Diagnosing William Baumol’s cost disease

Michael Maiello | May 18, 2017

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The late William Baumol of New York University’s Stern School of Business, who died in May, once pointed out a pattern: while rising wages are typically attributed in part to rising labor productivity, there can be upward salary pressure at jobs that haven’t experienced productivity gains.

The example Baumol and the late William G. Bowen made famous is that of the string quartet. The number of musicians and the amount of time needed to play a Beethoven string quartet for a live audience hasn’t changed in centuries, yet today’s musicians make more than Beethoven-era wages. They argued that because the quartet needs its four musicians as much as a semiconductor company needs assembly workers, the group must raise wages to keep talent—to keep its cellist from chucking a career in music and going into a better-paying job instead.

The effect now known as Baumol’s Cost Disease is used to explain why prices for the services offered by people-dependent professions with low productivity growth—such as (arguably) education, health care, and the arts—keep going up, even though the amount of goods and services each worker in those industries generates hasn’t necessarily done the same.

After Baumol died, Chicago Booth’s Initiative on Global Markets asked its panel of US economic experts to evaluate Baumol’s most famous theory, and it fared strongly: 59 percent of the experts polled agree that “rising productivity in manufacturing leads the cost of labor-intensive services—such as education and health care—to rise.” When the responses are weighted according to how confident respondents’ are in their responses, 88 percent agree with the statement.

Anil K Kashyap of Chicago Booth called Baumol’s Cost Disease “an example of something that is probably not obvious to non-economists but has been demonstrated to be true.”

Some panelists debated the nuances, however. Stanford’s Kenneth Judd said, “This is a serious problem in education. If you are good at math, why would you want to be a high school teacher?”  But his Stanford colleague Caroline Hoxby said economists greatly overstate the theory’s importance in explaining skyrocketing education costs. And Harvard’s Oliver Hart proposed a middle ground, arguing that mobile phones and technology are changing the salary range for superstar teachers.

While the panel is inclined to view Baumol’s Cost Disease as fundamental to modern economic conditions, there’s debate about which industries are affected, and how they are affected. Nobody argues that string quartets have the potential to become more productive, but some economists say that health care and education have more potential efficiency gains than are commonly recognized.

Larry Samuelson, Yale
“One sees clear evidence in a variety of labor-intensive services—education, health care, professional orchestras, and so on.”
Response: Strongly Agree

Pete Klenow, Stanford
“Productivity and price trends are inversely related across industries. It jumps out at you when looking at the data.”
Response: Strongly Agree

David Cutler, Harvard
“This is true for sectors without technological change. Health care has a lot of tech change.”
Response: Uncertain

William Nordhaus, Yale
“Could go either way depending upon labor demand. Unfortunately misconception.”
Response: Disagree