Alex Tabarrok, professor of Economics at George Mason University and co-author of the Marginal Revolution blog, has co-authored a new book with Eric Helland exploring why prices have risen so sharply in healthcare and education. Helland and Tabarrok argue that most of these price increases are caused by the rising price of skilled labor in these fields, driven by what economists call the Baumol effect,
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.
Jordan Ballor has pointed out the rising price of being middle class before and interviewed P.J. O’Rourke on the same issues in his latest book. In both the piece and interview the rising prices of these skilled labor intensive industries of healthcare and education loomed large. Along with home ownership, another industry heavily dependent on skilled labor, healthcare and education make up what we imagine to be the cornerstone of middle class life: a way of life that is getting more expensive.
Left-wing observers of this situation look to rising inequality, corporate greed, and regulatory negligence to explain this phenomena while those on the right often attribute it to unionization, over-regulation, and over-litigation. There is surly some validity to at least some of these concerns but what if they are missing the forest for the trees? What if the fault is not in our stars, but in ourselves?
Tabarrok reminds us, “that all prices are relative prices.” While prices of things not heavily dependent on skilled labor such as cars, clothing, and groceries have fallen we have chosen to spend that money on services in industries that have seen slower productivity growth such as healthcare and education.
There are reforms which, at the margin, can make markets in healthcare and education freer and more competitive, and government intervention often serves to increase demand and restrict supply exacerbating the problem of rising prices. What the Baumol effect provides is a powerful argument that these rising prices are primarily the result of an increase in the quantity of educational and medical services demanded by consumers. This increase in demand is the product of the success of entrepreneurs in higher productivity sectors in bringing down the cost of so many other goods. There is thus a real opportunity for entrepreneurs in housing, healthcare, and education to increase the productivity of these sectors. Tabarrok’s put his own efforts to trying to create a less labor intensive form of economics education, Marginal Revolution University. In a free and competitive market high prices signal not only scarcity but also opportunity for creative service to others.