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In an op-ed, Prof. William Baumol discusses rising education and healthcare costs

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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 six percent—well above the rate of inflation. If this trend continues, by 2035 annual tuition at a top-tier private school in the United States could cost nearly $200,000.

There is reason to believe that the Chinese education system will encounter similar problems. Indeed, both of our countries must find ways to cope with these rising costs—not only at home, but throughout the world.

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 “Baumol’s cost disease” or, in educational circles, “Bowen’s curse.” This theory asserts that the costs of education, health care, 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 labor required to produce these services is difficult to reduce.

Since the Industrial Revolution, labor-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 labor-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, the extraordinarily creative Cambridge economist Joan Robinson drew attention to an even more important aspect of the cost disease. With productivity rising almost everywhere in the economy of the twentieth and twenty-first 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 labor they require. This labor, Robinson noted, is surely the real cost humanity incurs in producing a commodity.

The key conclusion that follows from this is that no matter how painful rising education and medical bills may be, our societies can afford them and there is no need to deny them to ourselves, the less affluent members of our societies, or the larger world. Overall incomes and purchasing power must rise quickly enough to keep these services affordable, despite their persistently rising costs.
But how will these steadily increasing costs 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 American’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 in the United States will have only a little less than forty cents out of every dollar they earn or otherwise receive to spend on everything besides health care—food, clothing, vacations, entertainment, and even education! China, too, can achieve such improvements in the living conditions of its population by continuing to exercise its outstanding abilities in invention and entrepreneurship—instruments that enable ongoing growth.

This conclusion may seem strikingly implausible. But it should be noted that the bulk of the cost disease analysis presented here was first offered almost half a century ago by me and a colleague, William Bowen, in our book, Performing Arts: The Economic Dilemma (Twentieth Century Fund, 1966). Since then, our original predictions for the future costs of health-care and other labor-intensive services have been fully borne out.

Most notably, an independent study of a complete set of industry accounts data for 1948 through 2001 by 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.” (For more details, see the full paper: “Baumol’s Diseases: A Macroeconomic Perspective” in the B.E. Journal of Macroeconomics, 2008.) In addition, a more recent study of the economic challenges facing symphony orchestras in the United States, by Robert Flanagan (The Perilous Life of Symphony Orchestras, 2012), confirms that relentlessly rising costs and slow productivity growth still plague the performing arts.
When the cost disease analysis was first published, Bowen and I were too cowardly to venture bold claims. Instead, we referred to our theory’s future implications as extrapolations rather than predictions. But now, almost 50 years later, I am tempted to make bolder claims. Briefly, then, the central arguments of the cost disease 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 labor-saving change in a production process so that the output supplied by an hour of labor 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. Rising college tuition fees and the rapidly increasing cost of a hospital stay are prime examples of this.

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.

The picture that emerges is not so daunting. We can have it all: good education, better health care, 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 galloping college tuition increases and exploding cost of hospital care since World War II have not prevented us from consuming these and other services and goods. Indeed, a continually rising share of the population attends college, and we now live longer than ever.

After all, as Professor 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 labor will produce more of all goods and services than before. 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.

William J. Baumol is Harold Price Professor of Entrepreneurship and Academic Director of the Berkley Center for Entrepreneurship and Innovation at the Stern School of Business, New York University; and Senior Economist and Professor Emeritus, Princeton University. (Note: This op-ed column is based on Baumol’s recent book, The Cost Disease (2012), and a related article in the November 2012 issue of Policy Options.)