Learning to love Baumol’s cost disease

Baumol’s cost disease is one of the simplest ideas in economic theory, but I experience it as a kind of brain worm: once you know about it, you see evidence of it virtually everywhere. You can read the Wikipedia page as well as I can, but this is how I think about Baumol’s cost disease:

If productivity is increasing economy-wide, labor costs have to rise in sectors where productivity is rising more slowly in order to maintain the same quality and quantity of production in those sectors.

Consider an economy with only two industries: pizza production and hamburger production, both of which employ high school graduates for $1 per day. If the productivity of the hamburger industry were to double (say some new grinding technology or patty-pressing machine is developed), some combination of three things has to happen: hamburger factory owners charge lower prices, pay higher wages, or collect more profit. But to the extent that higher productivity is passed along to hamburger factory workers in the form of higher wages, it also has to raise the wages of pizza factory workers, since all pizza factory workers are qualified to work at hamburger factories and, all else being equal, would prefer to make more money rather than less money.

The pizza factory owners now also have to arrive at a combination of three options: accept lower profits (or, if necessary, go out of business), accept lower quality (hiring high school dropouts instead of graduates, for instance), or laying off some of their workers and reducing the quantity of pizza they manufacture.

Economy-wide, this process plays out constantly and with little fanfare, although of course in hindsight the effects can be dramatic. Motorized cab operators could serve many more customers per hour than horse cab operators, which put upward pressure on the price of horse cabs to the point that today they are only available at great expense to go in circles around Central Park. Industrial furniture manufacturing made the small amount of furniture still produced by hand in the United States a pricey luxury good.

Baumol’s cost disease makes the same quantity and quality of labor-intensive services more expensive

The key problem, Baumol’s namesake “disease,” arises when productivity is flat or only slowly rising in a sector where people refuse to compromise on quality or quantity. Childcare is a straightforward example: say one well-trained childcare provider can adequately care for a maximum of 6 infants at a time. In this case, an economy-wide rise in productivity leaves parents with the same options as the pizza factory owner: they can accept lower quality (hiring poorly-trained or untrained childcare providers or accept more crowded childcare facilities), pay higher wages to match the economy-wise rise in productivity, or go out of business (care for their own children or remain childless). If the parents demand the same quantity and quality of childcare, they’re forced to “share” the economy-wide rise in productivity they participate in with childcare providers whose productivity has not increased.

The exact same problem arises in the provision of public-sector services. If a fully-qualified teacher can provide quality instruction to a maximum of 30 high school students at a time, then an economy-wide rise in productivity mean either raising teacher salaries or lowering the quality or quantity of instruction. If a well-trained IRS phone agent can provide quality answers to a maximum of 30 callers per day, then an economy-wide rise in productivity requires either raising IRS phone agent pay or reducing the quality or quantity of IRS phone services.

Baumol’s cost disease is often invoked in the public sector, but as the example of childcare (which is largely provided privately in the United States) shows, it has nothing directly to do with who is responsible for providing a service. Rather, the question is how fast or slow productivity rises in a sector compared with the economy as a whole, and how willing people are to accept lower quantity or quality of service provision.

The point is that if productivity in a sector is flat or rising slowly compared to the rest of the economy, and consumers are unwilling to compromise on quality or quantity, they must “share” some of the economy-wide productivity growth with workers in less-productive industries.

Baumol’s cost disease is a moral foundation of calls for redistribution

The most important ideological movement today is the movement for redistribution. The Affordable Care Act was at its core a redistribution of medical services from those with stable, long-term employment to freelancers, the self-employed, and low-income workers. “Free college” is a demand for the redistribution of educational services from the children of well-off professionals to the children of workers, immigrants, and the poor. The teacher strikes we’ve seen over the past few years are a call for all students to receive the quality education the most privileged students already receive.

Baumol’s cost disease makes the problem clear: wealth and income inequality mean that most private sector workers don’t have enough to “share” with workers in less-productive industries; low-income workers send their kids to public schools with 45 kids in a classroom while high-income professionals send their kids to private schools with 25 students per classroom. The question is not whether low-income workers are willing to compromise on the quality or quantity of education their children receive. It’s that they don’t have a choice: there’s not enough leftover to “share.”

To the extent that people are unwilling to compromise on demanding high-quality childcare, healthcare, and education, increases in economy-wide productivity require increased redistribution. The flip side is that increases in economy-wide productivity mean there is plenty to go around.

Calls for redistribution are simply demands that the plenty actually does go around.