New Paradigm in the Service Economy The Search of Economics for Scientific Credibility: In between Hard and Soft Sciences

4.2 The Horizontal Integration of all Productive Activities: The End of the Theory or the Three Sectors of Economic Activity and the Limits to Engel’s Law
Traditional economic theory still distinguishes between three sectors: the primary or agricultural, the secondary or industrial, and the tertiary which includes all services, sometimes subdivided further to produce a quaternary sector.5 Such a theory focuses essentially on the industrialization process where predominantly agricultural societies are those which are not yet industrial, and where the tertiary sector is frequently no more than a “trash can” used to classify all those economic activities which simply cannot be called industrial.

In reality, for all three types of society – agricultural, industrial and service – the relevant issue is the choice of priority in stimulating the production of wealth and welfare. In an industrial society, agriculture does not disappear. Quite the contrary. Agricultural production becomes more and more efficient thanks to its industrialization. Industry does not develop as a completely separate productive activity from agriculture, but influences the traditional way agricultural products are produced and distributed. In the same way, the Service Economy is not an outgrowth completely detached from the industrial productive structure, but permeates that structure, making it predominantly dependent on the performance of service functions within (as well as outside) the production process. The real phenomenon therefore is not the decline and growth of three vertically separate processes or sectors, but their progressive horizontal inter-penetration. In other words, the new Service Economy does not correspond to the economy of the tertiary sector in the traditional sense, but is characterized by the fact that service functions are today predominant in all types of economic activity.

With every fundamental switch from one priority mode of wealth and welfare production to another, there is a modification in the perception of needs or demand. The very definition of what constitutes a basic need also changes.

In an agricultural society, the agricultural (pre-industrial) system of production was obviously perceived as addressing the problem of satisfying basic needs. After the onset of industrialization, and in line with the history of economic theory, which until then had coincided essentially with its development, primary needs were defined in terms of what basic needs the manufacturing system (integrating key agricultural production) could satisfy. Engel’s law states that services are secondary in most cases because they only fulfil non-essential needs. In this approach the Industrial Revolution is supposed to be an efficient method of providing people with food, shelter and health. Only once these basic needs are satisfied can the consumption of “services” commence.

In reality, however, the true impetus towards the Service Economy has been precisely the fact that services are becoming indispensable in making available basic products and services which fulfil basic needs. Services no longer constitute a mere secondary sector, but are moving to the forefront of economic activity, where they have become indispensable production tools in meeting basic needs and the essential means whereby the wealth of nations may be made to increase.

The insurance industry is a typical example. Until a few decades ago everybody, including those in the insurance industry itself, accepted that insurance policies covering, for example, life risks or material damage, were a typical secondary product in the economic sense that they could only expand once basic needs had been satisfied by material production.

However, during the years following 1973, when the growth of GNP in the world dropped from an average of 6% to less than 3% per year, the overall sales of policies continued to grow at about 6% per year. If insurance consumption was of secondary importance the slowdown in other activities, and in particular in manufacturing would, according to Engel’s law, have produced more than a proportional reduction in the sale of insurance. The explanation for this continuous growth of insurance activities, even in periods of declining growth, lies precisely in the nature of the modern production system which depends on insurance and other services as key tools to guarantee its proper functioning, based on the availability of products and services. At a very advanced technological level of production, where risks and vulnerabilities are highly concentrated and represent an essential managerial challenge, insurance has become – increasingly so in recent decades – a fundamental pre-condition for investment. Similarly, at a more general level, social security, health and life insurance have by now achieved the status of a primary good in most “industrialized countries”.

4.3 From Product Value to System Value
Another key difference between the industrial economy and the Service Economy is that the former attributes value essentially to products which exist materially and which are exchanged, while value in the Service Economy is more closely related to performance and real utilization (over a given period) of the products (material or not) integrated in a system. Whereas during the classical economic revolution the value of products could be identified essentially with the costs involved in producing them, the notion of value in the Service Economy is shifting towards evaluation of costs in terms of the results obtained in utilization.

The first approach considers the value of a washing machine per se, the second evaluates the actual performance of the washing machine, taking into account not only its cost of production but also all other kinds of costs (learning time for those using the machine, maintenance and repair costs etc.). The applicability of the two approaches is, in most cases, inherent in the technological complexity of the product: in the case of simple products and tools, the assessment of value can be limited to the tool or product per se. Nobody buying a hammer would think it necessary to take courses to learn how to use it. In the case of a computer, however, the cost of learning how to use it tends to exceed the purchase cost of the machine itself, especially where the former includes the cost of essential software.

Similarly, people buying goods such as dishes or even a bicycle might not consider signing a maintenance contract. With purchases of electronic typewriters, photocopiers, or even television sets, however, maintenance contracts – even for individual consumers – are more and more common. In the Service Economy it is not a tool that is being purchased, for people are buying functioning systems, not products. People buy performance.

System evaluation, i.e. the organization of tools and persons in a given environment to obtain desirable and economically valuable results, must also take account of various degrees of complexity as well as vulnerability in systems’ functioning.

The notion of systems becomes essential then in the Service Economy. Systems produce positive results or economic value when they function properly. The notion of system operation (or functioning) has to be based on real time and the dynamics of real life. Whenever real time is taken into consideration the degree of uncertainty and probability, which conditions any human action, becomes a central issue.

The economics of the Industrial Revolution could, in contrast, rely on the fiction of a perfect equilibrium theory (outside real time), based on an assumption of certainty. During most of the economic history of the Industrial Revolution, risk and uncertainty have been the meat of historians and sociologists. The first systematic study to give timid though serious consideration to risk and uncertainty was that carried out by Frank Knight during the 1920s.6

Any system working to obtain some future result by definition operates in a situation of uncertainty, even if different situations are characterized by different degrees of risk, uncertainty or even indetermination. But risk and uncertainty are not a matter of choice: they are simply elements of the human condition.

Rationality therefore is not so much a problem of avoiding risks and eliminating uncertainty, but of controlling risks and of reducing uncertainty and indetermination to acceptable levels in given situations.

Furthermore, the very systemic nature of modern economic systems and the increasing technological developments requires an ever deeper economic understanding and control of the increasing vulnerability and complexity of these systems. The Siberian railway accident of June 5, 1988, when a leak from an LNG pipeline led to an explosion that destroyed two trains, killing all passengers, can serve as an example of systemic risks.

Unfortunately, the notion of vulnerability is generally misunderstood. To say that vulnerability increases through increase in the quality and performance of modern technology might seem paradoxical. In fact, the higher level of performance of most technological advances relies on a reduction in the margins of error that a system can tolerate without breakdown. Accidents and management mistakes can still happen – even if less frequently – but their effects now have more costly systemic consequences. Opening the door of a car in motion does not necessarily lead to a catastrophe. In the case of a modern airplane, it will. This shows that the notions of system functioning and of vulnerability control become a key economic function within which the contributions of, for example, economists and engineers must be integrated. In a similar way, problems of social security and savings for the individual have to take vulnerability management into account. Thus the notion of risk and the management of vulnerability and uncertainty become key components of the Service Economy.

4.4 The Notion of Risk in the Industrial Revolution and in the Service Economy – Moral Hazards and Incentives
The first great economists did not study risk-taking in detail. It was rather taken for granted by the cultural environment of the time, even if Schumpeter made more explicit reference to the risk-taking entrepreneur. It was not until 1992 that the first comprehensive study of the subject was made, by Frank Knight in his Risk, Uncertainty and Profit.7 But even Knight tended to confine himself to a discussion of risk of the entrepreneurial type. The field of pure risk linked to the vulnerability of systems was still considered too secondary to be given priority among the managerial objectives of firms.

The activities of the service sector and of insurance in particular, have traditionally been regarded as secondary or marginal in the national economy, even if they have existed for centuries. Theories and even attitudes have not yet adjusted to the new facts in this field. Some types of non-entrepreneurial risk are nevertheless now seen as more important due to changes in social philosophy. This applies to risks covered by social security and workers’ protection in industrialized countries. Indeed as early as the 1850s the government of Prussia had organized the first compulsory insurance scheme for miners. But at the time of the great depression in 1929 this type of risk management was still in its infancy.

The development of social security can be attributed mainly to changes in social philosophy, which in turn is conditioned by the changing levels and characteristics of the risks and vulnerability produced by the modern environment. Indeed, the growth of risk and vulnerability, interwoven into the functioning of the economic system, largely explains why we now experience a new risk dimension and a fundamental change in our expectations concerning the possibilities for traditional growth.

The connotation of risk in the Service Economy covers a much wider area than the notion of risk in the Industrial Revolution. With the latter the main risk area involved was the so-called entrepreneurial or commercial risk; while the Service Economy has to be extended to include so-called ‘pure risk’.

An entrepreneurial risk is one where the people involved in an activity can influence its purpose and manner by deciding to produce, to sell or to finance etc.

Pure risk is beyond the control of those involved in an activity. It depends on the vulnerabilities of their environment or of the system within which they work, and it will materialize by accident, by chance. This notion of pure risk is exclusively related to the notion of the vulnerability of systems we have been discussing in the preceding paragraphs and is a hallmark of the Service Economy.

One of the great differences between neo-classical economics and the new Service Economy is that not only is “entrepreneurial” risk taken into account (as in the case of Frank Knight), but that the notion of economically relevant risk is extended to include the notion of pure risk. Globally the notion of risk, therefore, has two fundamentally different but complementary connotations.

Today, in any significant economic endeavour, equal strategic importance must be given to both types of risk (both being linked to the concept of systems vulnerability).

Many people when discussing risk management (meaning the management of pure risk) do not make a clear link with the global strategy of risk. Therefore, instead of showing clearly how the two risks are correlated, they tend to confuse or confound them.

The distinction between pure and entrepreneurial risk is also to be found in the notion of “moral hazard”.8 This notion has long been familiar to insurers when they have had to face damages occasioned by those who have exposed themselves to risk for reason of profit. Take for instance the case of somebody who burns down his own home in order to collect the insurance (the cause of over 20% of fires!).

5. Jean Fourastier, Le Grand Espoir du XXe Siecle (Paris: Gallimard, 1958): Colin Clark, Les Conditions du Progres Economique (The Conditions of Economic Progress) (Paris: PUF, 1960); Daniel Bell, The Coming of the Post-Industrial Society (New York: Basil Books, 1973).
6. Frank Knight, Risk, Uncertainty and Profit (Chicago: University of Chicago Press, 1921).
7. Knight, Risk, Uncertainty and Profit
8. Joseph Stiglitz, “Annual Lecture of the Geneva Association,” The Geneva Papers on Risk and Insurance 8, no. 26 (1983); See also The European Papers on the New Welfare 2005-2008. Nos. 1, 3, 6, 10 (


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