Monday , July 6 2020

America cannot shake the Baumol cost disease

A disturbing graph is making the rounds. Labelled the “chart of the century” by some commentators, it shows the changes in prices for various goods and services in the US since 1997. Although food, clothing, cars and electronics have all become cheaper, health care, child care and education have soared in price relative to workers’ wages.
Why is this happening? The rise in health-care prices is often blamed on hospitals’ monopoly power and on the perverse incentives of the employer-based health-insurance system. The rise in education costs, meanwhile, is often blamed on administrative-cost bloat at universities.
But what if these explanations are too complex and adhoc? In a recent paper, Alex Tabarrok and Eric Helland of the Mercatus Center, a free-market think tank, suggest a simple theory that they say can explain all or most of the spectacular rise in service prices: Baumol cost disease.
The theory of Baumol cost disease, developed in the 1960s by economist William Baumol, states that some things rise in price even as productivity goes up. When society gets better at making cars, electronics, food and clothing, wages go up. But as wages go up, industries that don’t find ways to use less labour to produce the same service — for example, a string quartet — rise in price as well.
Tabarrok and Helland maintain that this explains why education and health care cost so much more than they used to. It takes about the same number of hours for doctors and nurses to treat a patient as it did two decades ago, and it takes about the same number of teacher hours to instruct an algebra class. But because the career alternatives to teaching and providing health care — for example, software engineering — now pay higher wages, hospitals and schools have to pay more to retain their staff, sending the cost of tuition, hospital prices and other service items soaring.
They write: Teachers are earning a normal wage for their level of skill and education…[and] the high wages of physicians, nurses, and other skilled healthcare workers in the United States correctly represent the opportunity cost of skilled labour.
But is pay in other fields where doctors, teachers and nurses could work — what economists call opportunity cost — really increasing fast enough to account for cost increases in health care and college education? Probably not. Wages for educated workers have gone up, but not nearly as much as service prices.
Meanwhile, Tabarrok and Helland cast doubt on the typical explanations for cost bloat. But perhaps not enough doubt.
For example, using data from the Department of Education, Tabarrok and Helland argue that administrative costs have remained roughly constant as a share of universities’ total costs for decades. But a 2010 report from the Goldwater Institute, another free-market think tank, shows administrative expenses outpacing other university costs significantly from 1993 to 2007.
As economist Gabriel Mathy of American University has pointed out, the discrepancy is due to definitions — the Goldwater Institute includes employees who are not officially classified as administrators but who perform administrative tasks. So perhaps the number of these employees captures the cost bloat. Overspending on administrative labour isn’t a total explanation for the rise in tuition, but it shows that the problem probably has more than one cause.
The Baumol explanation also struggles to explain why US health care costs have outpaced medical spending in other nations as a share of the economy, even though the US has a younger population and achieves health outcomes that are no better.
So if it’s not because of better quality, an older populace, or better outside options for doctors and nurses, why does the US spend so much more of its income on health care than other developed countries? One possibility is that as people get richer, they tend to pour more of their income into living just a little bit longer. This would predict that as countries consume more, they tend proportionally more on health care.
But looking at the details of health-care pricing casts doubt on this explanation. For example, economists Zack Cooper, Stuart Craig, Martin Gaynor and John Van Reenen have uncovered a number of odd anomalies in the way health care is priced in the US. They find that a MRI on a leg can vary by a factor of 2.5 or more between hospitals in the same city. Prices for these services can even vary a lot within a single hospital. Meanwhile, they find that at hospitals with little local competition, prices are substantially higher. These facts are hard to explain with either Baumol cost disease or income effects.
So although Baumol cost disease is one part of the story for increased health-care and higher-education prices, it doesn’t look like the whole story. Other explanations — monopoly power, falling productivity and perverse incentives should all be considered.
It’s likely that the US’s service sector cost disease has multiple causes.


Noah Smith is a Bloomberg Opinion columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinio

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