Electronics get cheaper, health care gets more expensive

Glenn Reynolds says of the digital camera’s improving performance and lower prices, “Yes, why isn’t healthcare this way? Hmm, what could be different?”

The most likely reason is Baumol’s Cost Disease, a 2007 word of the day that’s worth repeating.

Baumol’s cost disease (also known as the Baumol Effect) is a phenomenon described by William J. Baumol and William G. Bowen in the 1960s. The original study was conducted for the performing arts sector. Baumol and Bowen pointed out that the same number of musicians are needed to play a Beethoven string quartet today as were needed in the 1800’s; that is, the productivity of Classical music performance has not increased.

In a range of businesses, such as the car manufacturing sector and the retail sector, workers are continually getting more productive due to technological innovations to their tools and equipment. In contrast, in some labor-intensive sectors that rely heavily on human interaction or activities, such as nursing, education, or the performing arts there is little or no growth in productivity over time. As with the string quartet example, it takes nurses the same amount of time to change a bandage, or college professors the same amount of time to mark an essay, in 2006 as it did in 1966.

Baumol’s cost disease is often used to describe the lack of growth in productivity in public services such as public hospitals and state colleges. Since many public administration activities are heavily labor-intensive and have a limited desirable provider-customer ratio, there is little growth in productivity over time. As a result, the costs of the bureaucracy will inflate quicker than the growth in the GDP.

From The New Yorker:

There are really two American economies: one that’s getting more productive and one that’s not. In the first—the economy of Dell, Toyota, and Wal-Mart—consumers have grown accustomed to paying less for more. In the second—the economy of Harvard, the Yankees, and Bob’s Body Shop—they pay more for the same. The first economy has policymakers worried about deflation. The second has consumers worried about paying their bills.

Cost disease isn’t anyone’s fault. (That’s why it’s called a disease.) It’s just endemic to businesses that are labor-intensive. Colleges, for example, could do many things more efficiently, but, since their biggest expense is labor, the only way to reduce costs is either to increase the number of students each professor teaches or to outsource the work to poorly paid adjuncts. The same goes for health care: you can control drug costs and limit expensive new procedures, but, when it comes to, say, hospital care and doctor visits, the only way to improve productivity is to shrink the size of the staff and have doctors spend less time with patients (or treat several patients at once). Thus the Hobson’s choice: to lower prices you have to lower quality.

Interesting. It seems that it’s the very sectors of the economy – such as education and health care – where government is being asked to step in that are the very ones vulnerable to Baumol’s cost disease. And once government steps in to subsidize it, the prices are going nowhere but up – as the cost decreases due to subsidy, the utilization and demand increases. (Demand doesn’t really increase, because there’s more or less unlimited demand for education and health care, but effective demand increases.)

It’s well-known that health care costs and education costs are rising faster than the rate of overall inflation. Is that simply a function of Baumol’s cost disease, or is it caused by government subsidy, or some of both? I don’t know the answer, but in either case it may suggest limits on government intervention. In the latter case, subsidy creates demand, and in the former case government is attempting to solve a problem that is to some degree insoluble. Or am I reading this wrong? Tell me in comments.

Related: Why Are U.S. Health Care Costs So High?