Abstract
We construct a spatial equilibrium model where agents have nonhomothetic preferences over final goods that differ in the intensity of use of local services as production inputs. Over time, the expansion of employment in local services is both a consequence (income effects) and a cause (productivity growth) of the development process. We estimate the model using household data from the Indian NSS exploiting granular (district-level) information on sectors of employment and individual data for consumption expenditure. By way of counterfactuals, we assess the welfare effects of different sources of technical progress for different group of agents in the economy (rich vs. poor; rural vs. urban residents). We find that productivity growth in consumer services is an important driver of rising living standards between 1987 and 2011 accounting for 1/3 of aggregate welfare gains. However, these gains are heavily skewed toward high-income households living in cities. Productivity growth in the service sector is also a powerful driver of the process of structural change shifting employment out of agriculture into the service sector with only limited industrialization.