The services economy: Revisiting Baumol’s cost disease

The services economy: Revisiting Baumol’s cost disease

Phuah Eng Chye (26 August 2017)

If we are to meet the growth challenges of the future, the answer isn’t likely to lie in creating more manufacturing plants and jobs. The answer must lie in how we are able to harness and manage growth in the services sector; which already accounts for more than two thirds of GDP in many developed countries. The problem is that we don’t really have a good economic model that is dedicated to analysing and formulating policies for the services economy.

But it is difficult to design a coherent and robust policy model for the service economy. I will start by illustrating the policy dilemmas posed by Baumol’s cost disease. An earlier article[1] highlighted how rising costs and low productivity results in the service sector expanding its share of GDP at the expense of the manufacturing sector. But it was also pointed out that there is a mismatch between service costs which is continuously rising while wages are stagnating. The mismatch implies that, over time, social problems will worsen as incomes lag rising service costs.

This is the core policy dilemma for the services sector. Is the economy better off targeting higher salaries or lowering service costs? Charles Hugh Smith thinks the problem is not stagnant wages but rather “the soaring cost of living. If essentials such as healthcare, housing, higher education and government services were as cheap as they once were, a wage of $10 or $12 an hour would be more than enough to maintain a decent everyday life.”

This perspective can be extended to cover the debate over whether governments should subsidise service costs, particularly for healthcare and education. Scott Alexander observes “this is the basic intuition behind so many people, even those who genuinely want to help the poor, are afraid of tax and spend policies…the government saying Okay, fine, and increasing taxes however much it costs to pay for whatever they’re demanding now.”

Scott Alexander adds “it’s not fair to the poor people, who have to face the stigma of accepting handouts for something they could easily have afforded themselves if it was at its proper price.” He thus suggests that “if some government program found a way to give poor people good health insurance for a few hundred dollars a year, college tuition for about a thousand, and housing for only two-thirds what it costs now, that would be the greatest anti-poverty advance in history. That program is called having things be as efficient as they were a few decades ago.”

The simple notion that the problem of rising service costs can be overcome by bring prices down has been dismissed by William J. Baumol. He asserts “we will be able to afford the cost of these services in the future – unless we fail to understand the nature of this phenomenon…Although costs of personal services appear to be out of control, they are actually falling in terms of the labor time required to earn enough to pay for them”; in other words, consumers need to work fewer hours to afford them.[2]

William J. Baumol argues “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…because politicians do not understand the mechanism and nature of the cost disease, and because they face political pressures from a similarly uninformed electorate, they do not realize that we can indeed afford these services without forcing society to undergo unnecessary cuts, restrictions and other forms of deprivation.”[3]

These discussions illustrate the gap between theory and application. While framing sweeping generalisations help to punch a point home, they can be too broad-brush to function as useful policy advice or principles to adopt. Most critically, there is a need to reconcile these individual arguments back to a holistic frame where the macroeconomic dynamics and outcomes can be stimulated to provide a better perspective to guide informed decision-making on policies to regulate the costs of various services.

In this regard, I would like to highlight several macroeconomic features of Baumol’s cost disease. First, Baumol’s cost disease is a growth mechanism with different effects at different phases. In the growth phase, service costs are rising but the effects are not noticeable because the sector is adding so many jobs. In the maturity phase, job creation tapers and more critically, job creation now reflects the outcome of corporate efforts to cut costs and increase profits; hence wage stagnation sets in.

The onset of wage stagnation means rising service costs will eventually outstrip the ability of wage earners to pay for these costs. Demand for services (and therefore GDP growth) will stall unless governments intervene to subside consumption of services which will lead to the anorexic economy. At the next stage, rising service costs take its toll on the fiscal budget until governments are pressured to bring costs under control. The general rule seems to be that service costs rise until they are unaffordable. These cycles can and often are elongated by debt financing of service expenditures by households or governments[4].

Second, the expanding services share of the economy implies that services costs will rise as a share of household expenditures. The rising costs of housing, transportation, education, utilities and healthcare worsen the consequence of unequal income distribution[5] as it worsens the plight of those without or lacking sufficient income.

There are other serious knock-on effects. In particular, rising service costs raise the ante or minimum income and act as a wedge[6] that raises the amount of returns needed to justify an investment of capital or labour. Hence, rising service costs undermines the viability of the traditional family-style low-cost business models and discourages participation in the labour force. Higher service costs also acts as a deterrent to maintaining large families and increases social burdens such as increasing the budget costs of welfare and the required amount of retirement savings.

Third, the obvious “solution” of bringing down the costs of services to improve affordability for individuals and the government ignores the macroeconomic consequences. For example, cutting fiscal spending on education, healthcare and housing will reduce corporate profits and this could trigger an asset price downturn as well as lead to an economic contraction.

William J. Baumol’s earlier point that rising service costs incentivises “a cornucopia of desirable services and abundant products” is an important one. In comparing the US market approach and the European welfare approach to education and healthcare, it is often acknowledged that while the US education and healthcare services are expensive, there is admiration for their success in attracting top talents and fostering innovation.

Hence, high service costs are an important factor in the international competition for talent and investments. On the other hand, price restrictions are likely to discourage investments and job creation. Low prices, whether by regulation or market forces, is likely to result in the rationing[7] of services and labour availability or quality.

These discussions illustrate the complexities involved in managing the service economy. It is evident markets and technology do not only restrain service costs in the same way that it does for physical products but that rising prices is probably an important driver of growth for the services sector. Crucially, rising service costs also seems to occur simultaneously with wage stagnation. Hence, there are trade-offs between the impact of higher service costs on supporting sector growth and their adverse effects on social inequality and fiscal soundness. Next week, I will further explore the features of the service economy by comparing the paradigms for the manufacturing and services sector.

 

References

Amy Wallace (6 October 2012) “The case for calm over rising health costs”. New York Times. http://www.nytimes.com/2012/10/07/business/cost-disease-offers-a-case-for-health-care-calm.html

Charles Hugh Smith (March 3, 2017) “Why is the cost of living so unaffordable?” oftwominds.com. http://www.oftwominds.com/blogmar17/unaffordable3-17.html

Phuah Eng Chye (2015) Policy paradigms for the anorexic and financialised economy: Managing the transition to an information societyhttp://www.amazon.com/dp/B01AWRAKJG

Phuah Eng Chye (12 August 2017) “The services economy: Macroeconomic overview.” Economicsofinformationsociety.com. http://economicsofinformationsociety.com/the-services-economy-macroeconomic-overview/

Scott Alexander (9 February 2017) “Considerations on cost disease”. Slatestarcodex.com http://slatestarcodex.com/2017/02/09/considerations-on-cost-disease/

William J. Baumol, William G. Bowen (1966) Performing arts: The economic dilemma.

 

[1] Phuah Eng Chye (2017) “Services phase of the transition to an information society.”

[2] Article by Amy Wallace based on  William J. Baumol’s book, “The cost disease: Why computers get cheaper and health care doesn’t” (Yale University Press)

[3] Sourced from Amy Wallace

[4] Housing, education, healthcare related loans and borrowings by governments to finance related budget deficits

[5] Phuah Eng Chye (2017) “The services economy: Macroeconomic overview.”

[6] The wedge refers to the additional revenues now needed by investors or workers. In the absence of higher returns or wages, rationing occurs as investors will not supply capital while the unemployed do not find it worthwhile to be employed.

[7] The preference of suppliers or workers to withhold services below a given price leads to rationing.

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