In 1980, it cost $3,500 per year, on average, to attend a four-year undergraduate school in the United States, including room and board. By 2008 that figure was ancient history: a single year of undergraduate study cost nearly $20,500. That’s an average annual increase of more than 6 percent – well above the rate of inflation. If this trend continues, by 2035 annual tuition at a top-tier US private school could cost nearly $200,000.

College tuition is not an isolated case. Medical care and live theatrical performance are also victims of a widespread pattern of increasing costs that has come to be called “the cost disease,” “Baumol’s disease” or, in educational circles, “Bowen’s curse.”

The cost disease asserts that the costs of health care, education, the live performing arts and a number of other economic activities known as the “personal services” are condemned to rise at a rate significantly greater than the economy’s rate of inflation, as indeed they have throughout the period for which data are available. This is so because the quantity of labour required to produce these services is difficult to reduce.

Since the Industrial Revolution, labour-saving productivity improvements have been occurring at an unprecedented pace in most manufacturing activities, reducing the cost of making these products, even as workers’ wages have risen. In the personal services industries, meanwhile, automation is not always possible, and labour-saving productivity improvements occur at a rate well below average for the economy. As a result, costs in the personal services industries move ever upward at a much faster rate than the rate of inflation.

Many years ago, I received a handwritten note from the extraordinarily creative economist Joan Robinson, in which she commented on the cost disease. In her note, Professor Robinson did not disagree with this assertion but drew attention to an even more important point. With productivity rising almost everywhere in the economy of the 20th and 21st centuries — in some industries more slowly, in others more rapidly — she pointed out that all industries must be growing less costly in the amount of human labour they require. This labour, she noted, is surely the real cost humanity incurs in producing a commodity. I sent her a note expressing my agreement, but at the time I did not understand the full implications of her comment.

They are indeed profound. The key conclusion that follows from this is that no matter how painful rising medical and educational bills may be, society can afford them, and there is no need to deny them to ourselves or to the less affluent members of our society, or indeed to the world. Overall incomes and purchasing power must rise quickly enough to keep these services affordable, despite their persistently rising costs.

This conclusion — that our descendants will likely be able to afford more health care and education as well as more of all the other goods and services they consume — may seem strikingly implausible. We all know that health care and educational costs are rising at a disturbingly fast rate. But how will these increases affect us? The answer is suggested by a straightforward calculation, which shows that if health care costs continue to increase by the rate they have averaged in the recent past, they will rise from 15 percent of the average person’s total income in 2005 to 62 percent by 2105. This is surely mind boggling. It means that in the year 2105 our great-grandchildren will have only a little less than 40¢ out of every dollar they earn or otherwise receive to spend on everything besides health care — food, clothing, vacations, entertainment and even education!

Exploding cost of hospital care and galloping college tuition increases have not prevented us from consuming these and other services and goods. indeed, we now live longer than ever, and a continually rising share of the population attends college. instead, the true threat to this desirable future is foolish public policy.

But is this really plausible? Of course events may change the current trends in productivity and economic growth — wars, earthquakes and myriad other things that cannot be foreseen by anyone, most notably by economists. (As the saying goes, economists are qualified to predict anything but the future.) But it should be noted that the bulk of the cost disease analysis presented here was first offered almost exactly half a century ago by me and a colleague, William Bowen, in our book, Performing Arts: The Economic Dilemma. The predictions we made in that original work for the future costs of health care and other labour-intensive services were fully borne out.

Recently, in “Baumol’s Diseases: A Macroeconomic Perspective,” an independent study of industry accounts data for 1948-2001, the eminent economist William Nordhaus concluded that “Baumol’s hypothesis of a cost-price disease due to slow productivity growth is definitely confirmed by the data.” An even more recent study of the economic challenges facing symphony orchestras in the United States, The Perilous Life of Symphony Orchestras, by Robert Flanagan, confirms that relentlessly rising costs and slow productivity growth still plague the performing arts. In the half-century since our analysis first emerged, our predictions have achieved what is surely a special status: they may well be the longest valid forecast ever to emerge from economic analysis.

I must confess that when our analysis was first offered, Bowen and I were too cowardly to venture such bold claims. Instead, we referred to the theory’s future implications as extrapolations rather than predictions. But now, almost 50 years later, I am tempted to make bolder claims. Briefly, the book’s central arguments are these:

(1) Rapid productivity growth in the modern economy has led to cost trends that divide its output into two sectors, which I call “the stagnant sector” and “the progressive sector.” Productivity growth is defined as a labour-saving change in a production process so that the output supplied by an hour of labour increases, presumably significantly.

(2) Over time, the goods and services supplied by the stagnant sector will grow increasingly unaffordable relative to those supplied by the progressive sector. The rapidly increasing cost of a hospital stay and rising college tuition fees are prime examples of persistently rising costs in two key stagnant-sector services, health care and education.

(3) Despite their ever increasing costs, stagnant-sector services will never become unaffordable to society. This is because the economy’s constantly growing productivity simultaneously increases the community’s overall purchasing power and makes for ever improving overall living standards.

(4) The other side of the coin is the increasing affordability and the declining relative costs of the products of the progressive sector, including some products we may wish were less affordable and therefore less prevalent, such as weapons of all kinds, automobiles and other mass manufactured products that contribute to environmental pollution.

(5) The declining affordability of stagnant-sector products makes them politically contentious and a source of disquiet for average citizens. But, paradoxically, it is the developments in the progressive sector that pose the greater threat to the general welfare by stimulating such threatening problems as terrorism and climate change. I argue that some of the gravest threats to humanity’s future stem from the falling costs of these products, rather than from the rising costs of services like health care and education.

The picture that emerges is not so daunting. We can have it all: better health care, good education and even more orchestral performances. In exchange, we will not have to surrender food, clothing, shelter or even less essential commodities such as comfortable vacations, unrestricted travel and readily available entertainment. This is not merely naïve optimism but something we have already experienced. The exploding cost of hospital care and galloping college tuition increases since the Second World War have not prevented us from consuming these and other services and goods. Indeed, we now live longer than ever, and a continually rising share of the population attends college. Instead, the true threat to this desirable future is foolish public policy.

Let us consider two alternative scenarios. In the first, overall productivity continues to expand, as it has done in recent centuries in many parts of the world. Of course, there is no guarantee that this will happen, but it is what I expect will occur in societies with competitive economies. In this scenario, we will be able to afford ever more of what society desires. Even if health care and education keep getting more expensive, our earnings will grow fast enough to make these services affordable.

After all, as Joan Robinson pointed out, if productivity is rising everywhere — even if it is slower in some industries than in others — then by definition the same or even fewer hours of labour will produce more of all goods and services than before. That is essentially what happened in the United States during the 20th century. As a result, we now can afford more of everything — all the ingredients that make for an improving standard of living — for virtually all members of society (except, of course, during periods of recession).

This does not mean that our economic problems have been solved. The poor will still be with us, and some of the funding for health care and other services affected by the cost disease will probably have to be channelled through government agencies, with all the political problems that entails.

But suppose the future does not bring ever growing productivity. Suppose innovation grinds to a halt, we run out of natural resources and average income levels cease their steady rise. Then what? The cost disease, too, will terminate, because it stems from unequal rates of productivity growth in different sectors of the economy. If productivity growth is zero in all areas of the economy, these inequalities will disappear. The cost disease would no longer be any part of the problem, but that’s the only good news: our problems — particularly poverty — would be far worse.

This second, dismal scenario is not about to play out. Even if innovation were slowing down, as some observers claim, the productivity growth driven by innovation would still be far from zero. Consider the miracle of the Internet, where innovation begets further innovation. Although we are currently in the midst of one of history’s periodic eras of slower-than-normal economic growth, it seems clearly appropriate to aim for a future of continued productivity growth, with prosperity reaching previously unachieved heights.

Given this, it is clear that if improvements to health care and education are hindered by the illusion that we cannot afford them, we will all be forced to suffer from self-inflicted wounds. The very definition of rising productivity ensures that the future will offer us a cornucopia of desirable services and abundant products. The main threat to this happy prospect is the illusion that society cannot afford them, with resulting political developments — such as calls for reduced governmental revenues entwined with demands that budgets always be in balance — that deny these benefits to our descendants.

This article is based on William Baumol’s The Cost Disease: Why Computers Get Cheaper and Health Care Doesn’t (2012). 

Photo: Shutterstock by janews

William Baumol
William Baumol was a professor of economics at New York University, academic Director of the Berkley Center for Entrepreneurship and Innovation, and Professor Emeritus at Princeton University.

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