The Rise of the Service Economy

This paper models the relationship between product cycles, specialized capital, specialized skill, and non-homothetic preferences in the shift in production toward services over time. We explicitly model the decision of whether to produce services at home (using manufacturing goods as inputs) or in the market. Market production benefits from increasing returns in the use of specialized capital and skilled labor, but involves a utility cost due to join joint consumption. As the productivity grows, individual services follow a product cycle of moving from market services to home production as the costs of capital fall relative to the utility cost of joint consumption. Skill-intensive services follow this cycle more slowly and non-homothetic preferences increase demand for skill-intensive services over time, which drives a shift toward market services. The model predicts an increase in the share of services, the share of services produced by skilled labor, the level of skill, the return to skill, and the fraction of market services consumed by high income workers