• The Cost Disease: Chapter 1

    I’m blogging my way through The Cost Disease, by William Baumol. All posts related to the book will be tagged with “Cost Disease.”

    Chapter 1 sets the stage with the central puzzle and a sketch of the solution. The puzzle is observed in health care and higher education. In both, costs* have been rising at rates above that of overall inflation for decades. This is fairly well known and certainly so to readers of this blog. What is probably less well known is that the cost growth above that of inflation is not due to above-inflation wage growth in either sector. The chart below, reproduced with permission from the book’s publisher, Yale University Press, illustrates this fact. I know it’s a bit hard to make out, so I’ll explain it in words.

    Inflation, as measured by the consumer price index (CPI), and wages of medical professionals nearly hug each other (the top two lines), with CPI higher from the late 1970s through the late 1990s. The wages of employees of colleges and universities (bottom line) are well below both those of medical professionals and CPI.

    So, this is the puzzle, actually two: (1) How can, or why do, costs consistently rise for certain sectors and not others? (2) In the sectors that suffer this “cost disease,” why doesn’t the additional spending accrue to its workers? Baumol, I trust, will answer these questions. In Chapter 1, he provides a sketch:

    My argument, in brief, is that the cost disease is largely a product of the unprecedented and spectacular productivity growth that the world’s industrialized nations have achieved since the Industrial Revolution, commonly said to have begun in the eighteenth century, which has contributed so much to standards of living and reduction of poverty. This unprecedented productivity growth—carried out primarily by the partnership of inventors and entrepreneurs and expanded to a large scale by companies, governments, and nonprofits—has all but eliminated famine in wealthy countries, created technology unimaginable in earlier eras, given us ever rising standards of living, and greatly reduced poverty in both extent and severity. But it has also brought the rising costs of health care, education, and other important services. The argument here is that the productivity growth that gives rise to the cost disease also gives society the means to deal with it.

    So, I infer (and I also know from prior reading) that the cost disease is due to the difference in productivity growth between the diseased and non-diseased sectors. It’s relatively low in the former and higher in the latter. In reading the book, apart from connecting the dots in the above sketch, I look forward to understanding more about how productivity is measured in health care. To date, I’ve been disappointed with the approaches to this measurement problem I’ve seen. Today’s doctor visit, hospital stay, prescribed drug, and the like are not like those of prior decades. There have been qualitative changes in health care. It is a huge challenge to account for this in measures of productivity. How does Baumol do it, if at all? Let’s find out.

    * I’m using “cost” because that’s the term used in the book. We mostly observe spending, which is different.

    @afrakt

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    • “Today’s doctor visit, hospital stay, prescribed drug, and the like are not like those of prior decades.”

      Ditto for today’s college and university education. Over the course of the time in that chart, the distribution of wages of employees in both areas has changed. I doubt that the typical employee of a college/university has fallen that far behind the CPI curve; rather, effects such as having low-paid graduate student shoulder much of the teaching burden lower the average wage in this sector. A better comparison would somehow normalize total wages in the sector by the quantity of a good (health care, education) delivered.

      Less importantly, as you note it’s nearly impossible to figure out which plot is which, (almost) anything comparing growth rates is best plotted on a log scale and “Index 1972 = 100″ is pretty lazy. How much of the slow growth in higher-education wages came from Yale apparently firing the editorial staff at Yale Press? More importantly, choosing a normalization point that immediately precedes the highest decade of post-WW2 inflation is questionable, although it doesn’t make much of a difference here.

      This sort of laziness really turns me off from a book that I’d otherwise be receptive to.

    • In the sectors that suffer this “cost disease,” why doesn’t the additional spending accrue to its workers?

      Do you mean wages, or all benefits? As per the chart (medical employees), they are not laggards relative to “other,” in this case workers in educational sector.

      Brad

    • Can you put the line for all wages up for comparison? Or is that going to be the same as the CPI line?

      (Didn’t pay attention in Macro :()

    • “My argument, in brief, is that the cost disease is largely a product of the unprecedented and spectacular productivity growth…”

      This sentence left me scratching my head and running to the dictionary where I found this definition:

      “Economics: The rate at which goods or services are produced especially output per unit of labor.”

      So how does productivity increase labor costs???

      • Productivity does not increase labor costs. The cost disease argument is that productivity rises generally in the economy but is found in those areas where output outpaces costs. In highly regulated, labor-intensive areas such as HC and ed, output does not increase significantly but wages continue to rise. Thus productivity declines in those industries.

    • You should use spending because cost makes no sense in the context. The mixing of these to words causes confusion in this discussion.

      Are costs really rising? Why would costs rise in one industry due to an increase in productivity in other areas? On the other hand spending would be expected to rise due to wealth effect.

      • @Floccia: Why would costs rise in one industry due to an increase in productivity in other areas?

        It’s because it’s a matter of relative costs rather than absolute costs. I also think of it as a matter of the costs of some things standing still (the human-intensive services particularly like health care, education, social services, policing, and many other things government does [leading to other challenges]) while other things get much cheaper. Compare the productivity of a physician who has a limited amount of time in the day to see patients (and the length of the day hasn’t changed since 1960) to the productivity of a manufacturing working who ran a machine that made 10 widgets per hour in 1960 and now supervises a robotic assembly line that makes 10,000 widgets per hour. Intrinsic factors in the nature of the product let some workers and industries make huge productivity gains through technology and innovation while others are much more limited.

        Of course as Austin notes this is further complicated by the problems with actually measuring productivity in a way that’s equivalent over time. This doesn’t only affect health care either. What’s the relative productivity of a worker making rotary phones to one making iPhones?

        • I’m still not sure I fully explained this. (or have it right myself!) Given that shift in relative productivity over time the cost of a unit of health care and the cost of a unit of widgets increasingly diverge.

          Does this explanation account for the wage data? I think it implies that fewer and fewer workers are needed to make widgets while the same number of workers are needed to produce health care. Ultimately implying that manufacturing wages should increase (fewer workers each collecting more money) while health care wages remain constant (you need the same number of health care workers relative to the population over time).

          I’m not sure the empirical data agrees with this. I’d probably better get the book too.

    • It looks to me that workers in those sectors are able to extract rents due to constriction in supply.

      • I miss read the chart. I am surprised.

      • They also happen to be heavily subsidized – I believe they are the most heavily subsidized sectors of the economy, but I could be wrong . I don’t think that’s an accident, but I’m interested to learn how or if Baumol accounts for cost-growth without factoring that in.

      • You are right on target with respect to rents. Healthcare does not necessarily have to be subject to slow growth in productivity, but it is because there is so much rent taking through pay to delay patent protection, restrictive scope of practice laws, certificate of need laws, excessive licensure requirements, etc.

    • Ok, now I have to buy this book too. I am also interested in how he will look at productivity.

      Steve

    • So over the past ten/twenty years, has productivity in health care been *increasing slowly*, or outright *decreasing*?

    • I find this book’s line of logic rather tortured. Admittedly, if. I have less productivity growth than the market mas a whole, then I will have a cost push inflation premium. The question is when does a substitution effect kick in?

      It is simply not reasonable that this can be extrapolated to be 50%+ of GDP. Substitution and innovation economics would kick in LONG before then to find ways to increase productivity at an acceptable discount…

      …Unless the public continued to make irrational price decisions in an absence of information to believe they had to spend at those levels. :)

      That line of logic is a much more fruitful avenue of thinking, because what both education and health care also have in common is a third party payer system where the consumer doesn’t have sufficient information to make rational consumption decisions.

      Greg