So Much Water Has Flowed Down the River

There is so much new, particularly new terminology in economics since I studied it in college! (when dinosaurs ruled the earth) The term “rent-seeking” hadn’t been coined yet, John Maynard Keynes was Holy Writ, and the discussion of externalities and public goods was barely a footnote. I learn something new or, at least, new to me practically every day.

Today what I’ve learned about is Baumol’s cost disease:

Baumol’s disease can be explained simply. Only some areas of production will see strong improvements in labour productivity, typically through the substitution of capital for labour (such as in manufacturing and agriculture). Workers in these industries use their bargaining power to capture part of the increased profitability arising from productivity gains in their wages.

As a wage differential between these newly productive jobs and other existing jobs emerges, workers are faced with a choice of seeking employment in the high paying productive sectors or the lower paying unproductive sectors. Employers in the unproductive sectors still need workers and the wages need to remain competitive with the productive sectors to attract them. Bargaining between workers and businesses in each sector (including government sectors) equalises wages over time. Thus productivity growth in just one area of production is shared amongst workers across the economy.

This means the cost of labour intensive services with low productivity growth will increase relative to other goods and services in the economy over time. In addition, the amount of labour employed will shift towards service sectors with low productivity growth. Ever wondered why all developed countries seem to have relatively large service sectors? This is part of the story (the other part is displacement of tradable industries to cheaper locations).

Note that the degree to which the costs in a sector with low productivity growth can rise relative to other goods and services over time is proportional to the ability of that sector to bargain.

What struck me about this is how neatly it explains rises in the cost of healthcare and the size of the healthcare sector. What are the policy implications? The article cited draws one conclusion, i.e. that we’d (or, at least, Australians had) better get used to spending a lot more on healthcare but I don’t think that’s the best conclusion.

I think that this provides further support for the arguments that I’ve been making for some time, i.e. that the direction in which we need to go is one in which the bargaining capabilities of the sector are reduced and/or we start incentivizing productivity a lot more effectively than we have been.

The irony in healthcare spending is that very few other than some mentally ill individuals really want more healthcare. We want more health but, unfortunately, we’re subsidizing healthcare in the form of paying for specific procedures. If you subsidize something, you get more of it and we’re getting a lot more procedures without getting a lot more health.

This might be a good place to mention that outputs per input in healthcare have been declining for decades but that’s something we’ll go back to another time.

5 comments… add one
  • Interesting article, I hadn’t heard of it before either, but it makes sense. One thing from the article though,

    …and the associated problems of gaming and moral hazard this may entail.

    People love to point to problems with asymmetric knowledge (hidden information, moral hazard, adverse selection) and then suggest that the market throws its hands up and says, “Can’t deal with it, market failure!!!”

    But there are ways of dealing with asymmetric information. Granted, it results in a sub-optimal outcome but it isn’t like a stake through the heart or something like that. For example, how do you get around the issue of lemon cars in Akerlof’s lemon model? The dealer could offer a guarantee. The buyer could take the car to an independent mechanic for an evaluation. These things impose additional costs and can reduce the overall efficiency of the market, but it isn’t like people go “Oh, adverse selection, I’ll just roll over and die now.” If there is money to be made people can be pretty good at finding ways to make it. And, it isn’t like all these problems magically disappear when you go the route of the government either. Some of them might, but not all of them.

    In fact, note what Baumol wrote.

    If the citizens of these countries are willing to do what is necessary for the supply of educational, health care, and other related services to keep up with the overall expansion in economic output made possible by rising productivity, then, if my analysis is correct, a difficult choice will be required: either ever more gross national product will have to be channeled through the public sector, with all the problems we know that to entail; or, alternatively, these services will have to be transferred to private enterprise, in fields where private business firms can hope to succeed only if granted an (improbably) immunity from the temptation of unwise governmental interference.

    Link

  • Hmm, my html blockquoting messed up that last paragraph is Baumol’s.

  • samwide Link

    You might be interested in this, Dave: Tyler Cowen, Why I Do Not Believe in the Cost Disease.

    He criticizes the cost-disease theory in the context of the performing arts.

  • steve Link

    “these services will have to be transferred to private enterprise, in fields where private business firms can hope to succeed only if granted an (improbably) immunity from the temptation of unwise governmental interference.”

    The costs in the private sector, in health care, are higher than for the public sector. They have increased as fast or faster. Just turning it all over to the private sector and assuming it will slow costs is a magic pony solution. There is no example anywhere of this working.

    Your opening paragraph is more interesting. Most of the basic economic philosophies we embrace were created many years ago. I think that if these same guys were writing today, they would propose much different solutions. The speed with which money moves and the international nature of markets is much different. I think we are wrong to assume these same principles still fit as well as we thought.

    Steve

  • steve,

    Did you not read this part,

    ….private business firms can hope to succeed only if granted an (improbably) immunity from the temptation of unwise governmental interference.

    Really, I think you should see your optometrist about that blind spot.

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