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Making sense of services

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Services are important. Over 80% of UK workers are service sector workers, and the UK is the second-largest exporter of services in the world. We are a services superpower, and, according to some economists, services are the salvation for our stagnating economy.

But services – activities performed by producers for the benefit of customers, as opposed to tangible, exchangeable goods, which are separate from their producer – can mean a lot of things. Investment banking, IT support, yoga lessons and coffee brewed for us in cafes are all examples of activities sold for consumption. So, with such a broad sector, how do you make sense of it all?

This blog aims to help, suggesting a two-step approach for thinking about what high growth potential services look like at the local level. This is not the only way of thinking about services, but by breaking down the sector along these lines, you can quickly understand some of the important differences between services and what this implies for the local economy.

Step 1: tradeable vs non-tradable

One place to start is to understand which services are exportable (tradable), and which are not. Our blog on tradables and non-tradables goes into more detail, but in simple terms, tradable services are those which can be consumed outside of the area they are produced in, while consumption of non-tradable services is tied to the location of production.

A barbershop usually provides non-tradable services – you need to be in their shop to get your haircut. This means barbershops will generally be selling to consumers in their local area, though there might be exceptions where good barbers attract customers from further away, or barbers may travel to you. Non-tradables make up most of the local services sector providing the everyday needs of a population, like retail, hospitality, and housing services.

Tradable services aren’t tied to the physical location of their production and can be sold (traded) to consumers outside of the local area. Management consulting, architecture design, or in the modern zoom-equipped world, fitness training and dance teaching, are all examples of services which can be traded to be consumed away from the point of production.

The line between tradable and non-tradable is fuzzy – it is more of a continuum than a set division. Tourism for example involves services tied to a location sold primarily to people who live outside of it. The example of fitness training above shows how technology can transform non-tradable services into tradable ones.

But the distinction is helpful, and it will generally be the more tradable services that drive economic growth. This is because the size of a tradable service business is not limited by the size of the local market – successful ones can expand, to sell to more people at greater scale, without necessarily taking customers away from other local businesses. They also face a larger pool of competition which pushes them to be more effective and efficient in what they do by improving their productivity.

The opportunities for scale and incentives for productivity offered by tradable services are key to their potential for local economic growth. As explained in our blog on Gross Value Added (GVA), a local economy grows when it increases the amount of goods and services it produces. More customers, and greater pressures to be productive (do more with the same number of inputs) can mean more GVA.

Step 2: high and low skill intensity

The tradable services sector can be split further between services with higher and lower skills intensity to understand how each might contribute to different forms of growth.

Higher skilled tradable services – where the key productive input is human capital and skills – can include legal services, software development, or fashion design and consulting. The difference between £100 of hourly output in fashion consulting and £1000 of hourly output is in large part due to the skill of the consultant (or the consultancy’s marketers). More value in hourly output for the same input (the consultant) means higher productivity, and more profit to be shared. Because most of the productivity comes from the skills of the worker, more of that profit tends to go towards higher wages.

Examples of tradable lower skilled services might be call centres, back office administration services, or online content moderation. These are activities where, while productivity matters, the nature of the work being done means that productivity usually comes more through streamlined production and management processes, rather than human capital.

In an online content moderation centre for example, identifying rule breaking content is not a skills intensive process – it can be taught relatively quickly, and there are diminishing returns to increased skills, as even the best moderator can only look at so much content per hour. Productivity improvements will come from technology (like systems to sort content) and management processes (like having each moderator looking for a single type of content). Productivity in lower skill tradables can also come from efficiencies of scale – having moderators in one facility will be cheaper than across multiple ones. This means that lower-skilled tradable services might employ relatively large numbers of people, but wages will usually be lower, because the value added of any individual worker in production process is lower.

Differentiating between higher and lower skills intensity in tradable services helps understand what growth might look like. Higher wages from higher-skilled tradables can mean more spending in the local economy, benefitting and growing non-tradables too. At the same time, it may come with increased income inequality and pressures on housing costs, so growth may not benefit everyone in the local area.

With lower skilled tradables, growth may create a good number of employment opportunities, but wages will tend to be lower relative to higher skilled tradables. Because scale can be important for low skilled tradables, they might be concentrated in a smaller number of larger employers, which can make employment in this sector more vulnerable to job losses through business failure, offshoring, or automation.

Takeaways for local policy

Services come in all shapes and sizes, but looking at how easily they can be sold over distances, and how intensely skills are used to do them, will give a good picture of their larger place in a local economy, and what they mean for local growth.

Understanding where services employment is concentrated for a particular area can give an indication of the kind of challenges faced, and by extension the kind of policy issues to consider.