quantities and prices of output and of capital (K), labour (L),

energy (E), material (M) and services (S) inputs at the industry level. KLEMS categories are now widely

used by national statistical agencies in making productivity estimates.

Jorgenson &

Landefeld

2006 Applied their approach and that of colleagues to develop an improved architecture for the US national

accounts. This framework also measured capital as a service, instead of capital as a stock. This prototype

system is limited to economy wide aggregates and is not yet broken down by industry sector.

Fraumeni Fraumeni, et al, describe principles, requirements and structures for sector level as opposed to national

level aggregate production accounts, in Jorgenson, Landefeld and Nordhaus (eds) 2006 XXX

62The information in this table is based on the introduction in Jorgenson, D (Ed) , Economics of Productivity, An Elgar Reference

Collection, Cheltenham, UK 2009


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UN

Statistical

Commission

2007 Approved the incorporation of capital measured as a service into the 1993 revision of the UN system of

national accounts (SNA). The earlier exclusion of these measures was a serious barrier to the use of

national accounts data to measure productivity and economic growth

Oulten 2007 Showed that Solows model was a special case of the Griliches and Jorgenson 1967 model

UN 2009 Released 2008 SNA, the new international standard, replacing the 1993 version.

The measurement issues are complex one example will illustrate the nature of the problems.

Relatively speaking, the simplest measure of labour input is hours worked. Using this measure an

hours work by a kitchen hand is equivalent to an hours work by a neurosurgeon or air traffic

controller. Common sense suggests that this equivalence is wrong. The 2008 SNA finally describes

the problem and a solution the construction of quality adjusted labour indices that incorporate

qualifications and experience to achieve more accurate measures of labour productivity.63

Even with the new standard in place, there are long lags updating national accounts. In 2008 theOECD wrote that Despite the progress and efforts in this area, the measurement of hours worked

still suffers from a number of statistical problems.... In principle, the measurement of labour inputs

should also take into account differences in workers educational attainment, skills and experience.

Accordingly the OECD has started(our emphasis) to develop adjusted labour input measures.64 In a

similar vein, in a recent speech Australian Productivity Commission Chairman Garry Banks said that

notwithstanding the notable achievements of our independent statutory agencies in building a

robust body of official statistics, we continue to face debilitating data gaps in priority policy areas.65

WHY HAS THE MYTH LIVED FOR SO LONG 2 Intangibles are still handicapped

Models are maps. Firm level accounts, national accounts and economic growth models are maps of

territories that change constantly. Accounts map the enormous diversity of stocks and flows of

assets and the financial resources that pay for them; year to year fluctuations can be large and,

while medium terms trends are more stable, the rates of change and the mixes are in constant flux.

As scientist Alfred Korzybski observed, the map is not the territory. Accounting maps mislead,

especially when they fail to cover the territory they claim to cover and they fail to measure changes

correctly.

Despite the improvements described above, accounts dont recognise some intangible assets and

more seriously, they mis-measure the life span and thus the value and benefits of many others.

While the gap between the book value and the higher market value (capitalisation) of companieswas recognised decades ago; the problem received little attention from statistical agencies and

economists modelling growth. Financial accounting standards consistently under-value the

contribution of intangibles, and therefore of services; and until corrections are made to the

standards they are likely to continue to do so.

The intangibles that are not recognised and therefore not measured include brand names,

reputation, customer lists, data bases, and parts of human capital and proprietary know-how. Some

of these items may not seem significant but most of us know the power and value of brands and

63UN SNA 2008 Section 19.55

64 OECD Compendium of Productivity Indicators, April 2008

65Ibid, Pages 9 and 17


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reputation. For example, firms gain long term profitable competitive advantages from their brand

names and reputation.66

Intangible assets that are recognised include67

:

computer software licenses

patents training

copyrights import quotas

motion picture films franchises

customer lists customer and supplier relationships

mortgage servicing rights marketing rights

The problem is that these intangible assets are, with the exception of purchased software,68

classified as expenses, rather than assets. By being expensed their value is normally written off in

one accounting period, a year, when businesses can reap benefits from the continuing use of the

assets for many years.

PROGRESS CORRECTING THE MISTAKES

Just as there are R&D breakthroughs there are scholarly breakthroughs. Bosworth and Trippet

presented their breakthrough research in conferences and papers in the years before the publication

of their 2004 book, Productivity in the US Service Sector.69 They demonstrated that service sector

labour productivity advanced 2.6% per annum in the six years from 1995, exceeding the 2.3% growth

of the manufacturing sector. Over the same period service sector MFP jumped from 0.3% a year in

to 1.5% a year.70

Bosworth and Trippet also pointed out that service sector trends were broad

based. 17 of the 29 service sectors in the US industrial classifications showed high MFP growth over

the period; and 24 of the 29 sectors had positive growth. They acknowledged improvements in the

scope of data collected by US statistical agencies enabling them to pursue their research.71

It must be acknowledged that while service productivity trends rose faster than manufacturing

trends, manufacturing productivity levels remain higher as shown by this graph (Figure 3) of trends

in the US and the EU15 over 20 years.72

66Philip Little, David Coffee, Roger Lirely, Beverly Little, Explaining variation in market to book ratios: do corporate

reputation ratings add explanatory power over and above brand values? Journal of Finance and Accountancy No 2 200667Accounting standards also specify how the assets can be acquired: by separate purchase, as part of a businesscombination, by a government grant, by exchange of assets, and by self-creation (internal generation)

68Purchased software was first recognised as an asset in accounting standards in 1988

69Triplett, J. and Bosworth, B. Productivity in the U.S. Services Sector Brookings Institution, Washington. 2004

70Ibid Chapter 1, Introduction, pages 1-3

71Ibid The also listed key factors behind the growth - deregulation, which led to a major internal

reorganisation of rail transport, the relatively fast uptake of new ICT by the banking and finance sector and in

retaining new technology (scanners and IT) and organisational changes that significantly improved efficiency72Douglas Koszerek, Karel Havik, Kieran Mc. Morrow, Werner Rger and Frank Schnborn, An overview of the

EU KLEMS Growth and Productivity Accounts, European Economy Economic Papers, European CommissionDirectorate for General for Economic and Financial Affairs, Number 290 October 2007 and Bart van Ark and

Pieter Woltjer (eds) THE EU KLEMS PRODUCTIVITY REPORT, An Overview of Results from the EU KLEMS

Growth and Productivity Accounts for the European Union, EU Member States and Major Other Countries in

the World, Groningen Growth and Development Centre, Issue no. 2, December 2008 and own calculations.


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Figure 3

The graph shows that the relation between service and manufacturing productivity levels has been

quite stable, with manufacturing figures being about 2.5 % higher in the US and about 2% higher in

the EU15 for the first decade with services closing the gap gradually in the EU15 and at a faster rate

in the US. Data for Australia is expected to be available in the coming months when the PC releases

its report Investment in intangible assets and Australia's productivity growth - sectoral estimates

The stability of these trends is quite striking when seen against most comparisons of growth

between sectors and across countries. The variations and fluctuations often point to factors other

than labour and capital, such as government policies that explain differences in growth rates.

Services may be closing the productivity gap but they are still handicapped by the productivity

figures attributed to them as a result of measurement error. Recent US data shows that from 1987

to 2006 MFP growth was negative in 15 of the 40 service sectors for which data is now available.73

There are real world reasons for negative trends, such as the slow decline of mature and dying

industries. However the negative figures still puzzle statistical agencies - they dont fit with evidence

of investments in R&D and ICT in the sectors. In the paper quoted here, senior Bureau of Labour

Statistics economists report statistical experiments to uncover the source of the puzzles. Their

conclusions, in line with those of others who conducted similar tests, suggest that that the MFP

measurement error could be around 0.26%, and that actual MFP could be a quarter of a per cent

higher than currently reported. They conclude that problems may remain in measuring someoutputs or that something else is responsible for negative productivity.74

A different approach, focusing on quantifying the effect of including intangibles in national accounts,

is taken by US Federal Reserve Board senior economist Carol Corrado and her colleagues.75

They

develop a model that has different assumptions to Solows model and, in particular, include

equations on how people make saving and investment decisions. Their work shows that there is no

73MFP growth also declined in a smaller number, 28 of the 86, or 33% of, US manufacturing sectors according to the BLS News release-

MULTIFACTOR PRODUCTIVITY TRENDS FOR DETAILED INDUSTRIES, 2006. In addition the number of service sectors with positive rather thannegative or zero MFP growth has increased from 21 to 28, or 66% of all sectors, since 1995. Both of these points support our argument

that the manufacturing service gap is declining. Source: Michael J Harper, Bhavani Khandrika, Randal Kinoshita and S Rosenthal,

Nonmanufacturing industry contributions to multifactor productivity, 1987 2006. Monthly Labour Review, June Page 23.74

Ibid, page 2975

Corrado, C.A., Hulten, C.R. and Sichel, D.E. (2006) Intangible Capital andEconomic Growth NBER Working Papers 11948Cambridge, MA: National Bureau of Economic Research; 2006

0

1

2

3

4

5

80 - 85 85 - 90 90 -95 96-2000 2000-05

us manuf US service EU15 services EU15 manuf

LABOUR PRODUCTIVITY GROWTH RATES


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theoretical basis for treating intangible capital differently to tangible capital in accounts. They test

their theory by identifying intangibles in the business world. Their list is shown in Table 4 below.76

Group Type/form of knowledge (k) capital Status - US National

accounts

Expenditure

$ Billions 99-2000

Computerized

information

K embedded in computer programs

and databases

Included, software is

capitalised155

Innovative property K acquired through both R&D and

non-scientific creative activities

Most spending, e.g.,

R&D is expensed425

Economic

competencies

K embedded in firms human

capital, reputation, brands,

building, improving organisational

structures, training

Not recognised

640

All groups 1,200

Their last step is to estimate expenditure on the intangibles from 1988 to 2000 and use their model

to determine which expenditures should be classed as fixed business investments (capital rather

than expenses) in their national accounting system.

They find that expenditure on intangibles doubled in dollar terms over the 12 year period and

increased from 10% to 13% of GDP.77 They also find that overall businesses invested in intangibles at

roughly the same rate at which they invested in tangibles. Applying their estimates to national

accounts they conclude that if intangibles were fully recognised measured productivity might

increase by around 0.25% per year. They endorse the value of work being done by statistical

agencies to develop satellite accounts (frameworks for more detailed data collections coveringparticular sectors or assets) and recommend the development of satellite accounts for as many of

the categories of intangible assets as possible.

The very similar estimates of measurement error by Bureau of Labour Statistics economists and

Corrado; 0.26% and 0.25% of labour productivity and overall productivity respectively, may be co-

incidental but more likely will be shown to be related. While the papers cite US data they also refer

to international standards and practices. Similar magnitudes of error can probably be expected for

Australia and other countries. Given that services are mostly intangibles; on a conservative

interpretation services productivity growth is under-estimated by 0.2% and on a bullish

interpretation, by up to 0.5%.

Three different forecast for the EU15, the US and Australia all estimate MFP growth of around 1%

per year for the next 20 years78, a figure slightly lower than in previous decades, except for the EU15,

where it is much lower. When measurement errors are eventually corrected its possible that the

growth rate will be corrected up to a rate that at least maintains long term (100 year) historical rates

for the US and Australia. However this is little cause for optimism. In its Intergenerational Report

2010, the Australian Treasury documents the negative effects on the wellbeing of our aging

76Ibid page 23

77

Ibid, pages 34, 38 Figures rounded to the nearest percentage.78See: [1] Carone, Giuseppe, Denis, Cecile, Mc Morrow, Kieran, Mourre, Gilles and Roger, Werner Long-term labour

productivity and GDP projections for the EU25 Member States, , MPRA Paper No. 744, August 2006, page 44 Online at

http://mpra.ub.uni-muenchen.de/744/ [2] Robert J. Gordon, Revisiting U. S. Productivity Growth over the Past Century with a

View of the Future, NBER Working Paper No. 15834, March 2010 Gordons estimate of 1.05 MFP growth is considerably

loer than his previous estimate of 1.8 and yet is still described as relatively optimistic *3+ DCITA, Forecasting productivity

growth: 2004 to 2024, Occasional economic paper, March 2006, table 1, page 4 1.0
http://mpra.ub.uni-muenchen.de/744/http://mpra.ub.uni-muenchen.de/744/http://mpra.ub.uni-muenchen.de/744/


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population of a failure to not merely maintain but to increase long term growth rates.79

The services sector is perhaps the most heterogeneous of all economic sectors. There have been

huge variations in both the growth and the productivity growth rates of different services across the

sector over the last 15 years. Over this period service sectors that are not thought of as productivity

leaders; were. Across the EU15 and the US, four sectors with very high growth rates of 3% to 7%

wholesale trade, financial services, other business services and retail trade dominated labour and

productivity growth for most of the period.80 These sectors grew at a much faster rate in the US

than in Europe because of greater deregulation and because the businesses in the sectors actively

adopted and adapted to the surge of new ICT. As mentioned earlier, there is a similar pattern in

Australia.81

Over the same period the productivity growth rates of large service sectors such as education, health

and government services were barely above zero. Apart from the impact of improved measures, the

degree of optimism or pessimism about productivity improvements across the entire sector and

especially in these sectors has little to do with their labour intensity and a great deal to do with the

existence and effectiveness of policies that promote trade, deregulation, labour mobility, and

innovation.

79The Treasury, Intergenerational Report 2010, Page 99

80Douglas Koszerek, Karel Havik, Kieran Mc Morrow, Werner Rger and Frank Schnbor An overview of the EU KLEMS

Growth and Productivity Accounts, European Commission Directorate General for Economic and Financial Affair. No 290

October 2007. Pages 17-2081

House of Representatives Standing Committee on Economics INQUIRY INTO RAISING THE PRODUCTIVITY GROWTH RATE

IN THE AUSTRALIAN ECONOMY, Commonwealth of Australia April 2010 Quoting a study by Hughes and Grinevich, Page 56


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Myth 6 Investment in innovation in the services sector is low

In this section we debunk a group of myths surrounding service innovation and draw attention to the

dangers of ignoring them. We put service innovation in a historical context, review progress and

problems measuring innovation, present evidence of the level of investment in service innovation inthe private sector, and outline productivity and innovation trends in the education sector.

A cluster of myths surround service innovation

The myth that investment in service innovation is low relative to innovation investment in other

sectors is one of a constellation of beliefs about service sector innovation. Services innovation is

considered to be of little economic consequence and merits little attention. Two beliefs contribute

to this view. First, the extent of service innovation is seen as quite limited. Second the impact and

value of service innovation is not measured and is not considered measureable in any practical way.

These beliefs have the effect of putting much service innovation beyond the ambit of public policy.

The growing importance of service sector innovation has received attention from government. The

executive summary of the 2008 PMSEIC Working Group on Science and Technology-Led Innovation

in Services for Australian Industries82 provides a succinct overview:

Services are critical to the prosperity of the nation employment (85%), GVA (78%) and

community well being

Services are growing rapidly internationally and are an increasingly dominant and pervasive

feature of advanced economies. Knowledge-intensive services are an important area of growth

(particularly for developed nations)

Services in

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