BehindTheMedspeak: "Baumol's disease" explains why health care costs rise faster than hard goods

Fascinating column by Steven Pearlstein in today's Washington Post about Baumol's disease — formulated by young economist William Baumol 50 years ago.

Excerpts from Pearlstein's piece below.

Look beneath the surface of our polarized political debate over budgets, taxes and the size of government and what you’ll find is that it is largely driven by the seemingly inexorable rise in the cost of providing health care and education and other necessary services.

For conservatives, these rising costs are the inevitable result of too little competition, too much subsidy and regulation and too much power in the hands of public employee unions.

For liberals, the problem is not so much the higher costs as the inability of ordinary Americans to pay for them, because so much of the national income is now captured by the rich.

There is some truth to both arguments. But what if the more important explanation for our current predicament is that "goods" such as medical care and education, public safety, or social work suffer from the fact that they are so labor intensive. It's hard, if not impossible, for them to be produced more efficiently.

It was in the early 1960s that a young economist, William Baumol, working with his Princeton colleague William Bowen, hit upon what has become known as "Baumol's disease."

No matter how innovative people were in coming up with new technology and new ways of organizing their work, Baumol and Bowen reasoned, it would still take a pianist the same 23 minutes to play a Mozart sonata, a barber 20 minutes to cut the hair of the average customer. and a first-grade teacher 12 minutes to read her class "Green Eggs and Ham." Based on this observation, the duo predicted that the cost of education and health care would inevitably outstrip the price of almost everything else.

Now, 50 years later, Baumol has updated and expanded his observation with a new book, "The Cost Disease: Why Computers Get Cheaper and Health Care Doesn't," which sheds some useful light on our current economic debate.

The basic facts are well-known to most Americans: Over the past 30 years, overall prices have risen 110 percent, median income has risen 150 percent, medical costs have risen 250 percent, and college tuitions have risen 440 percent.

To grasp the impact of Baumol's disease on the entire economy, imagine a simple economy that has only two broad sectors, one that produces goods and the other that produces services.

In the goods sector, new machinery and production techniques have made it possible to produce each bushel of wheat, car, computer and suit with many fewer hours of labor. Because of these huge gains in productivity, the inflation-adjusted price of goods falls, leading to increases in consumption and production. The number of farmers and blue-collar workers declines, even as their wages go up to reflect some of the productivity gains.

Meanwhile, it still takes as many teachers and nurses and police officers and accountants to provide the economy with services as it always did — that's Baumol's disease. Despite no gains in productivity, however, the pay of these service workers rises — after all, if it didn't, over time all those service workers would be lured to the higher-paying goods sector. Moreover, demand for services rises because all those farmers and factory workers want to use their increased income to buy more services. In response to the increased demand and the higher pay, service companies raise their prices.

As a result of these developments, the economy is better off, with more goods and services produced and consumed. While the income of both sets of workers has risen, more people are now employed in the service sector while fewer are making goods. Significantly, a big price gap has opened — the prices of goods are lower than they used to be while service prices are higher.

While this story is obviously over-simplified, it offers a pretty good idea of what happens in an economy such as ours, where there have been big productivity gains in manufacturing and farming and high-tech services such as telecommunications, even while there is little or no productivity growth in health care, education, public safety, performing arts and — dare I say it — journalism.

In the real world, of course, there are many other factors that impact prices and wages and production volumes. But Baumol's point is that because of the cost disease, it is inevitable that the cost of things such as health care or a college education will rise faster than everything else.

Not only should we not be surprised, argues Baumol, but we shouldn't be that concerned. Given the large productivity gains in the goods producing sector, he says, we cannot only afford the higher prices for things such as health care and education, but still have plenty of money left over to pay for more food, more cars, bigger houses, more clothes, and more home appliances. The idea that we can't afford medical care or higher education, he argues, is just an "illusion" reflecting some fixed notion of what percent of our income should be devoted to such activities.

From a political perspective, Baumol's most important insight is that government spending must grow as a percentage of the economy. Most of the services that are provided by, or financed by government — health care, education, criminal justice, national security, diplomacy, industry regulation, scientific research — are those that suffer most acutely from Baumol's disease. That's not because of incompetence or self-interest on the part of public servants or even the socialist instincts of Democratic politicians — it's in the nature of those activities.