Nearly 50 years ago, William Baumol and William Bowen proposed an economic theory--the "cost disease"--to account for the fact that prices in service industries consistently rise so rapidly relatively to the prices of manufactured goods. The cost disease theory rests on the observation that in some industries, especially those that produce goods, ",technology has resulted in dramatic increases in productivity, which equate to decreases in the cost per unit of products. Baumol calls these industries the "progressive sector." When the cost to produce a product decreases, then the wages for the workers who produce that product can increase, without any increase in the price of the product. But when that happens, wages also tend to increase in those industries that have not seen productivity increases, the so-called "stagnant sector". Wages must increase there because if they didn't, then those industries would be unable to compete for workers. Since the increased wages in the stagnant sector are not offset by reduced costs of production, prices in that sector grow more quickly than those in the progressive sector.
Within the stagnant sector are "high touch" service industries, including health care, education, legal services, and the arts. As Baumol and Bowen noted a half century ago, it still takes five musicians the same amount of time to play a string quintet as it did in the 18th century: technology has not changed that. (In fact, as Baumol notes in the current book, technology has led to some productivity increases even for musicians; for example, by reducing the amount of time it takes them to travel to their concert sites. But any productivity gains in the stagnant sector are very small compared to those in the progressive sector.) The cost to attend a musical concert has thus grown at a greater rate than the cost of, say computers: the former has grown faster than inflation overall, while the latter has grown more slowly. And, as with concerts, so with health care, college tuition, and so on.
This much was understood 50 years ago, and has continued to be borne out by the economic facts. What Baumol adds in his new book is a corollary to the cost disease, namely, a claim that despite the out-of-proportion growth in the their costs, services are and will remain affordable at a society-wide level. In some sense, the reason for this is clear: while services cost more in real terms, products from the progressive sector cost more, and so all that is needed is to redirect spending. In fact, because productivity increases have happened everywhere, just more slowly in some sectors than others, the society as a whole has more wealth, and thus can afford more of everything.
Here's an example of the underlying math. As you read it, remember that it's just an abstraction to show how the cost disease works and is not meant in any way to provide realistic numbers. After all, autoworkers produce many more than 5 cars a year and professors teach many more than 5 students; the price of cars must take into account the cost of material and profit for the auto company, not just the salary of the autoworkers; autoworkers and college professors don't typically compete for the same jobs; etc. None of this matters to the core argument.
So: Suppose that at a given time--let's call it Time A--an autoworker can produce 5 cars a year, with each car selling for $10,000. Then each worker can be paid $50,000. And similarly suppose that a professor can educate 5 students a year, and that tuition is $10,000. By the same logic, the professor can be paid $50,000. Now assume that at Time B, as a result of technological improvements, the autoworker can build 6 cars a year, and so can now be paid $60,000. As already noted, competitive forces tend to cause wages to rise consistently across the economy, so now the professor also receives $60,000. But technology has not made the professor more efficient: bigger classes still provide a lower-quality experience to the student. Thus, we assume that the professor can still only teach 5 students and so tuition must rise to $12,000, to compensate.
What's happened? On the one hand, it looks like tuition has gotten more expensive. But note that wages have also grown: everyone has more money to spend: $60,000 at Time B versus $50,000 at Time A. In fact, at time A, after paying for tuition, a worker (autoworker or professor) has enough money left over to buy 4 cars. At time, a worker (autoworker or professor) has enough left over the buy 4.8 automobiles. Not only do the increases in productivity mean that the output of the service section--in this example, education--remains affordable: in fact, it's even "more affordable" in the sense that there's even more money left to spend on other things.
If this seems like economic sleight of hand, it's worth doing the calculations step by step, because it's anything but! Another way to get a feel for what's going on is to consider how long the average worker has to work to purchase various products. Baumol gives lots of examples: in 1940, you had to work (on average) for 27 minutes to purchase a Big Mac; today you have to work 9 minutes. In 1910, you had to work 553 hours to buy a clothes washer, but by 1997 it was only 26 hours. A Ford Model T required 4,696 hours of labor in 1908, versus 1,365 for a Ford Taurus in 1997. And on and on. As Baumol notes repeatedly, "We can surely afford it--cars and computers, as well as health care and education. The quantity and quality of the cost-disease affected services we obtain in the future will depend on how we order our priorities. . . Society does have a choice, but if we fail to take steps to exercise this, our economy could continue to drift toward a world in which material goods are abundant, but many things we consider primary requisites for a high quality of life are scarce, particularly for the poor (pp. 54-55)."
This last point is especially important: because wealth is not distributed equally, Baumol's conclusion that we can afford it all is true society-wide, but not necessarily for every individual in the society. Hence, he argues, it is society as a whole that must commit to shifting some resources from goods produced by the progressive sector to services produced by the stagnant sector. And that, he admits, is a huge political challenge, although a critically important one.
"The Cost Disease" is an important book, definitely worth reading. If you find it interesting, you may also want to read the very lucid "Why Does College Cost So Much?," by Archibald and Feldman, for an extended discussion of how the Cost Disease has played out in the higher education realm.
