Deindustrialization: Shift from Factories to Services (Causes Effects)

Indonesia is facing deindustrialization. We see the contribution of its manufacturing output to gross domestic product continues to fall, from 28% in 2008 to only 17% in 2019. The chart above shows you how severe the decline is.

The turning point was during the 1998 crisis, after which the percentage continued to fall. What is deindustrialization? How did that happen? What is the impact on the economy and society? Let’s discuss them one by one.

What is the definition of deindustrialization?

Deindustrialization is a phenomenon in which an economy evolves from a manufacturing-based to a service-based one. In other words, the economy is transitioning from relying on the secondary sector to the tertiary sector. However, what is even worse is when the economy transitions back to the primary sector (as opposed to industrialization).

How can we observe this transition? First, we can see it from the gross domestic product (GDP) data by economic sector. This data details a country’s economic structure. It breaks down GDP data into sectors based on the monetary value of their final output.

Then, we divide the manufacturing sector’s output value by GDP. When deindustrialization occurs, the manufacturing sector no longer contributes dominantly to the economy. As a result, the percentage of its output to GDP shows a decline.

The next impact is on employment. Employment in the manufacturing sector contributed to a decline in absorbing new workers. The creation of new jobs in this sector is less rapid than in the service sector. Thus, the manufacturing sector no longer dominates in absorbing labor in an economy.

Contribution of the manufacturing sector’s output to GDP (%)

What causes deindustrialization?

Several reasons explain why deindustrialization occurred. It can be seen as a natural phenomenon or as a result of structural problems in the economy.

Positive (natural development)

Deindustrialization is a natural phenomenon of economic development. An economy evolves from agriculture-based to manufacturing-based, a process known as industrialization.

Subsequently, it expanded to a service base, and the manufacturing sector contributed less than before (deindustrialization). Thus, when the economy matures and reaches full industrialization, as in developed countries, deindustrialization will occur.

The above phenomenon brings prosperity to the economy. The population has a high per capita income, prompting more consumer spending on services.

On the other hand, the increase in productivity in the manufacturing sector – due to advances in production methods and technology – makes the price of goods cheaper. In addition, they also get cheap goods from imports. As a result, the additional dollars spent on manufactured goods are less than those spent on services.

Negative (structural problems)

Deindustrialization can take place due to structural problems. Economists call this negative or premature deindustrialization.

Manufacturing sector output grew at a slower pace than economic growth or even fell before reaching maturity. In contrast, the non-manufacturing sector, usually the service sector, grew higher and became a new engine for economic growth.

Such a phenomenon occurs over a long period, not a year or two. As a result, industrialization did not achieve the same prosperity as developed countries produced during industrialization, causing a middle-income trap.

Then, due to declining competitiveness, low innovation, and investment, the manufacturing sector no longer creates many jobs. As a result, its contribution to % of GDP is also slowly decreasing.

Causes of deindustrialization in a nutshell

Well, here are the factors causing deindustrialization, both from a positive and a negative point of view:

Decreased competitiveness

Rising wages or poor infrastructure for logistics increase the cost of doing business. Low research and development can also weaken competitiveness due to low innovation.

As a result, the cost of producing manufactured goods increases. On the other hand, their quality is also less competitive compared to goods from other countries.

Trade liberalization and globalization pressure

Trade liberalization and globalization increase the flow of international trade. They allow foreign goods to enter abundantly into the domestic market. On the other hand, it is easier for consumers to get imported goods than before.

High imports threaten domestic manufacturers. Due to not competing, some eventually went out of business.

Capital flight

The capital flight associated with deindustrialization can be massive. When manufacturers perceive a long-term risk to their business due to political instability or government policies that don’t support manufacturing, they may withdraw their investments.

This exodus of capital starves the sector of the resources it needs to modernize and expand. Without these investments, factories struggle to keep pace with technological advancements and remain competitive in the global market. The result can be a vicious cycle: declining competitiveness attracts less investment, further hindering the sector’s ability to compete.

Outdated technologies and low investment

Insufficient investment in research and development (R&D) and equipment upgrades can leave a manufacturing sector reliant on outdated capital goods. This cripples productivity and hinders its ability to compete with more advanced producers who utilize automation, robotics, and other technological advancements.

The result? A stagnation in output and a struggle to meet the quality and efficiency standards demanded by the global market. Manufacturers become increasingly reliant on manual labor, further driving up production costs and making it difficult to compete on price with foreign producers.

Government policies promoting services

Some governments prioritize promoting the service sector over manufacturing through various initiatives, such as tax breaks or subsidies for service industries. While this can boost the service sector’s growth and create new jobs in areas like finance, healthcare, and technology, it may come at the expense of neglecting the potential for a competitive manufacturing base.

Such an initiative does not mean sacrificing the manufacturing sector at all. Instead, the government directed the economy towards deindustrialization as a natural phenomenon. Therefore, to support the program, the government also builds strategies supporting manufacturing, such as high-tech industries, ultimately increasing overall manufacturing productivity. “Made in China 2025” is a good example you can dive into.

Shifting consumer preferences

As mentioned above, rising incomes often lead to a preference for services over manufactured goods. Consumers with more disposable income may be willing to spend more on experiences and entertainment like travel, dining, or attending events than on material possessions. 

This trend, fueled by factors like increased urbanization and a growing emphasis on intangible experiences, naturally reduces demand for domestically produced manufactured goods. This puts pressure on domestic manufacturing firms to adapt by innovating and producing higher-value goods or face decline.

The rise of offshoring and its cascading effects

Businesses seeking lower labor costs may relocate their production facilities to countries with cheaper workforces. This phenomenon, known as offshoring, can lead to job losses in the domestic manufacturing sector and a decrease in its overall output. Offshoring can also have a ripple effect, impacting entire supply chains and related industries that previously supported domestic manufacturing. 

Local suppliers of parts and materials may experience a decline in demand, leading to further job losses and economic hardship in those sectors. Additionally, offshoring can raise concerns about quality control and intellectual property theft, especially for companies producing complex or innovative products.

Impacts of deindustrialization

Deindustrialization brings positive and negative impacts on the economy and society. It affects jobs, people’s incomes, and the environment.

Positive impacts

• Soaring standards of living: A robust service sector often correlates with higher incomes. This translates to increased consumer spending on experiences like healthcare, education, and entertainment, leading to a better standard of living.
• Productivity powerhouse: The service sector can be a breeding ground for innovation. With advancements in technology and automation, service-based industries often experience significant productivity gains, leading to more output per worker.
• A greener path: Manufacturing activity often carries a hefty environmental footprint. As economies shift towards services, there’s potential for reduced environmental degradation, particularly in areas like air and water pollution.
• The global marketplace advantage: Trade specialization allows countries to focus on producing goods and services where they have a comparative advantage. This can lead to cheaper goods for consumers due to increased competition and efficiency in the global market.
• Safer workplaces: Service sector jobs generally involve less physical risk compared to factory work. This shift can lead to a safer working environment for the overall workforce.

Negative impacts

• The jobless gap: Deindustrialization can lead to increased structural unemployment. As manufacturing jobs disappear, workers may lack the skills or training necessary to transition smoothly into service-based roles. This skills mismatch creates a gap in the labor market.
• Trade imbalance woes: A heavy reliance on imports and a shrinking manufacturing base can lead to a persistent current account deficit. This situation occurs when a country spends more on imports than it earns from exports, potentially affecting its financial stability.
• Tax revenue shortfall: Deindustrialization can lead to a reduced tax base. Manufacturing jobs often pay higher wages compared to some service sector positions. With fewer manufacturing jobs, governments may collect less tax revenue, impacting their ability to fund social programs and infrastructure development.
• Environmental issues: While deindustrialization may reduce pollution in developed countries, it can create environmental challenges for developing nations that become hubs for manufacturing. Stricter environmental regulations and responsible investment practices are crucial to mitigate these issues.