The service paradox and endogenous economic growth

“Stagnant services” [Baumol, W.J., Blackman, S.A.B., Wolff, E.N., 1989. Productivity and American Leadership. MIT Press, Cambridge (Mass.)] are characterised by low productivity growth and rising prices, but also, and paradoxically, by output growth proportional to the rest of the economy, and hence by an expanding employment share, with a negative effect on aggregate productivity growth. This paper considers that many of these services, inclusive of education, health and cultural services, contribute to human capital formation, thus enhancing growth. This effect is distinguished according to whether it is a side-effect of spending on services or an intentional investment by households, as in Lucas’ model [Lucas, R.E., 1988. On the mechanics of economic development. Journal of Monetary Economics 22, 3–42.] Preferences for services are assumed to rise with income. The main result is that the productivity of stagnant services and their quality displayed in raising human capital play a central role in opposing the negative Baumol effect on growth, and in reinforcing the explanation of the paradox.