Baumol’s Cost Disease — An Exploration

Source: Marketing91

Have you ever wondered how mobile phones and automobiles keep getting cheaper over the years while services like education, healthcare, and custom shoe production are becoming more and more expensive? Well, Baumol’s cost disease may be to blame, at least partly!

Healthcare, education, a string quartet

What comes to your mind when you see the above three items? Not much, right? But, you’ll agree that arranging for these services today is much more expensive than it was in the past. On the other hand, mobile phones, computers, and cars have become a lot cheaper. This image from Vox is highly telling:

This trend can be partly attributed to Baumol’s cost disease.

A Primer on Wage Rates

Economics tells us that wages must be linked to productivity (ceteris paribus). For optimality, wage per hour = marginal revenue generated by that worker in that hour. Why should this be the case? Well, let’s consider two scenarios:

Scenario 1: A firm ABC overpays an unproductive worker

As time progresses, ABC would realise that its profitability isn’t looking great. It would identify other workers with similar low productivity levels being hired at lower wages by competitor firms. ABC would try to hire those workers instead or bring down wages for the existing worker. At the end of the day, the firm seeks to bring the salary back to a sustainable, lower level (wage/hour=marginal revenue generated/hour).

Scenario 2: A firm underpays a productive worker

If a firm doesn’t reward a worker’s higher productivity with a higher wage, competitors can easily poach the worker at a higher salary and benefit. This tactic would be repeated by various firms till an upper salary cap is reached (wage/hour = marginal revenue generated/hour).

So, ideally, wages and worker productivity are linked. Of course, demand and supply factors come into play, but the interplay between the two usually pulls the wage rate close to the equilibrium level. Note that productivity can, on one hand, be related to the individual’s skill and ability. But, it can also be that the job role or the industry itself doesn’t offer much scope for productivity. If a pianist takes 30 minutes to perform a piece in the 1800s, she would take 30 minutes to perform the same piece today as well!

In reality, a lot of other factors like seniority, networking, experience etc. play major roles in determining pay.

The Cost Disease

William J. Baumol and William G. Bowen, in 1966, identified a phenomenon that is now referred to as Baumol’s cost disease. Baumol’s cost disease occurs when wages in an industry rise without a commensurate increase in productivity.

Why does this happen? Well, in an economy, there are some sectors with rising productivity and some sectors with stagnant or falling productivity. In accordance with the fundamental economic idea of wages being linked to productivity, productive sectors raise their employees’ wages. Now, the unproductive sectors, to avoid a labour exodus to these other high-paying jobs, must also raise the wages they offer. Thus, these sectors see increasing costs despite lacking any productivity upside. This effect is noticed in labour-heavy sectors.

Baumol and Bowen used the string quartet (and the performing arts space) as an example to illustrate this. Say 4 musicians needed 40 minutes to render a Beethoven composition in the 1800s. Even in 2021, 4 musicians and 40 minutes would be needed to recreate that effect. And, real wages for the quartet players have risen quite significantly over this time period despite no increase in productivity. On the other hand, while workers at GM needed over 41 hours to make a car in the past, that fell to less than 24 hours in 2016.

Here’s a poll conducted at Chicago Booth’s Initiative on Global Markets (IGM):

Looks like many experts (59%) do support this finding. However, significant opposition is also present.

Impact of Baumol’s Cost Disease

When a sector witnesses a rise in productivity, it can cut costs and raise wages at the same time. But, unproductive sectors don’t have that luxury. When wages for such sectors rise, they have three options:

1. Absorb the extra costs at the risk of lowering profit margins
2. Transfer the extra cost to the customer
3. Shut shop and remove the particular service or offering from the market

All the above three are problematic to different stakeholders. Now, many scenarios can be envisioned here. Some of the impactful ones are as follows:

Scenario 1: The service or product offered by the unproductive sector has a high, growing, and relatively inelastic demand (think education, healthcare)

Here, the adoption of (2) makes more sense to the sector/firm. People would still make the purchase despite rising costs, and the overall productivity of the economy would be bogged down (slightly maybe) by the presence of these unproductive industries. Instead, if in such a situation (1) is adopted, then Baumol’s cost disease could wipe out a lot of unproductive sectors and firms unless investors are willing to finance low-margin sectors, with only the fittest and strongest left to survive.

Scenario 2: The sector faces a demand that is highly elastic and falling

Now, regardless of whether (1) or (2) is employed, downsizing of the sector would occur.

Musings on the String Quartet

Let’s go back to the string quartet example. Here’s how I see that market today:

• Alternatives: 200 years ago, if you wanted a rendition of Für Elise, you needed to hire a musician or attend a concert. Today, you can listen to the piece on Spotify, Apple Music, YouTube and a bunch of other sources at the click of the button. Essentially, the service has been converted into a somewhat commoditized good.
• Supply: String quartets might be relatively rarer to come across today than in the past, due to the availability of so many options in terms of music access as well as alternative careers.
• Demand: The nature of demand has also changed. String quartets may be called during special occasions. A wedding, a dear friend’s birthday, etc. The pull comes not from the ability to listen to music, but from the relative exoticity, speciality, and uniqueness of string quartets in today’s world.

So yeah, while I agree that productivity hasn’t really increased over the last two centuries, falling supply, rising speciality and exoticity are factors contributing to a higher salary for the remaining quartets. Unless these performers are sufficiently compensated, they can just quit and explore well-paying jobs in other industries. But, if you can command a good enough price from the customers, things are okay for this sector. This is indeed a way to mitigate Baumol’s cost disease from the point of view of the industry.

Now, you might think that, logically, unproductive sectors would just vanish and pave the way for productive sectors right? That is true, in a sense. While getting shoes from a cobbler who makes them especially for you was the modus operandi in the past, even today some people opt for this strategy. Sure, it’s a lot more expensive than taking a shoe off the shelf from a Bata store, but it’s still a niche market offering customers the feeling of possessing something special, customised, and unique.

So, let’s take a look at the buckets one has to check to see if Baumol’s cost disease has infected the quartet and custom shoemaking sectors:

1. Rising productivity? No
2. Rising (real) wages? Yes

Hmmm, looks like it has.

Now, what about the big guns like education and healthcare?

Education and Healthcare

Now, both education and healthcare are people-heavy sectors. Let’s look at college education via the two frames for Baumol’s cost disease:

1. Rising productivity? Not really. According to the NCES, in 1999, there were 14.8 students per faculty member. In 2017, the number was 14. This doesn’t indicate an increase in teaching productivity.
2. Rising wages? Yes. Faculty salaries (adjusted for inflation) increased overall by 9% between 1970 and 2016 according to the NCES. Sure, accuracy would be higher if we compare teaching salaries alone, but this is a good enough proxy. What we see isn’t a very steep rise, but a rise nevertheless.

So, can we conclude that Baumol’s cost disease is the reason for the massively rising costs of education? No, data shows that only 10% of the increase in costs is attributable to the rise in faculty salary cost borne per student. So, while Baumol’s cost disease is indeed present in the higher education space, it doesn’t seem to be the major driver for cost increase to students.

Healthcare, too, has witnessed a portion of rising costs attributable to Baumol’s cost disease.

Alleviating this Issue

Simple supply-demand matching suggests that the following steps can help alleviate this issue:

• Lowering supply (to generate uniqueness and command more prices)
• Increasing the price (to maintain margins)

In the case of the 21st-century string quartet/custom shoemaker, lower supply and the proclivity of certain customer segments to seek exquisite, unique experiences allow for charging of higher prices, thus reducing the impact of Baumol’s cost disease.

• Bringing in volunteers instead of fixed employees
• Enhancing non-monetary compensation to employees
• Incorporating of technology to industrialize and commoditize services

Think of store-bought shoes instead of custom shoes from a cobbler, mp3 music in place of live music from a quartet. What’s essentially happening is a conversion of services into goods. This reduces optionality and reduces the speciality of the service, but makes the product available for lower costs.

In industries like higher education and healthcare, incorporating technology like AI to tackle some repetitive tasks would help in ‘commoditizing’ the current people-intensive service to a certain extent. True, we’re nowhere near having AI that can replace a lot of manual tasks, but even a small transfer of processes to AI can cause immense impact in a field as big as healthcare.

It looks like we’ll have to bear with rising education and healthcare costs for some more time, party due to Baumol’s phenomenon.

So, now you know what Baumol’s cost disease is. The next time you’re playing Beethoven’s Moonlight Sonata on Spotify, take a moment to reflect on this bemusing yet somewhat obvious phenomenon. As Nassim Nicholas Taleb says, ‘Things always become obvious after the fact.’