Friday 31 January 2020

Market Structures in Services

Services have long been thought to suffer from a productivity problem. In fact, there is a long-standing concern that services add little to the economy. Particularly compared to manufacturing, which is typically more receptive to technological improvements, services productivity looks bleak.

What’s more, for various technical reasons a natural tendency exists in many OECD economies for services to expand as these countries become richer.

This creates a double whammy: if productivity in services are low to start with, plus a natural expansion of services exists in many rich economies, then ultimately the sector becomes a real drag on overall economic growth the richer we get. That’s the long-held view.

However, this view becomes increasingly debunked. A new report that ECIPE has developed, which was commissioned by the Bertelsmann Foundation, now shows that not all services are unproductive. In fact, some services show healthy productivity growth patterns.

Therefore, good evidence is starting to come up proving the point that services do not need to weigh down on the economy. On the contrary, there is enough potential for services to perform better. The truth is that there is a lot of productivity in many services sectors that remains unrealized.

What can explain this? For one, our study shows that the low pick-up of digital technologies by services firms is an important factor to blame. For instance, using Eurostat data, the report shows that the share of business services firms in the UK and Poland that pick up digital technologies (as measured by our self-developed E-business indicator) is only half the rate of Denmark and Finland, as shown in the figure below.

However, it’s not only digital technologies that we need to look at. Over the years, services have also become increasingly tradable, a factor that further causes productivity growth to happen. Actually, it’s also thanks to digital technologies that services have become more tradable in recent time, but not enough as many countries still hold back their trade potential in services.

Here comes the second explanation: regulatory policies in services restricting their tradability across borders, in combination with all sorts of other digital trade restrictions, such as those on online platforms, are still relatively high for various countries. That is particularly true in countries where firms exhibit a low pick up of digital technologies, as shown in the report.

As a result, there is a straightforward negative relationship between the regulatory and digital barriers in services that exists and the absorption rate of digital technologies by services firms.

One conclusion of the report is therefore that both categories of regulatory restrictions prevent markets to function as they should and allow markets to pick up digital technologies. Digital penetration is restricted, which hinders potential productivity gains from being realized in services.

But that’s not all what the report has to say. As regulatory restrictions hold back trade and competition in services sectors, their markets are likely to be distorted. This point is crucial. We show that distorted markets structures in services, as measured as the “productivity gap”, i.e. the unequal distribution of firm productivity in a market, actually exists in those countries where services firms exhibit a relatively low pick-up of digital technologies.

So here there is a second straightforward negative relationship: the greater the extent to which services markets are distorted, the lower the absorption rate of digital technology by services firms, as illustrated in the figure below.

Services should in principle become more productive because they can. If the market lacks the right incentives by having a low exposure to competition and trade, firms are not inclined to pick up digital technologies, which prevents productivity from being lifted in many services.

In fact, we calculate that when services firms do use digital technologies this effect is likely to be entirely nullified by the distorted market structures in which they operate. That’s a forgone loss and greatly inhibits services sectors from realizing their productivity potential.

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