I came across this interesting essay the other day and finally have time to revisit it today. It is provocative and prompted me to search for the Baumol’s cost disease, which essentially says rising labor productivity in some sectors of production will transform other sectors to raise their labor costs — with or without a higher productivity. Put differently as the above essay: “rising labor productivity in one part of the economy drives up the cost of labor generally, and thereby makes labor-intensive parts of the economy more expensive.”
The classic example used by William Baumol in his book published in 2012 by Yale Press, was computers versus healthcare. But other examples are easy, such as servants, class music and education and performing arts. All these sectors do not witness very rapid growth of productivity and yet their costs keep growing.
The existence and description of associated rising costs are mostly true — at least when we only consider the amount of outputs — but not when we consider the quality of services, which has been increased sometimes tremendously. Take healthcare for example. Today’s healthcare has been greatly improved. Cancers and AIDS have been tamed to a large extent and I was able to have dental implants in my mouth when my natural teeth fell off. Even when we limit ourselves to the quantity side of the story, we can still say that now with the Internet of Things and modern technologies, a single MD can handle more patients at the same. Looking from the disease side, the same cancer may have required 10 doctors from different departments to diagnose and to treat, nowadays it may only require one doctor to get the job done.
The bigger problem is with the explanation. Economists have been quick to bring this phenomenon in line with the classic economic conclusion that wage reflects productivity. In so doing, they have focused on the labor supply side, which argued that because employers have to raise wages in order to compete with other employers and as a result, the general wage level will be increased. But this explanation ignores the demand side. I would say that when one sector of production has significantly higher productivity, workers from that sector will have a higher disposable income.
In San Francisco Bay Area, we have witnessed the drama with our own naked eyes. The IT sector has significantly raised its productivity and many of its workers became millionnaires. Pretty soon, we see that the cost of living in San Francisco surpassed that of New York City.
To understand why, we must bear in mind that in real life, the story does not stop at matching wage with productivity like the economists have proposed. Immediately the question comes up: How the higher salaried workers spend their money? It is here that we see the real link between sectoral high productivity and general wage level. Employers’ competition comes secondary because employers simply react to the changes but not create the changed cost of living.
General economics do provide explanation for the “cost disease” indeed — if we open our eyes wider. The law of scarcity works here because the very fact that labor intensive sectors like healthcare and education have a slower growth in productivity makes workers in these sectors relatively scarce, because more of them is required to accomplish a single task. The higher number of computers on the other hand can be produced relatively quickly and easily — with prices dropping down quickly. Therefore, for the IT workers in the Bay Area with more money to spend, their demand for computers can be easily met but not for babysitters, nannies and servants. It is the difference in relative changes of productivity that largely pushes up the price for labor intensive sectors.
Think of an engineer in the Silicon Valley from India, he and his wife could not afford a nanny in their home country but can now in the States. The demand for nannies will be increased but the number of people qualifying for nannies is relatively stable. Inevitably the price or hourly wage of nannies will have to be increased in order to attract the good ones.