CHAPTER 1

The Role of Services in an Economy

Services lie at the very hub of economic activity in any society. Writing about the role of the service sector in world development, Dorothy Riddle formulated the economic model shown in Figure 1.1. This model shows the flow of activity among the three principal sectors of the economy: extractive (mining and farming), manufacturing, and service, which is divided into five subgroups. All activity eventually leads to the consumer. Examples of services in each of the five subgroups are: Business services. Consulting, finance, banking Trade services. Retailing, maintenance, repair Infrastructure services. Communications, transportation Social/personal services. Restaurants, health care Public administration. Education, government Infrastructure services, such as transportation and communications, are the essential links between all sectors of the economy, including the final consumer. In a complex economy, both infrastructure and trade services function as intermediaries between the extractive and manufacturing sectors and as the channel of distribution to the final consumer. Infrastructure services are a prerequisite for an economy to become industrialized; therefore, no advanced society can be without these services. In an industrialized economy, specialized firms can supply business services to manufacturing firms more cheaply and efficiently than manufacturing firms can supply these services for themselves. Thus, more and more often we find advertising, consulting, financing, testing, and other business functions being provided for the manufacturing sector by service firms. Except for basic subsistence living, where individual households are self-sufficient, service activities are absolutely necessary for the economy to function and to enhance the quality of life. Consider, for

example, the importance of a banking industry to transfer funds and a transportation industry to move food products to areas that cannot produce them. Moreover, a wide variety of social and personal services, such as restaurants, lodging, cleaning, and child care, have been created to move former household functions into the economy. Public administration plays a critical role in providing a stable environment for investment and economic growth. Services such as public education, health care, well-maintained roads, safe drinking water, clean air, and public safety are necessary for any nation's economy to survive and people to prosper. Thus, it is imperative to recognize that services are not peripheral activities but rather integral parts of society. They are central to a functioning and healthy economy and lie at the heart of that economy. The service sector not only facilitates but also makes possible the goods-producing activities of the extractive and manufacturing sectors. Services are the crucial force for today's change toward a global economy. CHAPTER PREVIEW We begin with a discussion of economic evolution, finding that modern industrialized economies are dominated by employment in the service sector industries. This represents a natural evolution of economies from preindustrial to industrial and, finally, to postindustrial societies. The economic activity of a society determines the nature of how its people live and how the standard of living is measured. The nature of the service sector is explored in terms of employment opportunities, contributions to economic stability, and sources of economic leadership. Finally, the role of the service manager is discussed in terms of innovation, opportunities for new services based on demographic trends, and the many managerial challenges in an expanding service economy. ECONOMIC EVOLUTION In the early 1900s, only three of every ten workers in the United States were employed in the services sector. The remaining workers were active in agriculture and industry. By 1950, employment in services accounted for 50 percent of the workforce. Today, services employ about eight out of every ten workers. During the past 90 years, we have witnessed a major evolution in our society from being predominantly manufacturing-based to being predominantly service-based. Economists studying economic growth are not surprised by these events. Colin Clark argues that as nations become industrialized, there is an inevitable shift of employment from one sector of the economy to another1.As productivity increases in one sector, the labor force moves into another. This observation, known as the Clark-Fisher hypothesis, leads to a classification of economies by noting the activity of the majority of the workforce.
1

Colin Clark, The Conditions of Economic Progress, 3d ed., The Macmillan Co., London, 1957.

Table 1.1 describes five stages of economic activity. Many economists, including Clark, limited their analyses to only three stages, of which the tertiary stage was simply services. We have taken the suggestion of Nelson N. Foote and Paul K. Hatt and subdivided the service stage into three categories.2 Today, an overwhelming number of countries are still in a primary stage of development. These economies are based on extracting natural resources from the land. Their productivity is low, and income is subject to fluctuations based on the prices of commodities such as sugar and copper. In much of Africa and parts of Asia, more than 70 percent of the labor force is engaged in extractive activities. Based on the work activity of their populations, however, many of the so-called advanced industrial nations would be better described as service economies. Table 1.2 is a partial list of industrialized countries ranked in order of the percentage of those employed in service-producing jobs. This table contains some surprises, such as finding Canada and Australia (known for their mining industries) high on the list. Several observations can be made: global economic development is progressing in unanticipated directions, successful industrial economies are built on a strong service sector, and just as it has in manufacturing, competition in services will become global. In fact, many of the largest commercial banks in the world at present are owned by the Japanese. Trade in services remains a challenge, however, because many countries erect barriers to protect domestic firms. For example, India and Mexico, among others, prohibit the sale of insurance by foreign companies.
2

N. N. Foote and P. K. Hatt, "Social Mobility and Economic Advancement," American Economic Review, May 1953, pp. 364-378.

As Figure 1.2 shows, the service sector now accounts for more than three-fourths of total employment in the United States, which continues a trend that began more than one century ago. Therefore, based on employment figures, the United States can no longer be characterized as an industrial society; instead, it is a postindustrial, or service, society. STAGES OF ECONOMIC DEVELOPMENT Describing where our society has been, its current condition, and its most likely future is the task of social historians. Daniel Bell, a professor of sociology at Harvard University, has written extensively on this topic, and the material that follows is based on his work.3 To place the concept of a postindustrial society in perspective, we must compare its features with those of preindustrial and industrial societies. Preindustrial Society The condition of most of the world's population today is one of subsistence, or a preindustrial society. Life is characterized as a game against nature. Working with muscle power and tradition, the labor force is engaged in agriculture,, mining, and fishing. Life is conditioned by the elements, such as the weather, the quality of the soil, and the availability of water. The rhythm of life is shaped by nature, and the pace of

work varies with the seasons. Productivity is low and bears little evidence of technology. Social life revolves around the extended household, and this combination of low productivity and large population results in high rates of underemployment (workers not fully utilized). Many seek positions in
3

Daniel Bell, The Coming of Post-Industrial Society: A Venture in Social Forecasting, Basic Books, Inc., New York, 1973.

services, but of the personal or household variety. Preindustrial societies are agrarian and structured around tradition, routine, and authority. Industrial Society The predominant activity in an industrial society is the production of goods. The focus of attention is on making more with less. Energy and machines multiply the output per labor-hour and structure the nature of work. Division of labor is the operational "law" that creates routine tasks and the notion of the semiskilled worker. Work is accomplished in the artificial environment of the factory, and people tend the machines. Life becomes a game that is played against a fabricated nature--a world of cities, factories, and tenements. The rhythm of life is machine-paced and dominated by rigid working hours and time clocks.

An industrial society is a world of schedules and acute awareness of the value of time. The standard of living becomes measured by the quantity of goods, but note that the complexity of coordinating the production and distribution of goods results in the creation of large bureaucratic and hierarchic organizations. These organizations are designed with certain roles for their members, and their operation tends to be impersonal, with persons treated as things. The individual is the unit of social life in a society that is considered to be the sum total of all the individual decisions being made in the marketplace. Of course, the unrelenting pressure of industrial life is softened by the countervailing force of labor unions. Postindustrial Society While an industrial society defines the standard of living by the quantity of goods, the postindustrial society is concerned with the quality of life, as measured by services such as health, education, and recreation. The central figure is the professional person, because rather than energy or physical strength, information is the key resource. Life now is a game played among persons. Social life becomes more difficult, because political claims and social rights multiply. Society becomes aware that the independent actions of individuals can combine to create havoc for everyone, as seen in traffic congestion and environmental pollution. The community rather than the individual becomes the social unit. Bell suggests that the transformation from an industrial to a postindustrial society occurs in many ways. First, there is a natural development of services, such as transportation and utilities, to support industrial development. As labor-saving devices are introduced into the production process, more workers engage in nonmanufacturing activities, such as maintenance and repair. Second, growth of the population and mass consumption of goods increase wholesale and retail trade, along with banking, real estate, and insurance. Third, as income increases, the proportion spent on the necessities of food and home decreases, and the remainder creates a demand for durables and then for services. Ernst Engel, a Prussian statistician of the nineteenth century, observed that as family incomes increase, the percentage spent on food and durables drops while consumption of services that reflect a desire for a more enriched life increases correspondingly. This phenomenon is analogous to the Maslow hierarchy of needs, which says that once the basic requirements of food and shelter are satisfied, people seek physical goods and, finally, personal development. However, a necessary condition for the "good life" is health and education. In our attempts to eliminate disease and increase the span of life, health services become a critical feature of modern society. Higher education becomes the condition for entry into a postindustrial society, which requires professional and technical skills of its population. Also, claims for more services and social justice lead to a growth in government. Concerns for environmental protection require government intervention and illustrate the interdependent and even global character of postindustrial problems. Table 1.3 summarizes the features that characterize the preindustrial, industrial, and postindustrial stages of economic development. NATURE OF THE SERVICE SECTOR For many people, service is synonymous with servitude and brings to mind workers flipping hamburgers and waiting on tables. However, the service sector that has grown significantly over the past 30 years cannot be accurately described as composed only of low-wage or low-skill jobs in department stores and fast-food restaurants. Instead, as Table 1.4 shows, the fastest-growing jobs within the service sector are in finance, insurance, real estate, miscellaneous services (e.g., health, education, professional services), and retail trade. Note that job areas whose growth rates were less than the rate of increase in total jobs (i.e., less than 31.8 percent) lost market share, even though they showed gains in their absolute numbers. The exceptions are in mining and manufacturing, which lost in absolute numbers and thus showed negative growth rates. This trend should accelerate with the end of the cold war and the subsequent downsizing of the military and defense industry. Changes in the pattern of employment will have implications on where and how people live, on educational requirements, and, consequently, on the kinds of organizations that will be important to that society. Industrialization created the need for the semiskilled worker who could be trained in a few weeks to perform the routine machine-tending tasks. The subsequent growth in the service sector has caused a shift to -collar occupations. In the United States, the year 1956 was a turning point. For the first time in the history of industrial society, the number of -collar workers exceeded the number of blue-collar work-

ers, and the gap has been widening since then. The most interesting growth has been in the managerial and professional-technical fields, which are jobs that require a college education. Figure 1.3 shows the shift in employment from an industrial society of machine operators to a postindustrial society of professional and technical workers. Today, service industries are the source of economic leadership. During the past 30 years, more than 44 million new jobs have been created in the service sector to absorb the influx of women into the workforce and to provide an alternative to the lack of job opportunities in manufacturing. The service industries now account for approximately 70 percent of the national income in the United States. Given that there is a limit to how many cars a consumer can use and how much one can eat and drink, this should not be surprising. The appetite for services, however, especially innovative ones, is insatiable. Among the services presently in demand are those that reflect an aging population, such as geriatric health care, and others that reflect a twoincome family, such as day care. The growth of the service sector has produced a less cyclic national economy.During the past four recessions in the United States, employment by service industries has actually increased, while jobs in manufacturing have been lost. This suggests that consumers are willing to postpone the purchase of products but will not sacrifice essential services like education, telephone, banking, health care, and public services such as fire and police protection. Several reasons can explain the recession-resistant nature of services. First, by their nature, services cannot be inventoried, as is the case for products. Because consumption and production occur simultaneously for services, the demand for them is more stable than that for manufactured goods. When the economy falters, many services continue to survive. Hospitals keep busy as usual, and, while commissions may drop in real estate, insurance, and security businesses, employees need not be laid off. Second, during a recession, both consumers and business firms defer capital expenditures and instead fix up and make do with existing equipment. Thus, service jobs in maintenance and repair are created. ROLE OF THE SERVICE MANAGER Successful growth of the service sector will depend on innovation and skilled management that will promote an ethic of continuous improvement in both quality and productivity. Innovation The product development model that is driven by technology and engineering could be called a push theory of innovation. A concept for a new product germinates in the laboratory with a new scientific discovery that becomes a solution looking for a problem. The 3M experience with Post-it notes is one example of this innovation process. The laboratory discovery was a poor adhesive, which found a creative use as a glue for notes to be attached temporarily to objects without leaving a mark when removed. Information technology provides many examples of the push theory of service innovation. The growth of the World Wide Web as a place of commerce is changing the delivery of services. People can browse the Internet for every imaginable product or service from around the world. In fact, to stay competitive, many businesses may soon be required to offer new cost-effective and convenient services for customers who have home computers equipped with modems. For services, the Cash Management Account introduced by Merrill Lynch is an example of the pull theory of innovation. During the period of high interest rates in the 1980s, a need arose to finance short-term corporate cash flows, and individual investors were interested in obtaining an interest rate that was higher than those currently available on passbook bank deposits. The French Revolution provides another view of service formation, this time based on changing demographics. Before the revolution, only two restaurants were in existence in Paris; shortly afterward, there were more than 500. The dispossessed nobility had been forced to give up their private chefs, who found that opening their own restaurants was a logical solution to their unemployment. For a manufacturing firm, product innovation is often driven by engineering-based research, but in service firms, software engineers and programmers are the technocrats who develop new innovations. Customers interact directly in the service process; therefore, the focus on meeting customer needs drives service innovation and explains why marketing plays such a central role in service management.

The introduction of a new technology, however, does have an ancillary effect on service innovation. For example, the VCR has spawned a video rental business and created a renewed demand for old movies. Thus, the creation of an innovative service enterprise has many sources. Service innovation also can arise from exploiting information available from other activities. For example, records of sales by auto parts stores can be used to identify frequent failure areas in particular models of cars. This information has value both for the manufacturer, who can accomplish engineering changes, and for the retailer, who can diagnose customer problems. In addition, the creative use of information can be a source of new services, or it can add value to existing services. For example, an annual summary statement of transactions furnished by one's financial institution has added value at income tax time. Service innovators face a difficult problem in testing their service ideas. The process of product development includes building a laboratory prototype for testing before full-scale production is initiated. New services are seldom tested before they are launched in the marketplace, however, which provides a partial explanation for the observed high failure rate of service innovations, particularly in retailing and restaurants. At present, new service concepts usually must prove themselves in the field instead of in a "laboratory" setting. Methods to simulate service delivery systems before their introduction must be developed. One example of an effort in this direction is provided by Burger King, which acquired a warehouse in Miami to enclose a replica of its standard outlet. This mock restaurant was used to simulate changes in layout that would be required for the introduction of new features such as drive-through window service and a breakfast menu. The marketing concept of a "focus group," consisting of customers selected to review service proposals in a roundtable discussion, is another means of evaluating new service ideas. The difficulty in service prototyping is the need to evaluate the service delivery system in operation where technology, service providers, and customers are integrated. Social Trends Three social trends will have a major influence on services: the aging of the U.S. population, the growth of two-income families, and the increase in the number of single people. As the baby boom generation matures, the percentage of older people in America will increase greatly. Currently, 6.2 million Americans are older than 80 years old. By the year 2000, this figure is projected to be 8 million, and by the year 2010, the number will be 21.1 million.4 This aging of the population will create opportunities for retired people to take part-time work, in part because of fewer young people entering the workforce. In the future, companies facing
4

Susan B. Garland, "The Graying of America Spawns a New Crisis," BusinessWeek, Aug. 17,1987, pp. 6062. a labor shortage may be forced to hire retired workers, at least on a temporary or part-time basis, and this trend is already apparent. For example, The Travelers' Insurance Company has developed a Retirement Job Bank of its retired employees that is used as a source of skilled labor to fill in during peak work times, absences, and vacations.5 Also, elderly people are living longer and have more active lives, with consequent demands on health care, public transportation, and leisure services. The two-income family is fast replacing the traditional family of the 1950s, which consisted of a husband, a housewife, and two children. The new two-income family unit has created demands for services such as day care, preschool, and "eating out" services. For two-income families, time is at a premium, and they are willing to pay for services that give them more free time. As a result, many new services have been created that focus exclusively on saving time for these individuals. Examples include home delivery services and personal shopping services for everything from gifts to clothing. Increased disposable income from two wage earners also may translate into increased demands for leisure, entertainment, and tourism services. The number of single people in America is growing, and this trend is expected to continue.6 Recreational sports and other group-oriented activities will be in demand, because they will offer the opportunity to meet other single people. Home food delivery services that now offer pizza may find a market for the delivery of gourmet meals to single people.

All of these social trends support the notion that the home will become a sanctuary for people in the future, and that sanctuary will be supported by a communication system bringing video and electronic messages from the global community into the living room. Management Challenges Complacency in the management of service industries, inattention to quality, disregard for customer concerns, and exclusive attention to short-term financial orientation all threaten to undermine the service sector of the economy. It is important to realize that under the pressures just mentioned, the service sector could become as vulnerable to foreign competition as the manufacturing sector has. The following discussion of the competitive challenges in services is based in part on a classic article by James Brian Quinn and Christopher E. Gagnon, in which they caution the reader that services could follow manufacturing into decline.7 Quinn and Gagnon point out that the economic trends in services are undeniable, and that they are similar to the recent experience in manufacturing. Since the early 1980s, the net positive trade balances in services have fallen steadily. For example, a serious loss of market share has been experienced in international airline travel as the once powerful carriers, Pan Am and TWA, de
5

Harold E. Johnson, "Older Workers Help Meet Employment Needs," Personnel journal, May 1988, pp.100-105.
6 7

Edward Cornish, "The Coming of the Singles Society," The Futurist, July-August 1987, p. 2.

J. B. Quinn and C. E. Gagnon, "Will Services Follow Manufacturing into Decline?" Harvard Business Review, November-December 1986, pp. 95-103. clared bankruptcy in the face of foreign competitors that upgraded their fleets and emphasized quality of service. Purely domestic services are not immune to foreign competition, either. Direct foreign investment in the U.S. service sector is substantial. Many famous names in services, such as 20th Century Fox, Stouffer's Hotels and Restaurants, Marshall Field, and Giant Foods, are now foreign-owned. In California, Japanese banks are changing the nature of competition and winning accounts by taking a much longer view in making business loans to new ventures at very competitive interest rates. The nature of competition in services also is changing, because the forces of deregulation and new technologies have restructured service industries in recent years. Deregulation has caused significant restructuring in the domestic airline industry, with successful new regional carriers appearing (e.g., Southwest and Alaska) and old giants declaring bankruptcy (e.g., Eastern and Braniff). New route networks have formed around the hub-and-spoke concept to provide service in a more cost-effective manner. The use of computer reservation systems has allowed airlines to provide a variety of competitive fares based on preselling seats at a discount; thus, they can ensure high-load factors and profitable operations. Service managers need to understand these new competitive dimensions to take advantage of opportunities to improve service quality and performance, thereby creating barriers to the entry of foreign and domestic competitors. Competing on the traditional dimensions of quality, price, and availability will always be important, but consider the following additional dimensions based on the use of information technologies, which are the source of the value added by service firms. Economies of Scale Economies of scale are realized when fixed costs in new technology are allocated over increased volume; the result is reduced cost per transaction. For example, automation of the securities trading process changed the entire structure of the industry and made possible the handling of daily volumes in the millions of shares. The old system of transferring shares from seller to buyer manually has been replaced by an electronic clearinghouse. Without using a central electronic depository, Wall Street could not function as an efficient securities marketplace. New and expensive medical technologies, such as the CAT or MRI scanners, have resulted in regional treatment centers and the concentration of medical services at these large hospitals. Thus, we find that the introduction of capital-intensive technologies has resulted in the concentration of services and aggregation of demand. Economies of Scope

Economies of scope, a new and somewhat controversial concept, describes the benefits that are realized when entirely new service products move through established distribution networks with little added cost. For example, once the communications and information-handling technologies are in place, a much wider set of services can be distributed to a more diffuse customer base at low marginal costs. In addition, this information technology base can offer strategic benefits through more rapid product introduction and faster response to competitors' moves. Insurance companies that automated their back-office operations in the 1960s to improve billing and collections found themselves with a competitive advantage during the interest rate explosion of the 1980s. Companies had to alter their products rapidly to attract interest-sensitive new customers and to avoid the losses from current customers borrowing against their policies at low interest rates. Only those companies with the flexibility of computer information systems could design and deploy their products quickly enough to obtain a competitive edge. Some companies added new computer-intensive financial services such as cash management accounts to attract funds. A very common example of economies of scope can be found at any local convenience store that has added self-service gasoline and microwave meal service to its original grocery stocks. Complexity Since deregulation, the domestic airline industry has witnessed an ever-changing fare structure so complex that fares can no longer be published in flight schedules. Computerized reservations systems allow airlines to analyze the status of flights and customer buying behavior in such detail that they can optimize margins on each type of demand and meet competitors' responses. The ability to monitor hundreds of flights and make seat allocation decisions on an hourly basis is accomplished with significant computer support and software algorithms. This special use of computer information to manage perishable capacity and to maximize revenues is called yield management, a topic that will be treated in detail in Chapter 13, Managing Capacity and Demand. Sophisticated use of information systems to manage complexity also can be found in retail stores. Barcode scanners give instant feedback on sales and inventory movements, which results in a better match of inventory to customers' needs. This information has enabled major chains to customize the stock featured at their stores so that they can accommodate regional preferences and compete better with small specialty shops. Boundary Crossing Competition among services once thought to be in different industries is now becoming commonplace, some of the most striking examples are found in the financial services. Today, many consumers use their banks and brokers almost interchangeably, because neither is seriously restricted in its scope of operations. Banks, insurance companies, and brokerage houses offer a similar range of financial products and services and now compete in one market, without the traditional boundaries. As noted earlier, convenience stores now compete with fast-food restaurants as well as with service stations, and even manufacturing firms such as GM and Ford have entered the service arena by offering financing services to auto buyers. The ability of auto manufacturers to finance the sales of their cars has allowed them to offer loans at reduced interest rates as an incentive to buy their products. In fact, at present, General Motors Acceptance Corporation is the nation's largest single holder of consumer debt. Thus, we can readily see that competition in services can come from any quarter. International Competitiveness The worldwide service trade is growing with the help of cheaper and more flexible transportation and communication capabilities. During the 1960s, only 7 percent of the U.S. economy was exposed to foreign competition. Today, that figure is greater than 75 percent, and it is still climbing. With the world heading toward a single economy, or "global village," this trend toward greater international competition is expected to continue for both manufacturing and service firms. 8 For example, the purchase of Flying Tigers by Federal Express has enabled it to guarantee delivery anywhere in the world in two days; as a result, it joins DHL and others for a share in the growing business of global package delivery. Geographic distance is no longer a barrier between nations, and the challenges of ethnic diversity in the domestic market are multiplied by the difficulties of delivering a service in an international market with different cultural and language barriers. SUMMARY

We have discovered that the modern industrial economies are dominated by employment in the service sector. Just as farming jobs migrated to manufacturing in the nineteenth century under the driving force of labor-saving technology, manufacturing jobs in due time migrated to services. Chapter 2 will conclude our discussion of the role of services in our new society and prepare us for developing new managerial skills by arguing that the distinctive characteristics of services require an approach to management significantly different from that found in manufacturing. KEY TERMS AND DEFINITION Clark-Fisher hypothesis a classification of economies according to the activity of the majority of the workforce. Economies of scale allocation of the fixed costs of technology over an in creased volume of sales (e.g., airline reservation system). Economies of scope movement of new service products through established distribution networks (e.g., convenience stores adding self-serve gasoline pumps). Industrial society a society dominated by factory work in mass-production industries. Postindustrial society a service society in which people are engaged in information, intellectual, or creative-intensive activities. Preindustrial society an agrarian society structured around farming and subsistence living. Pull theory of innovation service innovations that are driven by customer needs. Push theory of innovation product innovations that originate in scientific laboratories. TOPICS FOR DISCUSSION 1. Illustrate how a person's lifestyle is influenced by the type of work that he or she does. For example, contrast a farmer, a factory worker, and a schoolteacher. 2. Is it possible for an economy to be based entirely on services? 3. Speculate on the nature of the society that may evolve after the post-industrial society. 4. What would be the impact on the service industry of the emerging social trend called voluntary simplicity (i.e., people choosing to spend less time working to enjoy life more)? 5. Comment on the role that marketing plays in the service innovation process.
8

John Greenwald, "Down and Down the Dollar Goes," time, Sept. 7,1992, pp. 36-37.

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