Disease Diagnosis - 2019 New Year's Resolution fulfillment

With the unintentional help of Alex Tabarrok and Eric Helland, I fulfilled my annual New Year's Resolution to change my mind on something. Specifically, I changed my mind:

That the runaway cost increases in higher education over the past several decades were simply due to third-party funding (spending other-people's money by the education-industrial complex (Big Chalkboard)). It turns out there is a much more elegant, though less tribally satisfying, answer: the Baumol Effect (aka, Cost Disease).

If relative productivity doesn't rise in a sector for which demand is rising, prices in that sector must rise relative to the sectors for which productivity is rising. This elegant explanation applies to health spending as well. Here is Tabarrok on the prototypical example:

The Baumol effect is easy to explain but difficult to grasp. In 1826, when Beethoven’s String Quartet No. 14 was first played, it took four people 40 minutes to produce a performance. In 2010, it still took four people 40 minutes to produce a performance. Stated differently, in the nearly 200 years between 1826 and 2010, there was no growth in string quartet labor productivity. In 1826 it took 2.66 labor hours to produce one unit of output, and it took 2.66 labor hours to produce one unit of output in 2010.

Fortunately, most other sectors of the economy have experienced substantial growth in labor productivity since 1826. We can measure growth in labor productivity in the economy as a whole by looking at the growth in real wages. In 1826 the average hourly wage for a production worker was $1.14. In 2010 the average hourly wage for a production worker was $26.44, approximately 23 times higher in real (inflation-adjusted) terms. Growth in average labor productivity has a surprising implication: it makes the output of slow productivity-growth sectors (relatively) more expensive. In 1826, the average wage of $1.14 meant that the 2.66 hours needed to produce a performance of Beethoven’s String Quartet No. 14 had an opportunity cost of just $3.02. At a wage of $26.44, the 2.66 hours of labor in music production had an opportunity cost of $70.33. Thus, in 2010 it was 23 times (70.33/3.02) more expensive to produce a performance of Beethoven’s String Quartet No. 14 than in 1826. In other words, one had to give up more other goods and services to produce a music performance in 2010 than one did in 1826. Why? Simply because in 2010, society was better at producing other goods and services than in 1826.

The 23 times increase in the relative price of the string quartet is the driving force of Baumol’s cost disease. The focus on relative prices tells us that the cost disease is misnamed. The cost disease is not a disease but a blessing. To be sure, it would be better if productivity increased in all industries, but that is just to say that more is better. There is nothing negative about productivity growth, even if it is unbalanced.

And this has very interesting implications. Tabarrok again:

• The Baumol effect predicts that more spending will be accompanied by no increase in quality.
• The Baumol effect predicts that the increase in the relative price of the low productivity sector will be fastest when the economy is booming. i.e. the cost “disease” will be at its worst when the economy is most healthy!
• The Baumol effect cleanly resolves the mystery of higher prices accompanied by higher quantity demanded.

Note that this does not change my view that we have inappropriately encouraged too many people to go to college and we have pushed and pulled too many resources into that chasm. Other-people's money and wishful thinking are still in play (as this discussion with Bryan Caplan indicates). But it seems they are only contributing and potentially secondary factors.

See here for lots of brief blog posts. See here, here, and here for very good podcasts on the study.