Cost disease in service sector

ABSTRACT

A higher growth rate of the service sector prices, rather than prices in the manufacturing sector, through time is known as cost disease in the service sector. This paper investigates supply and demand-side reasons for cost disease. First, we present an analysis of the supply side of the cost disease, when services and manufacturing play their role both in the intermediate and final demand. Second, we consider a CES utility function for the consumer, which is a function of two commodity services and manufacturing. The results indicate that there are two reasons for cost disease to occur from the supply side in an economy: first, when the growth rate of total factor productivity and technological progress in services is less than that in the manufacturing sector, and second, when the elasticity of substitution between labor and manufacturing input in the services production function is large and elasticity of substitution in manufacturing production function is small. From the demand side, the result shows that the cost disease occurred if the growth rate of the income elasticity of service is more than the manufacturing sector through time.

KEYWORDS:

• Cost disease
• productivity growth
• income elasticity

Acknowledgements

The authors thank Abdolreza Talane, Mohammad Moeini, Zahra Heidarian and Mehdi Amir Miandaragh for suggestions and two anonymous referees for helpful comments.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1. A dot above a variable denotes the percentage change through time.

2. Baumol considers two scenarios in his models. Scenario 1 assumes that the ratio of nominal output of the two sectors is constant: , where denotes the output in service, is the output of manufacturing, is the price of service and is the price of manufacturing. Scenario 2 assumes that the ratio of real output of the two sectors is constant: ; if we assume the consumption equals with the output: , then .