Tuesday, March 6, 2012

Curing the Cost Disease

Innovation in healthcare and education: can it stop ever-rising costs?

(Image credits: 1, 2, 3)
One of the most interesting economic challenges of the 21st century, in my opinion, lies in curing what economists refer to, somewhat mysteriously, as Baumol's cost disease. As we'll soon see, it connects many current economic grievances in the political arena, especially the cost of health insurance and a college education.

The basic idea is that in certain sectors of the economy, it's extraordinarily difficult, if not impossible, to increase productivity in the long run. Thus, as incomes rise, the prices of these services will rise in the long run and come to dominate an increasingly large fraction of total household spending. In his historic paper, Baumol uses the example of the performing arts:
It is apparent that the live performing arts belong to the stable productivity sector of our economy. The legitimate theater, the symphony orchestra, the chamber group, the opera, the dance--all can serve as textbook illustrations of activities offering little opportunity for major technological change. The output per man-hour of the violinist playing a Schubert quartet in a standard concert hall is relatively fixed, and it is fairly difficult to reduce the number of actors necessary for a performance of Henry IV, Part II. 
Although Baumol's idea formed in the arts, it extends well beyond that sector, into many different service industries which, as a matter of practice, "must be" delivered at an individual-to-individual level and are not scalable. The two most obvious examples, largely because they are substantial and growing fractions of household income, are spending on education and healthcare.

As we can see from this graph of inflation in the education and medical care components of the CPI (less core CPI inflation), the cost of these two services have risen well above the broader rate of inflation since 1994, as Baumol's disease would predict.
Baumol didn't see a way around it then, and he remains pessimistic about the capacity of innovation to produce sufficient low-cost alternatives to circumvent his cost disease.

I think Baumol's been right, historically speaking, ever since the end of World War II. But I think we're about to see something tremendously different -- the curing of the cost disease -- and this event may very well be the most significant impact of the communications and technological revolution which began in the 1990s with personal computing and continued into the 2000s with the Internet. The 2010s, in other words, will the the decade of market disruption in the service industries.

Baumol's disease, one might suppose, is eventually self-curing. When the price of the "diseased sector" goods increases, so does the incentive to produce a lower cost alternative. (This is fundamentally the same reasoning behind Julian Simon's optimism.)

With sufficient investment, productivity is most likely to increase by changing the medium and method of delivery. This is quite different from normal productivity gains, which tend to involve more incremental gains from speed or efficiency of production -- those opportunities don't exist for "diseased sector" goods. Tyler Cowen, in his response to Baumol's disease, argued that electronic recording and reproduction represents the "cure" in music, for example. Cowen wrote in 1996 with eerie prescience that "[s]omeday we may have all the world's music at our fingertips through the information highway." Subsequently came the iPod and iTunes, YouTube, and Spotify.

The same solution -- innovation in delivery -- appears to have cured the original cost disease in the performing arts, with the rise of festivals such as Bonaroo, SXSW, and Coachella.

Certainly, education and health care will be harder to cure, but I remain optimistic. Mark Perry of Carpediem, for example, has documented examples, examples, and more examples of exactly the sort of innovations which should cure cost disease in these sectors.

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