Economics #8: Cost Disease

 

In economics, there is a simple idea called the Cobb-Douglas production function that tries to explain the relationship between labor (the total number of person-hours worked), capital (the real value of all machinery, equipment, and buildings), total factor productivity (the ability to produce more output with less input), and the total output of an economy. The idea is that since labor and capital are relatively fixed, economies grow by increasing their productivity, which technology is the main driver of.

Let’s look at the past 70 years or so of productivity growth in the United States.

Nonfarm business productivity bar chart

In the 50s and 60s, we saw the first commercial computers and satellites. In the 70s, we saw the first microprocessors. In the 80s, we saw the start of a financial engineering boom. In the 90s, we saw Windows and Excel. In the early 2000s, we saw smart phones and Google. Currently, however, something weird is going on with productivity. We are seeing companies like Facebook, Uber, AirBnB, etc, but the top line productivity numbers are at generational lows. What is going on?

The bifurcated economy

Those top line numbers hide the productivity growth that is happening in certain sectors of the economy. Take the media industry for example. A single reporter on Twitter can reach the whole world. The news is increasingly on demand and free. Netflix brings us better content for less than the cable bundles of the past. Take retail as an example. Amazon and Walmart have made sure that prices are low and continue to get lower. Take financial services as an example. Vanguard offers funds for less than 10 basis points that use to cost 200 basis points. Productivity is growing and prices are falling.

But then take healthcare as an example. Real prices have dectupled in the past 50 years for similar, and in some cases worse, service (no house calls, longer waiting times). Take education as an example. Real college prices have dectupled in the past 50 years and it’s hard to argue that colleges are 10x better. Take real estate and infrastructure as an example. Real housing prices have doubled and infrastructure projects seem to take longer and cost more. Productivity is slow and prices are rising.

By definition, the parts of the economy that are getting cheaper have a smaller impact on GDP, and the parts of the economy that are getting pricier have a larger impact on GDP. Marc Andreessen recently made this point in a podcast:

So what’s actually happening is the sectors where tech is not having a big impact are growing and will eventually be the entire economy…So TVs are going to cost $10 and healthcare is going to cost $1 million…As a consequence, the answer is we are all going to be employed in healthcare and education which is actually what’s happening.”

But why do some sectors get cheaper while other sectors get more expensive? Why have globalization and technology improvements reduced the real price of a cell phone by a factor of 10 while the real price of health care has increased by a factor of 10. It turns out that Economics has a framework for thinking about this bifurcation and this long introduction leads us into the topic of today’s post – cost disease.

Baumol’s cost disease

Let’s start with an analogy. Suppose that we are living in an economy where there are only two possible jobs – either we can work as a painter or work in a factory. Let’s say that technological improvements occur and factory workers are able to increase output by 10x. However, these improvements had minimal effect on the painter’s output.

The factory workers begin to get pay raises to match their increased output. The painters see those pay raises and decide to switch fields. If art galleries don’t want to disappear, they need to start matching that pay. So a painter now costs more but produces the same amount of paintings – real prices increase and we see the bifurcation effect in action.

William Baumol first proposed this idea in his paper On the Performing Arts: The Anatomy of Their Economic Problems. He expanded the idea in his paper Macroeconomics of Unbalanced Growth, in which he concluded:

The analysis also suggests that real costs in the “nonprogerssive” sectors of the economy may be expected to go on increasing. Some of the services involved – those whose demands are inelastic – may continue viable on the free market. Some, like the theater, may be forced to leave this market and may have to depend on voluntary public support for their survival. Our hospitals, our institutions of private education and a variety of other nonprofit organizations have already long survived on this basis, and can continue to do so if the magnitude of contributions keeps up with costs.

Unbalanced productivity growth, then, threatens to destroy many of the activities that do so much to enrich our existence, and to give others over into the hands of the amateurs. These are dangers which many of us may feel should not be ignored or taken lightly.

Politics of cost disease

That first part, about healthcare and education contributions keeping up with costs, is a powerful idea when it comes to our politics. Tyler Cowen had an article about it earlier this year where he noted:

These dilemmas in health care and education don’t have easy fixes. For instance, as Medicare and Medicaid become more expensive, many people will suggest that taxes and spending be raised. We’ve done that in the past, but at some margin voters will balk at further spending and tax increases, or maybe governments won’t find it so easy to bring in more revenue.

The first problem will be that other areas of government spending (“discretionary spending”) will tend to suffer, as money is soaked up by the low-productivity sectors. Voters will feel that governments are neglecting some of their most important interests, such as infrastructure.

As it stands, we’re set to re-create these debates at higher and higher levels of government spending in the low-productivity sectors.

At the extreme, more and more of the economy is shifted towards these low productivity sectors. This means that even huge increases in the productivity of other sectors will have a relatively low impact on the overall growth rate and our standard of living.

That second part about sectors being turned over to amateurs can be seen in the current state of the gig economy. As productivity stagnates in sectors like transportation and entertainment, the door opens for Uber drivers and Youtube personalities. Baumol was worried this would reduce standards, which in my opinion hasn’t been the case. This brings us to some critics of Baumol’s idea.

Issues with cost disease

The basic story of salaries increasing in the non-productive sector doesn’t seem to actually describe the world. Teachers aren’t suddenly being paid 10x for example (can be argued that benefits and total compensation have increased though). Instead, maybe something else is going on.

Demand inelasticity might explain why prices can just increase without even having an impact on demand. For example, we will pay whatever we have to for a life-saving medical treatment and many view college education as a similar necessity. Maybe market providers have realized this and just started price gouging.

Maybe regulation and government inefficiency are the problems. Tech entrepreneurs like to point out that sectors, where regulation is low, are the ones experiencing technological change, and highly regulated sectors, like healthcare, would experience the same if they were allowed to move fast and break things.

Maybe we are just looking at inflation wrong. Sure healthcare costs more, but we also have access to the world’s information on Google for nearly free. Does it all net out to an increased standard of living? Measuring inflation is tough.

Whatever the reason, the main point that unproductive sectors are increasing in size and cost remains true. The fact that many of these sectors are fundamental to human lives brings us the real issue: what happens if the basic cost of human needs increases faster than incomes? It’s a scary idea and one that might define our generation.

Conclusion

In a NYT interview, William Baumol described cost disease as:

Basically what it says is that there are sectors that experience rapid productivity growth and other sectors that experience slow productivity growth. That’s no surprise. But what’s interesting is that the sectors that experience slow productivity growth tend to persist in that … If we look at what is happening to the content of expenditure in the economy, we’re heading towards 50 percent if GDP going into health care and education … So the danger is that we will deny ourselves health care, that we will deny ourselves education, that we will deny ourselves a lot of the activities or the products whose costs are determined by the cost disease – this will make an enormous difference, politically.

Cost disease gives us a framework, though incomplete, for thinking about the drastic bifurcation that is currently going on in our economy. The price of a cell phone might be dropping to zero, but the price of healthcare is rising to infinity. Taken to the extreme, will this lead to a decreased standard of living, or will innovation catch up?

References:
https://en.wikipedia.org/wiki/Baumol%27s_cost_disease
http://pages.stern.nyu.edu/~wbaumol/OnThePerformingArtsTheAnatomyOfTheirEcoProbs.pdf
http://piketty.pse.ens.fr/files/Baumol1967.pdf
http://slatestarcodex.com/2017/02/09/considerations-on-cost-disease/
http://graphics8.nytimes.com/packages/pdf/health/18baumol-doc.pdf
https://www.bloomberg.com/view/articles/2017-01-18/this-economic-phenomenon-is-making-government-sick

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Author: David Shahrestani

"I have the strength of a bear, that has the strength of TWO bears."

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