The service paradox and endogenous economic growth

Many empirical studies show the paradoxical fact that service output in proportion to industrial output does not tend to decline, in spite of rising service pricing. Baumol's "cost desease" model well explains rising service prices, but it simply assumes that the output proportion remains constant. It concludes that service employment expands, and aggregate economic growth declines. The paper extends Baumol's model in two main directions: it endogenises households' preferences by assuming that they favour services insofar as income rises; it endogenises income growth by considering that several services contribute to the formation of human capital. Both the cases of rising human capital as a side-effect of consuming services, and as an investment purpose are studied. The conclusions in both cases are that the paradox can find an explanation; service employment expands, but Baumol's pessimistic conclusion on the decline of aggregate economic growth can be alleviated, or even reversed, and more promising policy implications can be drawn.