From Chapter 3 of The Cost Disease:
As we have already seen, productivity growth ensures that both wages and per capita income will continue to increase, making most products and services cheaper relative to consumers’ buying power. This means that we can afford not merely the current quantities of these items and services but also ever greater quantities and ever rising quality in the future, despite their rising costs. Thus, there is no need to contemplate reductions in the provision of health care, education, or the performing arts.
Just in case it isn’t crystal clear what Baumol is saying, let me break this down. There are a few hidden assumptions.
The overall wage level rises because overall productivity rises. If the average worker can produce more per unit time (higher productivity), her employer can afford to pay her more per unit time (higher wage). This doesn’t itself mean that workers wages rise, because another thing employers could do is cut the price of the goods produced.
However, any way you slice it (wages go up or price of goods goes down, or some of each), productivity increases consumers’ buying power. In terms of real goods and services, you can afford more per unit of your labor when productivity goes up.
Just because you can afford more stuff, you don’t want or need more of all kinds of stuff. You can only eat so much. You can only listen to so much music. In general, how your demand for products and services changes with your purchasing power is different for different products and services. In economics jargon, price elasticity of demand varies by product. Consequently, some stuff both becomes cheaper and you don’t want that much more of it (inelastic demand). You’re spending less of your paycheck for such stuff over time. This has happened in the area of food, for example. Americans’ food budgets have gone down over the past century. Calories got cheaper. Sure, we have bought and consumed more calories, but not enough to offset the fall in price per calorie.
That fact opens up the possibility that some stuff can become more expensive and you can still afford it. If you’re spending less on food, you can afford to spend more on health care (ignoring all other types of spending), even if health care productivity is not growing as fast as that for food — that is, even if health care prices are not falling like those of food are.
Whether there is really no need to contemplate reductions in health care, education, or the performing arts (Baumol’s last sentence in the quote) depends on productivity rates and income elasticities across goods and services. Or, in less jargon-laden terms, it depends on how prices are changing across products and how much you need or want them. It is possible that we can continue to afford health care at the rates its prices have been growing. But that depends on how fast other stuff is becoming cheaper, all relative to our incomes.
All posts about the book are under the Cost Disease tag.