When the Treaty of Rome came into effect thirty years ago, agriculture and manufacturing dominated the European Community's economic activity, but now services account for more production and employment than agriculture and manufacturing combined in every member state. This growth of services has arisen because firms have shifted away from `in-house' provision of the services they require and also as a result of technological change and deregulation.

In Discussion Paper No. 498, Research Fellow André Sapir identifies the key features that distinguish services from other economic activities and assesses their influence on market structures. Services are normally consumed and produced simultaneously, and typically in the same location. They are therefore rarely `search goods': most are `experience goods' and a few (such as medical services) are `credence goods', so sellers know more than buyers about product quality a priori, which may create problems of moral hazard and adverse selection. Sapir maintains that an industry's `natural' market structure will depend on scale economies and product differentiation. For a few services, such as telecommunications and railroads, scale economies are substantial, but for most services they have traditionally been small or non-existent. The need for proximity between buyers and sellers has produced market structures with numerous small firms operating in localized markets.

Services are differentiated products par excellence. They are `spatially differentiated' in that producers' location matters to consumers; their `attributes' vary across suppliers; and their `quality' differs among producers. If barriers to entry are negligible, a market's actual structure may be competitive even when the (technologically-determined) optimal number of firms is very small. Conversely, if entry barriers are substantial, firms may possess strong monopoly power even if they are numerous. Service industries incur fixed costs in acquiring both tangible assets and also intangible assets, such as reputation. Tangible assets typically do not involve large sunk costs, and markets for services may be considered as contestable in this respect; but the fixed costs incurred in acquiring intangible assets are likely to be much harder to recover. Unless there are other means of conveying information about quality, the impact of reputation may severely reduce both actual and potential competition in certain services.

In most countries, government agencies intervene to modify market structures, and for most service industries regulation plays a major role in improving their efficiency by remedying market failures. These take three main forms: imperfect competition, imperfect information and externalities. Regulation is often criticized for limiting rather than fostering competition, and this widely held belief has contributed significantly to the deregulation movement that started in the US in the late 1970s, moved to the UK in the early 1980s and is spreading through the rest of Europe in the run-up to 1992.

The Structure of Services in Europe: A Conceptual Framework
André Sapir

Discussion Paper No. 498, January 1991 (IT)