How can digital technologies spur service sector productivity growth?

One of the striking features of the performance of the UK economy since the financial crisis has been the contrast between strong jobs growth and insipid productivity growth, as the chart below illustrates.

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In some ways this has been a good thing, because unemployment never ballooned to the levels of over 3 million seen after the early 1980s and early 1990s recessions. It’s now down to only around 4%, the lowest level since the mid-1970s. The UK employment rate is at record highs of over 75%, driven in particular by a rise in the number of women working.

But there are limits to how much further employment rates can rise and, in the long run, you can’t raise living standards on a sustained basis without higher productivity growth.

Recent OECD research shows that a key reason why productivity growth has been relatively weak over the past decade, both in the UK and other developed countries, is that those economies have become increasingly focused on services, where productivity growth tends to be lower than in manufacturing. In the UK, services now account for around 85% of employment, up from only around 55% in 1960. Manufacturing employment fell from around 35% of total jobs to less than 10% over the same period.

The OECD analysis, in common with our own past research on productivity, highlights the slowdown in productivity after the 2008-9 crisis in sectors like financial services. But it also points to three more fundamental factors that drag down productivity growth in services, as summarised in this table:

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Let’s take a closer look at each of these three factors in turn, and the way in which new technologies can potentially help to overcome these barriers to service sector productivity growth.

1. Lack of competitive pressure – the spur from digital platforms

In general, it is easier to standardise goods than services, leading to the emergence of highly competitive mass markets in goods that can spread globally and deliver economies of scale that help to drive up manufacturing productivity.

By contrast, services generally need to be tailored more to particular customer circumstances and often have to be delivered in person rather than remotely. Therefore, competition tends to be local rather than global. There are exceptions, such as financial services, but otherwise this applies to a broad range of service activities from shops and restaurants to hairdressers and personal trainers.

Economists relate this in part to informational asymmetries between buyers and sellers that make it harder to assess quality and build up trust quickly for many services transactions. This can lead to high switching costs for customers who prefer suppliers with whom they have built up long-term relationships. This tends to reduce competitive pressure and, as a result, the incentive for suppliers to make productivity gains.

Digital platforms, by making services more transparent and providing rating systems to assess quality and build trust, can help to overcome these barriers. We have seen this, for example, with Amazon in retailing, TripAdvisor for travel and Airbnb for accommodation.

If service providers wish to survive in the long run, this added competitive pressure and customer scrutiny should spur them to boost productivity. However, these effects will take time to come through as it requires investment in deploying and perfecting these new technologies.

2. Lack of scale and low capital intensity – the spur from AI and robotics

Relative to the large scale capital investments needed in traditional industrial sectors, like manufacturing, mining and utilities, many services industries tend to be ‘capital-lite’, growing primarily by taking on more people rather than facilities, machinery and other assets. This pattern has been very evident in the UK economy over the past decade where strong jobs growth has been focused in service sectors like retail and wholesale, and hotels and restaurants.

As our research has shown, however, the next decade or two will bring increasing capability to automate cognitive and routine manual tasks in service sectors like retail, finance and transport, through the adoption of new technologies driven by AI, including robots, virtual assistants and driverless vehicles.

This should boost productivity in these sectors, the benefits of which will flow through to the wider economy through lower prices, new varieties of goods and services, and increased investment. Overall, we estimate that the net impact on UK jobs should be broadly neutral in the long run, though there could be considerable disruption and need for reskilling in the transition to this new technological future.

3. Limited international trade – the spur from digital communications

International trade, by allowing specialisation and knowledge transfer, has been a key driver of productivity improvements in industrial sectors for the past 250 years. But, as mentioned above, some services are inherently local due to the need to be delivered in person. I am not going to travel from the UK to China just to get a cheaper haircut or a better foot massage. At least for the moment, many such services also require the ‘human touch’ and associated social skills, which are not easy to automate (although even that could change in the long run, as recent developments in ‘human-friendly’ robots illustrate).

There are, however, some services with significant unrealised potential for increased international trade, especially as digital communications become ever cheaper and more reliable. Video conferencing, for example, can facilitate many international business services transactions but, at least in my experience, the technology has not always been 100% reliable in the past. But that is changing and new advances in areas like AI-driven instantaneous translation could add further to the potential to overcome barriers to services trade linked to physical distance and language. This, in turn, could boost productivity in sectors like professional and business services.

The challenge ahead – unlocking the potential of new technologies

We have seen that there is considerable unlocked potential to use new digital technologies to spur service sector productivity growth in the UK and beyond. But how can this potential be realised?

Governments have a role to play in supporting early stage research in technologies like AI and in the development of relevant skills. They can also take the lead in employing digital technologies in the public sector.

But, ultimately, it will come down to individual businesses to deploy these technologies across the economy. As with any new technology this will involve risks, but there are also big prizes to be won for successful early adopters.