Study on business-related services

Transcription

1 Study on business-related services Main report Client: European Commission, DG Enterprise and Industry Rotterdam, 12 December 2012

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3 Study on business-related services Main report Client: European Commission, DG Enterprise and Industry Nora Plaisier Gert-Jan Linders Erik Canton Rotterdam, 12 December 2012

4 About Ecorys At Ecorys we aim to deliver real benefit to society through the work we do. We offer research, consultancy and project management, specialising in economic, social and spatial development. Focusing on complex market, policy and management issues we provide our clients in the public, private and not-for-profit sectors worldwide with a unique perspective and high-value solutions. Ecorys remarkable history spans more than 80 years. Our expertise covers economy and competitiveness; regions, cities and real estate; energy and water; transport and mobility; social policy, education, health and governance. We value our independence, integrity and partnerships. Our staff are dedicated experts from academia and consultancy, who share best practices both within our company and with our partners internationally. Ecorys Netherlands has an active CSR policy and is ISO14001 certified (the international standard for environmental management systems). Our sustainability goals translate into our company policy and practical measures for people, planet and profit, such as using a 100% green electricity tariff, purchasing carbon offsets for all our flights, incentivising staff to use public transport and printing on FSC or PEFC certified paper. Our actions have reduced our carbon footprint by an estimated 80% since ECORYS Nederland BV Watermanweg GG Rotterdam P.O. Box AD Rotterdam The Netherlands T +31 (0) F +31 (0) E netherlands@ecorys.com Registration no W 2 SJ-M/GJL FN97638Rep

5 Table of contents Preface 5 Summary 7 1 Introduction 11 2 Services in the EU economy: some key issues Business services in the EU economy: overview of the sector 13 Industry definition 13 Industry overview 13 Importance of business services in the sector structure of the EU economy Productivity in business services Interaction with downstream sectors 22 Outsourcing 22 Co-production 23 Knowledge spill-overs Information asymmetry and the role of standards 24 Current status of standards development 25 The role of service standards 26 Standardization versus customization in services Selection of sectors for detailed analysis 27 3 Main findings on advertising and market research Sector overview Competitive position Market conditions, downstream relations and business response Framework and regulatory conditions SWOT analysis 34 4 Main findings on design Sector overview Competitive position Downstream relations and market conditions Framework and regulatory conditions SWOT analysis 37 5 Main findings on facility management Sector overview: industrial cleaning Competitive position of the industrial cleaning sector Downstream relations and market conditions of the industrial cleaning sector Framework and regulatory conditions for the cleaning sector SWOT analysis for the cleaning sector Sector overview for private security services Competitive position of private security services Downstream relations and market conditions for private security services Framework and regulatory conditions for private security services 44 Study on business-related services 3

6 5.10 SWOT analysis for private security services 45 6 Main findings on technical consulting Sector overview Competitive position Downstream relations and market conditions Framework and regulatory conditions SWOT analysis 50 7 SWOT analysis of business services: a synthesis of the sector studies Strengths Weaknesses Opportunities Threats 53 8 Market failures relevant to business services Market structure- existence of entry and exit barriers? Asymmetric information Spill-over effects 59 9 Policy recommendations Reducing information asymmetry in the interaction with the client Enhancing innovation and knowledge spill-overs Addressing entry and exit barriers 65 References 69 4 Study on business-related services

7 Preface This report presents the results of the study on business-related services, which is carried out by Ecorys for the European Commission (DG Enterprise) under the framework contract for Sector Competitiveness Studies (SCS).The project started in September 2011 with data analysis and a literature review, the results of which were presented in the interim report in January In addition, four case studies were conduced by the following experts: Gert-Jan Linders, Lars Meindert and Susan Warmerdam (Ecorys) conducted the study on Advertising and Market research. Isabelle de Voldere (IDEA) was leading the study on design services, Paul Baker (Ecorys) the study on Facility Management (industrial cleaning and private security services), and Benita Kidmose Rytz (DTI) the study on technical consulting. This report contains a summary of the literature and case studies, provides a synthesis of the strengths, weaknesses, opportunities and threats, identifies market failures and formulates policy recommendations for business services. We would like to thank the interviewees for their co-operation in this study, and Henk Kox (CPB) for constructive feedback on draft versions of this report. We also want to thank officials from the European Commission, and in particular Peder Christensen, Chris Allen and Jerneja Jug, for their guidance and feedback during all stages of the project. Erik Canton Teamleader Study on business-related services 5

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9 Summary Background and objectives Over the last few decades, the EU has become a service economy as service sectors have grown faster than manufacturing sectors, and services now account for some 70 percent of the EU economy. This also implies that the performance of the EU economy will largely depend on the performance of the service sectors. In this report we concentrate on an important segment of the service sectors, namely business services. The business service sector currently accounts for almost 2000 billion euro turnover and 24 million people are directly employed in the sector in a total of more than 5 million enterprises. Several studies have shown that the level of productivity in business services is substantially below that of the U.S., explaining a large part of the productivity gap between the EU and the U.S. at the macroeconomic level. The question then comes to the fore what is behind this malfunctioning of EU business services, and what can be done at EU and national policy levels to improve its performance. We focus in particular on four business to business service sectors: 1) advertising and market research; 2) design; 3) facility management; and 4) technical consulting. The study should provide a comprehensive analysis of the strategic issues for each of the selected service sectors and explore strategies to respond to the challenges. We make policy recommendations both for the individual sectors and across sectors. Key issues The vast majority of enterprises in business services are SMEs, with strong emphasis on the micro and small enterprise segments. The medium sized category is underrepresented in the business services sector. Productivity performance of business services over time is lagging behind compared to manufacturing. This malfunctioning of business service sectors may also affect the performance of downstream sectors, as the importance of business services in value chains of manufacturing and service industries has grown rapidly since the last decade of the previous century. The increased demand for specialized knowledge inputs in manufacturing, combined with outsourcing of parts of these services, implies that performance of manufacturing and service industries in the EU have become more interdependent. About 12% of intermediate consumption in manufacturing is accounted for by business services. Three forms of interactions with downstream sectors are of particular importance: (1) outsourcing, (2) co-production, and (3) knowledge spill-overs. These interactions can co-exist, and are not mutually exclusive. With regard to outsourcing it is important to distinguish between two very different types of outsourcing: outsourcing of low-skilled activities versus outsourcing of high-skilled activities. Outsourcing of the first type of activities is driven almost exclusively by cost considerations, whereas outsourcing of high-skilled activities is often influenced by skills considerations as well. In knowledge intensive sectors companies tend to outsource those specialised (and often complex in nature) services for which they lack the required expertise inhouse or for which no full time position within the company can be created. The production of services often requires interaction between client and provider. This is referred to as co-production. Hence, service providers need clients with sufficient absorptive capacity Study on business-related services 7

10 (knowledge, capacity and dedicated resources and effort) to be productive and provide effective services. Clients need to find service providers that will be willing and able to engage in effective co-production. Knowledge spill-overs yield economic benefits for client firms of business service sectors. Particularly for knowledge intensive and creative services, co-production of service solutions by service provider and client involves knowledge transfers. This can lead to innovation in client sectors. We summarise in this main report our findings from the four in-depth sector studies on advertising and market research, design, facility management and technical consulting and provide a synthesis of these sectors in terms of their strengths, weaknesses, opportunities and threats (SWOT). Common strengths of the business service sectors is that they have been able to effectively respond to their clients needs. Increased multidisciplinarity in their service provision allows business service providers to interact with the client at multiple stages of the value chain. Business service firms often play a role in their clients innovation. The market structure, and in particular the missing middle, is considered a weakness of the business service sector. For a variety of reasons, micro and small companies show limited growth. At the same time, there is increased consolidation, concentration and scale enlargement, which discourages competition. Some services are particularly vulnerable to business cycle fluctuations. A number of developments provide opportunities for business service sectors. The economic downturn may cause clients to seek cost savings from outsourcing of certain services, and especially in the New Member States there seems to be scope for further expansion due to this outsourcing. Technological developments, further uptake of ICT and social media, and the shift to more sustainable modes of production opens new markets and creates opportunities for innovative firms. Threats, or better called challenges, mainly refer to the hard economic situation, which makes it for example more difficult to get access to finance, which is needed to be able to innovate. Some business service sectors are affected by the fact that the European industrial base is declining, and production activities are relocated outside Europe. Especially in engineering consulting, skill shortages are creating bottlenecks to the expansion of business activities. Market failures in business service sectors Next we address the issues identified in the sector studies in more detail to investigate whether certain issues are related to market failure, as market failure can provide a reason for government policy intervention. In particular we look at: (1) market structure, (2) asymmetric information, and (3) spill-overs. Regarding market structure, we find that all four business service sectors show a prevalence of micro and small enterprises, including a large number of self-employed, and a limited number of large players. On the one hand it can be argued that such a market structure is the outcome of market segmentation, in the sense that the small and large companies serve different markets and do not directly compete with each other, and related transaction costs. On the other hand, this phenomenon of the missing middle may be worrying, as recent research provides indications that small companies in business services witness lower productivity performance. Market failures related to imperfect information and the specific characteristics of business services as experience 8 Study on business-related services

11 goods may prevent small companies from growing to medium-sized and large companies. Market segmentation could diminish when small and large companies would work together more intensively. This improves access to larger markets for small firms. Asymmetric information on the value of the delivered service can make clients hesitant to buy these services from business service sectors. This has to do with the experience good character mentioned earlier (the value of the service becomes known only after delivery to the client), but also with the complex nature of the service which require a certain in-house knowledge base in the client company in order to be able to effectively engage in co-production of the requested service. Thirdly, knowledge intensive business services contribute to the innovation potential of their clients and the exchange of knowledge often takes place beyond the usual market transactions and can thus be labelled as knowledge spill-overs. The owner of the knowledge cannot appropriate the full benefits of his or her investment to acquire or develop the knowledge, which may lead to underinvestment in innovation from a social viewpoint. This introduces the issue of intellectual property rights, and how these rights should be protected by the business service providers. We notice that the IPR issue becomes particularly complex in environments where production of the service is the outcome of complex interactions between multiple actors (co-production with the client, cooperation with academic partners, insights from other disciplines etc.). Policy recommendations The policy recommendations in our study follow naturally from our observations regarding market failures. Information asymmetry in the interaction with the client can, in principle, be reduced by using standards. Such standards in business services are typically more oriented towards process (e.g. ISO standards regarding process quality in market research) and input (such as minimum standards on labour qualifications of staff), as outputs are mostly intangible and often tailor-made. Next to standards there are other avenues to reduce information asymmetry and increase transparency in business services, for example websites with client rating of services. Innovation in business services can be promoted along various lines, including through supplying labour with the right skills (certainly in the area of science, mathematic and technological skills), fostering science-industry collaborations, providing the right incentive structures for cooperation with third parties, and promoting innovative solutions in procurement. Addressing entry and exit barriers will help micro and small companies in their development to medium-sized and large companies. Implementation of the Small Business Act principles will help to address some of the entry or further growth barriers of small companies. Another factor that may foster growth is to increase awareness in client sectors of the added value and innovation business services can bring. One reason why client firms may undervalue business services is lack of absorptive capacity. Study on business-related services 9

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13 1 Introduction Background Over the last few decades, the EU has become a service economy as service sectors have grown faster than manufacturing sectors, and services now account for some 70 percent of the EU economy. This also implies that the performance of the EU economy will largely depend on the performance of the service sectors. This is not only because of the large share of services in the economy, but also because of indirect effects: many companies in the manufacturing sector rely on external services providers for both routine services and specialist expertise (business services). A better functioning of business services industries and markets would therefore also benefit other sectors and ultimately consumers. This study analyses four business to business service sectors: 1) advertising and market research; 2) design; 3) facility management; and 4) technical consulting. Objectives of the study The study should provide a comprehensive analysis of the strategic issues for each of the selected service sectors and explore strategies to respond to the challenges. It should make policy recommendations both for the individual sectors and across sectors. A key part of the analysis is to examine the relationship between the selected service sectors and some of the most important manufacturing client sectors, to illuminate the main issues related to outsourcing, market fragmentation, internationalisation and innovation in business related services. Structure of the report This report is structured as follows. Chapter 2 looks in more detail at the role of the services sectors in the EU economy and explores some of the key issues. This sets the stage for the remainder of the report. Chapter 3 to 6 summarise the main findings for the selected services sectors: advertising and market research (Chapter 3); design (Chapter 4); facility management (Chapter 5); and technical consulting (Chapter 6). Chapter 7 presents the strategic outlook for the sectors and analyses their strengths, weakness, opportunities and threats (SWOT). Chapter 8 identifies and describes several market failures prevalent in the selected sectors. Finally, Chapter 9 concludes with policy recommendations. The detailed sector studies are available in a separate annex. Study on business-related services 11

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15 2 Services in the EU economy: some key issues In the previous chapter we mentioned the importance of the services sectors in the EU economy. In this chapter we elaborate on the role of business services in the EU economy, and we sketch the key issues that will be discussed in greater detail in the remainder of the report. 2.1 Business services in the EU economy: overview of the sector Industry definition Business services consist of a range of professional services and support services. This includes knowledge-intensive and creative professional services (such as management consultancy, design activities, marketing services and architectural and engineering services) and IT services, but also labour recruitment services and support services such as security services and industrial cleaning activities. To demarcate the activities classified as business services, we start from an operational definition of business services provided by Eurostat as consisting of the activities in NACE revision 1.1 Divisions 72 and We will make use of the most recent data for the industry overview, based on NACE revision 2 classification where possible. The correspondence of these two NACE classifications unavoidably leads to some small differences in the operational demarcation of industries in the business services sector, but we stay as close as possible to the demarcation above and include all industries that fall within our definition as far as data are available. Industry overview The business service sector currently accounts for almost 1,500 billion euro turnover and 21 million people are directly employed in the sector at a total of almost 4 million enterprises (see table 2.1 below). Firms from the UK, Germany and France together account for about 56% of total EU turnover in the sector. Average firm size in terms of persons employed in Sweden, Italy and (to a lesser extent) Poland and Spain is smaller than in these three countries. Turnover per person employed is lower in Poland, compared to other countries reported in the table. Table 2.1 Business services: number of enterprises, turnover and number of persons employed (2010) Number of enterprises (thousands) Turnover (billion euro) Number of persons employed (thousands) EU 27** 3,907 1,518 20,695 Germany ,026 Spain ,800 France ,772 Italy* ,107 Poland Sweden United Kingdom ,619 Notes: Business services are defined closely following the operational definition of Eurostat and Kox (2012), as far as NACE rev. 2 correspondence and data availability allow. The activities of head offices are excluded. * Data for Italy are for ** Data for investigation activities for EU27 is for Source: Eurostat SBS. 1 See e.g. and Chapter 25 of Eurostat (2009) European business Facts and figures. The business services sector includes among others the five industries that have been selected for detailed sector studies (see section 2.5): private security, industrial cleaning, design services, technical consulting, and advertising and market research. Design activities are somewhat hidden in the NACE revision 1.1 class Other business activities n.e.c. Study on business-related services 13

16 Table 2.2 reveals that the vast majority of the firms in business services are micro-enterprises (between 1 and 9 persons employed). 2 Comparing the patterns for business services to the overall pattern for the non-financial business economy at the EU level, the category of micro enterprises is overrepresented in the share of firms. Small- and medium sized firms are underrepresented in the business services sector. The share of medium and large-sized firms in terms of turnover is a bit lower than in the overall business economy. Comparing the patterns for turnover and employment between and within these two broad economic sectors leads to some tentative conclusions on productivity. First, micro-firms in business services appear relatively more productive compared to larger firms in business services than in the overall business economy. Medium and large firms appear relatively more productive on average in the business economy compared to their position in business services. Second, SME firms appear to be more productive than large enterprise in the business services sector. No clear disadvantage for micro-sized firms appears from these aggregate figures. This is in contrast to detailed econometric evidence from the literature based on a more sophisticated productivity measure and on firm-level micro-data for disaggregated business services, which we will discuss in section 2.2. Table 2.3 shows for a selection of EU Member States that the vast majority of enterprises in business services is SME, with strong emphasis on the micro and small enterprise segments though patterns vary within these segments between Member States. Only Germany and the UK show a relatively larger share of medium sized firms. Large enterprises are a comparable fraction of the sector across the EU, albeit a bit larger in Germany. Table 2.2 EU-27 Business services and Non-financial business economy: number of enterprises, turnover and number of persons employed by employment size class (% of total) Number of enterprises Turnover Persons employed Size class Business services Business services Business services EU Business economy Business economy Business economy EU Note: Data for non-financial business economy: This aggregate consists of manufacturing and service sectors in the private sector, except financial and insurance services. Data for business services: most recent year (2010, or 2009 if latest available). Business services are defined closely following the operational definition of Eurostat and Kox (2012), as far as NACE rev. 2 correspondence and data availability allow. Source: Eurostat SBS 2 See the Eurostat definitions of SME and constituent firm size classes at 14 Study on business-related services

17 Table 2.3 Business services: number of enterprises, turnover and number of persons employed by employment size class (2010; % of total). Number of enterprises Turnover Number of persons employed Size class EU % 24.5% 3.1% 1.4% 0.8% 0.2% 11.9% 17.7% 8.7% 11.0% 17.7% 33.0% 12.1% 16.6% 7.2% 8.9% 17.1% 38.1% Germany 41.6% 44.9% 7.5% 3.6% 2.0% 0.5% 5.3% 17.0% 10.2% 12.9% 19.5% 35.0% 4.0% 16.5% 8.9% 10.3% 20.5% 39.9% Spain* 66.4% 27.9% 3.6% 1.2% 0.7% 0.2% 9.0% 18.3% 8.8% 9.3% 18.5% 36.1% 13.0% 19.3% 6.9% 7.5% 13.4% 40.0% France 80.7% 13.7% 3.2% 1.5% 0.7% 0.1% 15.9% 16.7% 8.0% 10.8% 15.0% 33.2% 10.4% 15.7% 8.4% 9.2% 13.6% 42.9% Italy** 78.4% 18.9% 1.7% 0.6% 0.3% 0.1% 15.2% 25.3% 8.1% 8.2% 14.4% 28.8% 26.6% 21.2% 5.8% 5.9% 11.4% 29.1% Poland 71.2% 25.6% 1.6% 0.8% 0.5% 0.2% 19.0% 23.1% 5.6% 9.4% 21.3% 21.6% 18.9% 23.5% 4.3% 5.6% 13.4% 34.2% Sweden 83.3% 13.7% 1.6% 0.9% 0.4% 0.1% 14.2% 16.7% 9.6% 12.1% 18.0% 31.5% 10.8% 18.2% 8.0% 11.4% 17.5% 34.1% UK 53.8% 38.2% 4.2% 2.2% 1.4% 0.3% 7.7% 15.8% 8.1% 10.3% 18.4% 39.7% 6.1% 14.4% 6.9% 9.9% 18.3% 44.4% Notes: Business services are defined closely following the operational definition of Eurostat and Kox (2012), as far as NACE rev. 2 correspondence and data availability allow; * Data for Spain for management consultancy was interpolated as average. ** Data for Italy are for Information service activities and activities of head offices are excluded. Data for France, Poland, Sweden, UK, EU27 is for 2009 if data for 2010 was not available. Source: Eurostat SBS. Study on business-related services 15

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19 Productivity performance of the business services sector over time remains a little behind compared to the manufacturing sector. The table 2.4 below shows average productivity growth between 2003 and 2010 in selected business service industries. The sectors in the table formed the focus for sector-specific analysis in this study. 3 Table 2.4 Wage adjusted labour productivity: average annual growth rates (%). Market Engineering Private Cleaning country/sector Manufacturing Advertising research activities security services EU Germany Spain France Italy Poland Sweden United Kingdom Note: Average annual growth rate computed as arithmetic average of year-to-year growth rates. Source: Eurostat SBS. Figure 2.1 Index of wage adjusted labour productivity by sector: EU-27 (2003 = 100) Advertising Architectural and engineering activities Private security Cleaning services Manufacturing Market research Note: EU-27 represents the aggregate group of the 27 countries that form the EU as of For earlier years, some of these countries were not members of the EU. Source: Eurostat SBS. Figure 2.1 above presents an overview of the development of labour productivity in the selected business service sectors (design services are not included due to lack of data over time) at the EU- 27 level, compared to the manufacturing sector. The overall picture of stagnating productivity growth at the EU level is confirmed. Productivity appears to be pro-cyclical over the recent economic crisis (though with a delay for engineering services). From 2003 onwards, the data do not provide strong evidence for a relative stagnation of the service industries compared to the manufacturing sector. 4 Volatility of labour productivity, at least at the level of individual industries, 3 4 Design services are also one of the business related (sub)-sectors included in this study. Due to lack of data over time, this sector is not reported in the table on productivity. In the next section of this report, we discuss evidence that productivity growth in business services is lower than for the rest of the economy in the EU, partly explaining the productivity (growth) gap between the EU and the U.S. economy. This evidence is based on trends over a longer time series and a different measure of productivity, total factor productivity. This productivity measure, unlike our measure of labour productivity, is not affected by changes over time in capita-labour ratios and relative wages, which may lead to somewhat different conclusions. Study on business-related services 17

20 exceeds the small difference in trend growth rates reported in Table xx. The advertising sector appears to fall behind over the last three years reported for which data are available, but shows recovery in line with manufacturing in Importance of business services in the sector structure of the EU economy The importance of business services in value chains of manufacturing and service industries has grown rapidly since the last decade of the previous century. Growth of employment in Europe illustrates this. The business service sector accounts for about half of this growth (Kox and Rubalcaba, 2007). The increased demand for specialized knowledge inputs in manufacturing, combined with outsourcing of parts of these services, implies that competitiveness performance of manufacturing and service industries in the EU have become more interdependent. The interdependence is illustrated in figure 2.2 below, showing the percentage share of business services in total expenditure on intermediate inputs by selected manufacturing industries. Business services are defined as before, consisting of NACE Division 72 (Computer and related activities) and Division 74 (Other business activities). Figure 2.2 Share of business services in intermediate input value for selected manufacturing sectors. Source: Eurostat; Harmonized EU-27 Input-Output table for Selection of manufacturing industries based on NACE classification (rev. 1.1): divisions On average, 8.3% of intermediate consumption in manufacturing is accounted for by business services. Some sectors producing equipment and the chemicals sector show higher business service intensity. Printed and recorded media and tobacco products use business services most intensively in their intermediate consumption. Within business services, the sector other business services accounts for the largest share of intermediate consumption by manufacturing (figure 2.3). Other business services mostly refer to professional service activities (NACE revision 1.1 Division 74). As noted before, this sector includes knowledge-intensive services such as management consultancy, professional training, market research, and technical and engineering services. Also included are creative industries such as advertising services and specialized design services, and the operational services industrial cleaning and security services. 18 Study on business-related services

21 Figure 2.3 Two main groups of business services in intermediate input value for selected manufacturing sectors (million euro) Source: Eurostat; Harmonized EU-27 Input-Output table for Selection of manufacturing industries based on NACE classification (rev. 1.1): divisions Productivity in business services The business services sector has grown over the past few decades in terms of output and employment and provides a larger share of intermediate inputs than before. However, productivity growth in the sector is lower than the economy wide average in the EU, and has stagnated relative to the U.S. over the past two decades. Evidence suggests that the level of productivity in business services is substantially below that of the U.S. (see e.g. Inklaar et al. 2008; Kox 2012). The relative performance of business services appears to be particularly relevant for a number of empirical results on productivity performance in market services and downstream client industries that emerge from recent research: Productivity growth in market services in continental Europe lags behind U.S. growth rates that have recently accelerated; Lagging productivity performance in EU services seems to reflect the relative absence of catching up and a lack of innovation; Lagging productivity performance in services contributes largely to explain the widening productivity gap at the macroeconomic level, among other things by impeding productivity growth in ICT-using sectors that make relatively intense use of intermediate services. A substantial body of recent academic literature has linked the lagging productivity performance in market services sectors (such as retail, transport, post and telecommunications, financial services and business services) to the macroeconomic productivity gap between the EU and the U.S. and its recent apparent widening. 5 This reflects a direct effect on productivity, as business services 5 Many of the recent studies make use of the recently developed EU KLEMS database that allows analysis and decomposition of productivity levels and growth in a variety of service and manufacturing sectors for a set of OECD countries. Study on business-related services 19

22 account for a substantial share of value added in the EU, and the indirect effects of business related services on productivity in downstream sectors (see Camacho and Rodriguez 2007). Triplett and Bosworth (2006) report that labour productivity growth rates in most market services have accelerated in the U.S. since the mid-1990s, whereas a similar pattern is not found for continental Europe. Timmer et al. (2011) report that most of the difference in labour productivity growth in services between the EU and the U.S. can be attributed to the performance of distribution services (retail and wholesale, and transport services) and business services. Labour productivity growth can be related to capital deepening (e.g. using more ICT and non-ict capital goods or human capital per hour worked) and to technological progress (increasing the productive efficiency of combining production factors to produce output). Technological progress here needs to be interpreted broadly to include all hard and soft factors that can increase efficiency (innovation induced by technical or scientific R&D, changes in the organizational structure, management and work practices). The impact of technological progress on productivity growth is reflected in the literature by the development of multifactor productivity (MFP). Timmer et al. (2010) find that lagging MFP growth is the main source of the difference in labour productivity growth in business services, financial services and distribution services between the U.S. and the EU. Two mechanisms of MFP growth are potentially relevant. First, technological progress can be absorbed by imitation, leading to catch-up to the frontier of innovation. Second, innovation of products, production process and organization can spur productivity growth. The latter form of technological progress becomes more important once an industry or firm is closer to the technology state of the art. For some services, such as retail trade, transport and financial intermediation, the EU countries do not lag far behind the U.S. in terms of MFP, or even exceed U.S. MFP. For business services, however, there is a clear gap between the EU and the U.S. leading technology position. While other Anglo-Saxon economies such as the UK, Canada and Australia, show clear catch-up growth in MFP relative to the U.S., the (continental) EU countries do not make use of this catch-up potential (see Inklaar et al. 2007). As growth in other services sectors also lags behind, the EU appears to experience problems to realize productivity growth both via catching-up and innovation in services sectors. Recent literature points at the likely importance of anticompetitive (i.e. restrictive) regulation and the advent of ICT in a context of deepening globalization to explain the variation in growth performance. Restrictive regulation refers to mostly national regulation that restricts domestic competition and market selection processes and hampers the operation of the Internal Market for services. This varies from direct government involvement in business operation, administrative burdens on startups and bankruptcy, legal barriers, antitrust exemptions, labour contract regulations (see Kox, 2012), to required professional qualification of personnel, regulation on legal form and capital ownership of the service provider (European Commission 2011, 2012) 6. Direct impacts of capital deepening (in recent years particularly related to ICT capital goods such as software, computers and communication equipment) and education of the workforce do not suffice to explain the difference in MFP growth (e.g. see Inklaar et al. 2008). Yet, the successful incorporation of ICT in production processes via a combination of organizational change and hard technological change is an important source for productivity growth. The importance of ICT uptake holds for both catch-up growth (see Conway et al. 2006) and for innovation processes (e.g. Arnold 6 European Commission (2011), Towards a better functioning Single Market for services building on the results of the mutual evaluation process of the Services Directive, COM(2011)20 27 January 2011, Brussels; and, European Commission (2012) The economic impact of the Services Directive: A first assessment following implementation, Note for the Economic Policy Committee, DG ECFIN (section Product Market Reforms), Ares(2012)504112, Brussels, as referred to in Kox (2012). 20 Study on business-related services

23 et al. 2008, 2011), and most for relatively intensive ICT-using industries and services. Restrictive regulation, particularly in intermediate services sectors, raises the cost of doing business and hampers productivity performance both in the services sectors and e.g. via the input-output linkages discussed in the previous sub-section in downstream (manufacturing) sectors. Conway et al. (2006) show that weak competition and regulatory burdens reduce productivity growth particularly for countries and sectors that start with relatively low productivity levels and mostly so for sectors that are ICT-using. Barone and Cingano (2011) show that the impact of services regulation on productivity performance is mostly related to regulation in the energy and business services sectors. Arnold et al. (2008) provide evidence that, at the level of individual firms within a sector, restrictive regulation affects primarily the most efficient firms in ICT-using sectors, thus obstructing the diffusion of technology. They reveal that more restrictive regulation of services distorts the allocation of resources towards firms with the highest growth potential and that would be most likely to increase domestic technological standards. Bourlès et al. (2010) stress that restrictive regulation of upstream services reduces access to downward markets (particularly when service inputs are needed that are more difficult to obtain on international markets). Moreover, market power of service providers reduces the incentive for efficiency improvement in client sectors because the profits generated will more likely be partly appropriated by higher prices charged by intermediate service providers. The evidence reported above points at the importance of regulatory conditions and import competition for effective competition and productivity growth in business services, with potentially large implications for economy-wide productivity performance. Recent research by Kox and Van Leeuwen (2012) suggests that the productivity difference between the U.S. and the EU can be traced to the persistence of two types of inefficiencies in the EU business services sector. First, small and very large firms have lower scale efficiency compared to the optimal firm size in the sector. Small firms suffer from high average fixed costs and low specialization due to the scale of output volumes at which they operate. Empirical evidence confirms and shows that scale efficiency increases along with the size of firm, but reaches an optimum; for very large firms, internal transaction costs increase and compensate the decline in average fixed costs. Second, within size classes large differences in production efficiency exist, implying that many firms operate at lower efficiency than the technology frontier in their size class. This form of inefficiency is known under the heading X-inefficiency. Kox (2012) argues that the persistence of scale inefficiency and X-inefficiency implies that dynamic market selection does not function properly. During their life cycle, successful small firms would expand and grow to benefit from economies of scale. Firms that are too large, would be forced to rationalize and reduce their size and market share. Firms that operate below the technology frontier would not be able to cope with competition and suffer from low profitability. In the EU, however, the size class with lowest overall efficiency, the very small firms, represent the vast majority (93%, Kox 2012) of firms in business services. Overall efficiency in the EU business service sectors has stagnated since the late 1990s, as well as average efficiency in most EU countries. This suggests that market segmentation, related to search costs, and lack of transparency of services markets obstructs competitive selection. Large and small firms may serve different markets and competition within the market served by smaller firms may be mostly local. Medium sized firms appear to have the highest overall efficiency, but most small firms do not seem to manage to grow to the medium range. Large firms appear to have a stable position, possibly related to market power. The medium size range, though most sustainable on the basis of market selection, is smaller than expected. This mystery of the missing middle may have important implications for competitiveness of EU business services and their client sectors. As noted by Canoy and Smith (2008, p. 324), the way Study on business-related services 21

24 that anticompetitive regulation combines with the specific characteristics of individual service markets determines to a large extent the economic performance of services. While, the spectrum between goods and services is gradual and some of their characteristics are becoming more shared, (business) services tend to be more intensely related to issues like asymmetric information and co-production. It is to these characteristics of services and the interaction with client sectors that we turn next. 2.3 Interaction with downstream sectors Service and manufacturing industries have become more and more interlinked. This party reflects changes in economic structure due to (technology enabled) outsourcing of business services and partly an increased demand for specialized knowledge inputs. Competitiveness of downstream sectors (manufacturing and services) depends on access to a wide variety of well performing business related services (see, e.g., Camacho and Rodriguez, 2007). Performance and effectiveness of these services relies on organization structure (decision to provide in-house or outsource the services), client and service provider capacities to interact in coproduction of business related services, and the implications for knowledge creation and spill-overs in service-client interaction. The relevance and implications of these three forms of interrelations in the value chain are briefly discussed below in more detail. Outsourcing partly explains the high growth of employment and value added in business services over the recent past. Co-production emphasizes the important role of business services as inputs that are closely related to core business processes of clients, such as product development and innovation. Knowledge transfer and spill-overs are important channels for creating value added in the supply chain. Outsourcing The main driver of outsourcing activities is cost reduction. Companies with a high-skilled workforce are more likely to outsource low-skilled, labour-intensive services like cleaning. Other factors that are positively related to outsourcing include: Size of the company: the larger the company and thus the more complex the internal organisation, the more the company will choose to externalise activities; High significance of geographical proximity: in sectors where geographical proximity is important (e.g. courier, security), the presence of good local service providers in the region increases outsourcing; Preferences of manufacturing companies for flexibility. Access to a labour force at a global scale favours outsourcing and offshoring activities to countries with low labour cost (for example low-skilled operational services, call centres) for both high-skilled and low-skilled service sectors. Furthermore, globalization of activities through e.g. outsourcing of activities leads to increased diversity of services, like provision of services at 7/7 and 24/24 basis (Ecorys et al. 2008). It is important to distinguish between two very different types of outsourcing: outsourcing of lowskilled activities versus outsourcing of high-skilled activities. Outsourcing of the first type of activities is driven almost exclusively by cost considerations, whereas outsourcing of high-skilled activities often is influenced by skills considerations as well. In knowledge intensive sectors companies tend to outsource those specialized (and often complex in nature) services for which they lack the required expertise in-house. Kox and Rubalcaba (2007) found that in the mid-1990s business service sectors that produce very specialized services have 22 Study on business-related services

25 gained most from outsourcing activities. This has happened because the very specific activities and the high quality of knowledge needed for the production are the main reasons why client sectors have chosen to outsource these activities. Although relative wages seem to be a less important driver for outsourcing of this type of activities, Merino and Rodriguez (2007) point out that the high wage costs of skilled workers imply that outsourcing the activities instead of in-house production might be more profitable from a cost perspective. As a countervailing force, manufacturing firms have become more service oriented as well due to increased demand for customization by their clients. Before and after sale services are increasingly important for competitiveness. This implies that service activities that are close to the core production process are more likely to remain largely in-house, apart from those services that require highly specialized knowledge (as mentioned before). Co-production Many services, in order to be produced, require interaction between client and provider. Consumption and production processes may coincide (e.g., health or transport services). Production of other services such as cleaning services requires access to the premises of the client. Also for business related services, customer-provider interaction is often a vital element for the productivity of the service provision and for the service to have the intended impact on client performance (see Ecorys et al. 2008). The various forms of interaction needed for services to be effectively provided are grouped under the heading co-production of services. Following studies by Bitner et al. (1997), Bettencourt et al. (2002), and Kuusisto (2008), a typology of co-production is presented in the 2008 study by the Ecorys led consortium. Services that deal with more peripheral business processes and that require little client participation, tend to be more standardized products and can be provided independent of the consumer (such as uniform cleaning services). These services still need the client to give property access to the service provider. Services for which customer input (information, materials) is necessary for effective provision but that are still provided mainly by the service firm usually require moderate interaction. Here, the customer could be seen as co-performing the service as it is involved in some supporting tasks. Examples are freight transport, engineering services and advertising campaigns. These services can be highly specialized (engineering) or more standardized (transport). When interactions between client and service staff are more prominent in the creation of the service, high participation is needed. These services tend to be the most customized and are provided via cocreation or involve co-designing the division of labour (where the client performs some of the supporting and essential service tasks. Examples include marketing campaigns, design services and management consulting. Highly knowledge-intensive or creative services tend to be more customized and more interaction intensive. The importance of co-production has potentially large implications for the structure of business service markets, service procurement and the process of innovation in services and client products. Both service providers and clients derive competitive advantage from selecting partners that match well. Hence, management of co-production is important for both client and provider. Service providers need clients with sufficient absorptive capacity (knowledge, capacity and dedicated resources and effort) to be productive and provide effective services. Clients need to find service providers that will be willing and able to engage in effective co-production. Both sides in the service transaction need to deal with information asymmetries and transaction costs. Client and service providers need to be competent and have specific knowledge, and the lack of transparency of this search-and-match process tend to increase market segmentation in business related services (see, e.g., Kox, 2012). Study on business-related services 23