Out of my colleagues in Carow Hall, I’ve learned the most from Tyler Cowen, and I reason the most like Robin Hanson. But I agree the most with Alex Tabarrok. I was surprised, then, to find so much to disagree with in Alex’s new monograph (co-authored with Eric Helland), entitled Why Are the Prices So Damn High? Helland and Tabarrok try to explain why prices in labor-intensive industries – most notably education and health care – have increased so much more rapidly than inflation. They conclude that William Baumol’s famous “cost-disease of the service sector” story is almost entirely correct:
We have found that the best, albeit perhaps pedestrian, explanation for increasing costs is that the price of the major inputs into education and healthcare—namely, teachers, faculty, physicians, nurses, and so forth—has increased and, secondarily, that we have bought more of those inputs.
But why have the prices of these major inputs increased? Baumol’s general explanation is that productivity grows far more slowly in the service sector, so when productivity in the rest of the economy rises, wages in the slow-growing sectors go up. Barbers’ productivity, for example, has barely changed in the last two centuries, but their wages have skyrocketed. If they hadn’t, no one would be a barber! In the view of Helland and Tabarrok, Baumol’s explanation isn’t just part of the story of “why the prices are so damn high”; it is the story:
It’s natural to look at high and rising prices in sectors such as education, healthcare, and the arts and to conclude that there is something wrong with these sectors. We have taken a close look at education and healthcare, and Baumol and Bowen examined the arts, and most of the specific explanations for problems in these sectors are either untrue or cannot explain rising costs. Education has not become more dominated by administrative costs or lazy rivers. Medical malpractice costs are not a large share of healthcare costs. Across a wide range of industries, neither regulation nor concentration does much to explain long-run changes in prices.
[…]
The Baumol effect is the best explanation for rising prices in education, healthcare, and other service sectors. In that sense, and only in that sense, is there something “wrong” with the service sector—namely, that it’s hard to increase productivity in services. [emphasis added]
Where do Helland and Tabarrok go wrong? Their purely factual claims seem solid to me, but their interpretation of these facts is deeply misleading.
Let’s start with the obvious: government spends an enormous amount on both education and health care. This spending has dramatically increased over time. Imagine, then, what would have happened if government had practiced extreme austerity instead. Demand for labor in education and health care would clearly have increased far less, so wages in these industries would have risen far less, so the prices in these sectors would be much less damn high. So while Helland and Tabarrok are not wrong to invoke the Baumol effect, they are wrong to fail to blame government for dramatically amplifying it. If paying customers bore the full financial burden of education and health care, prices could easily fall by 50% or more.
In conversation, Alex objected that the growth rate of health care prices did not dramatically increase after Medicare was adopted. This would be a reasonable objection if my story were speculative. But “spending hundreds of billions of extra dollars a year on anything will make it much more expensive” is anything but speculative. Indeed, it’s virtually bulletproof; are we really supposed to imagine that the supply of health care is perfectly elastic despite a thicket of licensing requirements?! If prices did not grow more rapidly after the adoption of Medicare, the sensible inference is that price growth would have slowed if Medicare hadn’t happened. “Unfalsifiable”? No, but it is an application of a general principle so well-established that it’s crazy to doubt it now.
Helland and Tabarrok’s deeper error, though, is subtler yet widely shared. They assume that something constant cannot cause something to change. “Bloat” can only explain rising costs if bloat is increasing:
The bloat theory is popular because it is easy enough to find examples of bloat in higher education. The lazy rivers do exist. But to explain increasing costs, the bloat theory requires longer and lazier rivers every year, and the data do not fit that story. Bloat and complaints about bloat are probably as old as the university itself.
Regulation, similarly, can only explain rising costs if regulation is increasing:
One alternative (or potentially related) hypothesis to explain price increases is an increasing regulatory burden.
Statistically, of course, this is right. But causally, it’s utterly wrong. Suppose, for example, you impose a maximum monthly rent of $500 for an apartment in 1960. This is far above the market price, so initially it has no effect. Over time, however, rents rise; eventually, the rent control law causes a massive shortage of housing. A naïve statistician could say, “Rent control doesn’t matter; the only thing that explains rising shortages is the rising CPI.” The reality, though, is that rent control was the cause of shortages, in the most important senses of the word “cause”: if the rent control hadn’t existed, the shortages never would have happened; and if rent control were abolished, the shortages would go away.
Aside: Apologists for European labor regulation have often argued that regulation cannot explain European unemployment, because unemployment stayed low for at least a decade after the main regulations were adopted. I say the apologists are conceptually confused. It is because of labor market regulation that European labor markets adapted so poorly to a long series of subsequent economic shocks. Statistically, the shocks “explain” the changes, but regulation of labor still caused them.
So what? Well, at least for the two sectors Helland and Tabarrok cover in detail – education and health care – the constant presence of non-profit incentives and regulation clearly cause much of the rise in prices. If K-12 education were all privately funded, for example, can we really imagine that schools would have continued their strict, insane practice of requiring primary school teachers to have B.A.s? Gym teachers to have B.A.s?! Without government licensing, can we really imagine that the use of lower-cost occupations like nurse practitioners would not have sharply grown? (Picture a world where any nurse could directly sell medical services to willing customers). Or if you want overkill, imagine the U.S. had open borders for medical workers. A constant policy – but health prices couldn’t have risen much if the U.S. welcomed any worker on Earth with relevant skills. (To be fair, Helland and Tabarrok briefly mention immigration reform; but they fail to loudly and clearly state that nefarious immigration regulation – constant though it may be – caused skyrocketing health costs).
The Baumol effect is important. Even for barbers, though, it’s only one factor among many; after all, every state licenses barbers. For education and health care, I doubt the Baumol effect causes even half of the price rise we’ve seen. Helland and Tabarrok carefully present the facts, but I fear that their misinterpretation of those facts will undermine not only our understanding, but an array of vital free-market reforms.
READER COMMENTS
Josh
Jun 10 2019 at 7:58am
So cost disease is the cause of the increase in both doctor’s and nurse practitioner’s salaries. But regulations are what prevent consumers from substituting from the high cost provider (MDs) to the low cost one (NPs). (Same thing for teachers with and without degrees, etc.).
That makes sense. But it still feels like a drop in the bucket. Maybe we could’ve cut health care costs a lot by switching to more NPs (how much is a lot though?). But that’s a one time fix and and then NP salaries will continue to outpace inflation because of Baumol, so we’ll still see rising HC costs. In the long run it seems like Baumol is going to be way more important here.
Dr. Michael Wu
Jun 10 2019 at 4:44pm
As a working hospitalist physician, working in the trench / front line daily, this is the obvious reason why the health care cost is so high. 1. ) redundant and convoluted insurance / medicare regulation and rules ie. Mr. Jones has advanced COPD and will require home oxygen, however, in order to discharge him safely home. Medicare does not allow Mr. Jones to qualify for home oxygen immediately. I had to admit Mr. Jones to hospital for two days to prove that he is persistently hypoxic, then he would qualify for home oxygen. Cost of home oxygen monthly around few hundred dollars the most. Hospital admission for two days, around 8 thousand dollars. 2. ) irresponsible patients, ie. patients who missed dialysis and not taking their meds. Mr. Smith just felt too tired to go to his routine dialysis session. He came in with fluid overload and pulmonary edema. ICU admission for two days. Each day of ICU stay at least 10 thousand dollars. He does this as he likes every two months or so. Guess who is paying for these? Medicaid or the public. 3.) Administration took the chunk of money. As a physician, I am paid about 100 plus dollars per hour, each hour I probably see four to fiver patients, each patient I see daily. However, when the patient is discharged after 2 days stay for some pneumonia for example, the price tag is twenty thousands dollars for 2 days stay in the hospital. Yes, it’s used to pay for the overhead for the hospital cost, but wait a minute, where did the chunk of the money go? paying to the nurses, doctors, x-ray techs, parking lot security guards?
Dustin
Jun 12 2019 at 2:09pm
Dr Wu, Recently I visited an ENT. I was having some ongoing sinus congestion, he stuck a little tube with a camera into my nose for ~20 seconds to look around. Diagnosis: a persistent allergic response. The incremental cost of the tube was $400. How does that fit into your outline above?!
The real kicker is that the ENT didn’t even mention the $400 incremental cost; if he had, I’d have rejected it.
Healthcare in the US is a broken market. It simply lacks the information symmetry required for consumers to make informed choices and, by extension, create competition.
David Manheim
Jun 11 2019 at 12:45am
Given that wages are low elsewhere, and that there is plenty of economic reason to find ways to substitute high-skill labor for low-skill labor, I suspect that the shift wouldn’t be from MDs to NPs, but from MDs and NPs to untrained labor for some tasks, and automation for others. And this is what we’ve seen in other fields. In medicine now, you can’t have untrained workers doing most tasks because of EMTALA (Medical anti-dumping rules) and other legal restrictions. You can’t have automatic refills of certain drugs, or automatic rules for routine medical tests, and doctors need to individually order them. Similarly, insurance regulations restrict them from paying to replace doctor visits with other care options, etc.
Keith K.
Jun 10 2019 at 9:49am
Another point which needs repeating: for these services the state is the primary buyer (or atleast the primary supplier of funds which then dictates how those funds may be spent). This is overwhelmingly true in Education and Medicine. Am I really supposed to believe that if individuals were paying 100% of the cost for these services that people would simply tolerate these price increases? Of course they wouldn’t; they would seek more cost effective yet goal effective alternatives. This would create a incentive for entrepreneurship in those areas, which would lead to productivity increases.
It would seem to me that inorder to make the kind of claims that Tabarrok is making here, you’d have to do a comparison of services along the following dimensions: 1) How much of that sectors funds come from the state vs. voluntary exchange and 2) how much does the state define the production structure of that industry (how regulated it is). I’d be willing to bet if you did a comparison of the service subsectors along these dimensions that while you’d see the Baumol effect in all of them, most of the aggregate effect would be in the sectors in which there is greatest state involvement.
Rob Rawlings
Jun 10 2019 at 10:09am
‘This spending has dramatically increased over time. Imagine, then, what would have happened if government had practiced extreme austerity instead. Demand for labor in education and health care would clearly have increased far less, so wages in these industries would have risen far less’
I’m not totally sure I get the economic logic of the ‘so wages would have increased far less’ bit of this. Take the barber example. If productivity of all other industries doubled while that in the hair-cutting industry stayed the same then the Baumol effect would predict large increase in the real costs of barbering – the exact amount depending on a huge number of other variables. Lets keep is simple and say the Baumol effect caused real barber prices to double.
Take a counter example with no Baumol effect where the government just starts hiring huge numbers of barbers directly. Short-term this may well more than double the wages of barbers. However long term these higher wages will attract new barbers and assuming barbering (even after the government action) emplyes a relatively small proportion of people in the labor market who have the prerequisite innate skills to be barbers one would predict a rather moderate long term increase in barbering costs – certainly much less than 100%.
Irrespective of increased govt-induced demand for barbers if the govt had stemmed the supply of barbers through new licensing rules etc then this would definitely increase costs. If I had to look for alternatives to Baumol I would look to the supply -side (licensing etc ) and not demand-side (increased govt spending in certain areas).
Rob Rawlings
Jun 10 2019 at 10:39am
To encapsulate my view as applied to healthcare and education:
Making the assumption that the proportion of the workforce with the required innate abilities to do jobs in healthcare and education is relatively small as a proportion of the total workforce I do not think (for reasons of labor mobility into these industries) that increased government-driven demand is very likely as an explanation of their large cost increase.
Mark Z
Jun 10 2019 at 11:46am
I don’t think that assumption is correct though. Certainly for education, the fraction of people who could be teachers or administrators is quite large. In health care, only physicians and perhaps nurse practitioners and certain kinds of technicians are really positions that require rare skills.
Rob Rawlings
Jun 10 2019 at 12:15pm
Damn: I miststated my own assumption!
I meant to say “Making the assumption that number of jobs in healthcare and education is relatively small as a proportion of the total workforce with the required innate abilities to do those jobs”
Thanks for spotting that.
Rob Rawlings
Jun 10 2019 at 1:47pm
Ugh: I miststated my own assumption!
I meant to say “Making the assumption that number of jobs in healthcare and education is relatively small as a proportion of the total workforce with the required innate abilities to do those jobs”
Thanks for spotting that.
Mark
Jun 10 2019 at 11:27am
B.A. for teachers sounds excessive for Prof Caplan?!? 🙂 Well, here in Germany, all primary school teachers have to be M.A. (after a tough 12 to 13 years school-system, that requires TWO foreign languages and much else – it is tough: one third of students needs to repeat classes at least once. And you can not repeat thrice during high-school, but would need to downgrade to “medium-school” – which would not lead to college, obviously). Yes, and ALL gym/”p.e.”-Teacher in all schools have to have a Master-degree, too. ( a few exceptions are made right now, as their is a shortage of teachers – but without any M.A. you would hardly be considered.)
I DO agree with BC that it is rather silly to require a college-degree for handling kids of any age in the gym. Or teaching them 6*7=42 – which is what German primary schools are aiming at (6 to 10 year old).
Mark Z
Jun 10 2019 at 11:50am
Wow, that’s disconcerting. Maybe this is something I just ‘don’t understand’, not having kids, but I would not pay a penny extra to get my kid into a gym class taught by someone with just a college degree as opposed to just high school. Do the janitors in Germany need to have a masters’ degree in custodial science?
Charles
Jun 10 2019 at 2:24pm
“If paying customers bore the full financial burden of education and health care, prices could easily fall by 50% or more.”
I disagree with this assessment. Much of healthcare demand is inelastic. This is econ 101.
john hare
Jun 10 2019 at 5:45pm
Demand for most medical care is very elastic. People don’t get procedures they can’t afford and the smokescreen of insurance convinces them they can afford it anyway. When sky high prices are thrown out that are not out of pocket, they “pay” it with insurance or government subsidy. So they don’t shop which allows ridiculous prices to continue.
Out of their own pockets, people will shop and compare which would make medical care operations compete which would drive prices down. Look at Lasic and cosmetic surgeries over the last several decades. I those two fields that are out of pocket, quality is up and prices much lower than the medical industry standard. This is econ 051.
WalterCO
Jun 11 2019 at 2:24pm
I honestly don’t know what it means to say that demand is inelastic when the consumer and the payer are different entities.
Mark Brophy
Jun 12 2019 at 1:21am
In my city an hour north of Denver, an MRI of my knee costs $1100 so I went 50 miles away and paid $284. Prices are the same for all goods unrelated to health care in the two areas. People don’t shop around when a third party pays so the industry remains inefficient.
Floccina
Jun 10 2019 at 5:48pm
I saw this on Marginal Revolution a while back. David Chapman claims here : Medical care could be 80 to 90% cheaper. Then he says:
Are there measures of direct labor cost in medicine. Do hospital;s do cost accounting?
John Alcorn
Jun 10 2019 at 6:08pm
Arnold Kling has a pithy, incisive mini-essay, “What Gets Expensive and Why,” which identifies four causes of expensive education and health care:
1) The Baumol effect
2) Category creep
3) Demand de-linked from outcomes
4) Subsidize demand, restrict supply
Note that no. 4 actually comprises two causes: 4.a) Subsidies and 4.b) Regulatory restrictions on supply.
To avoid confusion let’s call no. 1 “The Baumol mechanism.” It links a cause (uneven change in productivity) to an effect (d*mn high prices in sectors that lag in productivity).
Eric Helland and Alex Tabarrok make a case that the Baumol mechanism empirically accounts for the majority (or most?) of the d*mn high prices phenomenon in education and health care.
By contrast, Bryan Caplan focuses on no. 4.a and no. 4.b (the mix of subsidies and regulatory restrictions on supply). Bryan argues that these mechanisms empirically account for the majority of the d*mn high prices phenomenon in education and health care.
My intuition is that cause no. 3 (demand de-linked from outcomes), too, is empirically important. Arnold Kling writes, “Our spending on health care and education is driven by hope.”
Each of the several causes listed by Arnold Kling has bite. Each of them is necessary to explain a component of the overall magnitude of the d*mn high price phenomenon. Jointly, the several causes surely explain most of the phenomenon. The empirical question, then, is about the relative strength of each of the several causes.
Might Helland/Tabarrok and Caplan (and Kling) reach agreement about what kind of evidence could in principle resolve the dispute about the relative weights of the several causes?
Daniel Hill
Jun 10 2019 at 8:50pm
The use of music performance as the classic example of the Baumol effect is instructive, because it only holds if one takes a narrow view of the delivery model. In fact, I can listen to say Beethoven’s Fifth performed by a world class orchestra any time I like, for a fraction of the cost of attending a live performance.
Recorded music fundamentally changed the delivery model. The problem with pervasive government provision/regulation of education and healthcare is that it stifles the equivalent of recorded music emerging. If these sectors were unregulated and unsubsidised, fundamentally different and dramatically more efficient delivery models would undoubtedly emerge.
Daniel Klein
Jun 11 2019 at 5:21am
Sometimes I wonder whether Adam Smith threw Jeremy Bentham a fat pitch on interest-rate restrictions.
Ben Woden
Jun 12 2019 at 5:49am
Imagine the following scenario: You are going for a walk. You know there’s a high chance of rain, but you choose to take no coat or umbrella. 1 hour into your walk, it rains. You get wet. Later, it stops raining, and the sun comes out. You slowly dry off.
It seem that Helland and Tabbarock would then say this: “Your wetness was entirely a function of whether or not it was raining. You didn’t start getting wet until it rained, and dried off when it stopped. All the variance in your wetness is explained by the variance in degree of rain. Therefore, it makes no sense to invoke your lack of coat and umbrella as reasons why you got wet; the rain is sufficient explanation alone.”
Caplan could then reply “But it still makes sense to say that not taking a coat or umbrella was part of the reason you got wet, because we know coats and umbrellas are good at keeping people dry in rainy conditions from other experience, so we can still confidently predict that, had you taken a coat or umbrella (and used it), you would not have got wet, and that’s concomitant with our common-sense notion of the word ’cause’.”
Am I understanding this chain of argument correctly (I realise it then gets more complex from here in, that this isn’t all of it), because, if so, Caplan seems trivially right, but I’m sure Tabarrock and Helland have thought things through more in their writing of a book than I have in the last five minutes, so this must have occured to them, and they must have so response, no?
John Alcorn
Jun 12 2019 at 9:35am
Over at Marginal Revolution, Alex Tabarrok has replied to this blogpost. Dr. Tabarrok casts himself as an empirical economist, and Bryan as an armchair economist:
In my previous comment, I listed Kling’s several mechanisms; and I noted that Bryan focuses on no. 4, “Subsidize demand, restrict supply.”
Dr. Tabarrok’s reply to Bryan addresses only the latter half of this mechanism; namely, the impact of regulations on prices.
In the meanwhile, Bryan has posted a separate critique, which focusses on the former half of this mechanism; namely, subsidies. Specifically, Bryan analyzes the impact of subsidies for public schools on price trends in education. This mechanism is actually the intersection of two distinct mechanisms: 4.a.i) Taxpayer subsidy of education and 4.a.ii) Government supply (production) of education. Bryan concludes:
Would Dr. Tabarrok characterize this, too, as armchair economics?
John Alcorn
Jun 12 2019 at 10:11am
Arnold Kling has weighed in on Alex Tabarrok’s rejoinder to Bryan about the impact of regulations:
http://www.arnoldkling.com/blog/the-tabarrok-rejoinder/
Sebastian H
Jun 13 2019 at 11:49pm
The discussion seems to confuse the Baumol prediction about labor costs, with the general observation about health/education spending.
The Baumol prediction suggests that for a various reasons the relative labor costs of certain sectors will increase. But university education for example, there isn’t any evidence that professor salaries plus benefits have increased nearly enough to account for the increase in overall cost. This suggests that the Baumol effect can’t be very explanatory because the predicted mechanism for cost increase is not actually observed.
Mike G
Jun 20 2019 at 7:03am
Possibly related:
In my nonprofit k-12 work, I’m often approached by foundations/governments for ideas on how to spend money improve outcomes. “Cut in half the number of 4th graders reading below grade level, for example.”
Yet in my for-profit k-12 work, I’m often asked for ideas on how to cut costs.
Comments are closed.