The cost disease of the personal services, sometimes called "Baumol’s disease," refers to the tendency of costs and prices in a number of services, notably healthcare, education, legal services and live artistic performance, to rise persistently and cumulatively faster than the rate of inflation. This phenomenon has led to pressing social and political problems. Where the activities are provided via the market, less-affluent individuals have been deprived of such services, many of which are generally considered essential for their welfare. Where government finances the services in question, their rising cost has led to dramatic fiscal pressures and has engendered great political controversy. The data show unambiguously that such cost and price behavior of the affected services has persisted with little or no hiatus for as long as the statistical data are available, in some cases well over a century. The evidence also indicates that none of the many different programs various countries have adopted to counteract the cost disease has succeeded. Yet, as will be shown below, the cost disease is not a threat to the general welfare unless the measures taken to counteract it turn out to conflict with the public interest. Unfortunately, socially damaging policy responses are a very real possibility.
The evidence that the cost disease pervades all the industrialized countries seems incontrovertible, though there is often the illusion in any particular country that it alone is infected. Popular attempts at explanation usually entail a search for wrongdoers and the disease is frequently attributed to greed on the part of the suppliers of the services, notably "greedy lawyers and greedy doctors." Where this hypothesis is patently indefensible, as in education, the explanation often offered is incompetence and inefficiency. Yet, while there may indeed be instances of greed and inefficiency, there is reason to conclude that these are peripheral influences, and the fundamental explanation is to be found in the special technology of the affected services and the implications of such technology for the relative rate of productivity growth in those sectors. Their technology tends to make productivity in the pertinent services grow more slowly than it does elsewhere in the economy and that, in turn, makes relative increases in their costs and prices unavoidable.
1. What Types of Service are Affected by the Cost Disease?
The cost disease generally affects only services, not manufacturing or agriculture. But there are also many services, such as telecommunications, that are immune. Only those services whose production is highly labor intensive and in which it is very difficult to reduce the labor content have experienced the problem. Besides, as will be shown, they have experienced it with little let up and for very long periods. Because the affected services are characterized by substantial direct labor content it is convenient to refer to them as the "personal services," that is, services whose supply entails direct personal labor. The reasons why just these outputs are affected will be explained below, as the key to the analysis of the cost disease.
2. Significance of the Issue
Over the years, many communities have experienced a decline in the quality of a variety of public and private services. Not just in the United States, but throughout the world, streets have grown increasingly dirty. Bus, train, and postal services have all been reduced. For example, in the 1800s in suburban London, there were twelve mail deliveries per day on weekdays and one on Sundays (Kapp, 1972, p. 48n). Today, British postal services are held up as an extreme example of breakdown in performance. Parallel cutbacks have occurred in the quality of private services. Doctors now virtually never visit patients at home, though 50 years ago it was commonplace. Today, even some of the most elegant and expensive restaurants serve frozen and reheated meals — charging high prices for what amounts to little more than TV dinners. Overall, the result has been a threat to the affordability and quality of some of the services many associate most closely with quality of life.
3. Illustrative Data on Cost Trends of Personal Services
In the half century between 1948 and 1999 the Consumer Price Index increased at an average rate of about 3.8 percent per year, whereas the price of physicians’ services rose 5.4 percent per year. Compounded over those 51 years it increased the price of a doctor visit 125 percent, in dollars of constant purchasing power. An example that is even more extreme is the price of a hospital room, that during this same period increased at an annual rate of 8.2 percent compounded, amounting to an almost 900 percent increase since 1948, in constant dollars (U.S. Department of Labor, 2001). The available data for the real cost of a doctor visit and the real cost of a day in the hospital also indicate that the pattern of sharply rising real costs of these services had virtually no let up, compounding and accumulating throughout the second half of the 20th century.
Virtually every major industrial nation has tried to prevent health-care costs from rising faster than its economy’s rate of inflation, but none has succeeded, as Table 1 shows. The table reports for 9 leading OECD economies for the more than quarter century 1970-1998 that real health-care cost per person has grown at an annual compounded rate between 0.8 percent (United Kingdom, Italy) and 7.3 percent (Japan). In the Netherlands, Germany, and Japan real health-care cost has grown even faster than in the United States, with its absence of price controls (OECD, 1998).
The cost of education has a similar record — real cost per pupil in the United States has increased an average of 2.7 percent per year, compounded, between 1965 and 1994. The corresponding figures are 3.4 percent for Canada, 4.3 percent for Germany, 7.25 percent for Japan and 9.7 percent for France. Only in the United Kingdom have these costs not kept up with the economy’s rate of inflation (UNESCO, 1999).
These increases in costs occurred despite the fact that doctors’ earnings barely kept up with the economy’s overall inflation rate during this period (Noether, 1986), and teachers’ salaries actually fell behind. Persistent cost increases have also plagued other services such as postal delivery, police and fire protection, libraries, and theater tickets.2
Table 1: Growth rates, real per-capita healthcare costs, 1960-1998
|
Country U.K. |
Italy |
Sweden |
France |
Canada |
U.S. |
Netherlands |
Germany |
Japan |
|
Growth 0.8 Rate (%/Yr) |
0.8 |
1.4 |
3.2 |
3.5 |
4.6 |
4.7 |
5.2 |
7.3 |
4. Why do Personal Service Costs Consistently Outpace Inflation?
These ever-increasing costs may sometimes be attributable partly to inefficiencies in government management or to political corruption. But there is also another reason — one that cannot be avoided by any government administration, no matter how pure and efficient — and one that affects the private service industry just as severely as it does the public sector. The common influence underlying all of these problems of rising cost and deterioration in service quality, which is economic in character and expected to grow even more serious with time, is the cost disease.
The problem stems, ultimately, from differences in rates of productivity growth in the different sectors of the economy. It is hardly surprising that productivity growth rates should differ among industries, sometimes substantially. But what is perhaps less widely recognized is the persistence of the pattern. Industries whose productivity growth is relatively slow today are largely the same industries as those for which this was true many decades ago and even longer. This persistence phenomenon is not accidental, and is critical for the analysis.
The cost disease stems from the inherent technology of the personal services and the resulting slow growth in their productivity. Most such services have handicraft attributes. They often require slight or large differences in the work done, from one unit of output to another, as when one hospital patient requires different treatment from another. Others unavoidably entail direct contact between those who provide the service and those who consume it. Doctors, teachers, and librarians all engage in activities that require direct, person-to-person contact. Moreover, the quality of their service deteriorates if less time is provided by doctors, teachers, and librarians to each user of their activities.
In contrast, in other parts of the economy such as manufacturing, products and the production processes are uniform for all units of a given product and no direct personal contact between the consumer and the producer is required. For instance, an automobile comes off an assembly line and its buyer usually has no idea who worked on it and could not care less how much labor time went into its production. A labor-saving innovation in auto production need not imply a reduction in product quality. As a result, over the years it has proved far easier for technological change to save labor in manufacturing than to save labor in providing the personal services. Labor productivity (output per worker) in U.S. manufacturing and agriculture has increased at an average rate of something like 2 percent a year since World War II, but the productivity of college teaching (crudely measured by number of students taught per teacher) has increased at a rate of only 1 percent per year during that period. And, in elementary and secondary education labor productivity has actually declined — the average number of pupils per teacher has fallen from about 27 pupils per teacher in 1955 to 17 pupils per teacher in 1994, partly because classes have become smaller.3
5. Consequences for Costs and Prices
These disparate productivity performances have direct consequences for prices. When manufacturing wages rise 2 percent, the cost of manufactured products need not rise because increased output per worker can make up for the rise in wages. But as we have just seen, the nature of many services makes it very difficult to introduce labor-saving changes. A 2 percent wage increase for teachers or police officers is not offset by comparable increases in productivity and must lead to a substantial rise in municipal budgets. In the long run, wages for all workers throughout the economy tend to go up and down together, for otherwise the activity whose wage rate falls seriously behind will tend to lose its labor force. So autoworkers and police officers will see their wages rise at roughly the same rate in the long run. But if productivity on the assembly line advances, but productivity in the patrol car does not, then police protection must grow ever more expensive, relative to manufacturing, as time goes on.4
Because productivity improvements are very difficult for most personal services, their costs and prices can be expected to rise faster, year in and year out, than those of manufactured products. Over a period of several decades, this difference in the growth rate of costs of the two sectors adds up. In this way, personal services have grown steadily more costly compared to manufactured goods, and they are likely to continue to do so.5
6. A Future of More Goods but Fewer Services: Is it Inevitable?
If some services continue to become ever more expensive in comparison to goods they can significantly affect patterns of consumption. With continued growth in general productivity in the economy the typical household may well enjoy an abundance of goods that is difficult to imagine. But it may suffer from great deterioration in public services such as garbage removal. The services of doctors, teachers, and police officers may, to the extent feasible, be increasingly mass produced and impersonal, and the arts and crafts may be increasingly supplied only by amateurs, because the cost of professional work in these fields is too high. Many will undoubtedly question whether the quality of life has really increased.
But the cost disease does not make this future inevitable. To see why, one must first recognize that the problem’s source, paradoxically, is the growth in our economy’s productivity — or rather, the unevenness of that growth. Trash removal costs go up, not because garbage collectors become less efficient but because labor in automobile manufacturing becomes still more efficient, thus enhancing the sanitation worker’s potential value on the automotive assembly line. The sanitation worker’s wages must go up to keep him at his garbage removal job.
But increasing productivity in goods manufacturing makes an economy wealthier, not poorer. It does not make it unable to afford things that could be afforded in the past. Increasing productivity means that a society can afford more of all things — televisions, electric toothbrushes, cell phones, and medical care, education, and other services (Bradford, 1969).
The role of services in the future depends on how the community orders its priorities. If it values the personal services sufficiently, it can have more and better services — at some sacrifice in the rate at which manufacturing output grows. Society does have a choice, and if it fails to take steps to exercise it, plausibly the economy will continue to drift toward a world in which material goods are abundant and many things that most people now consider primary requisites for a high quality of life are scarce.
The problem is that the relative prices of the personal services can be expected to rise as a consequence of the cost disease, and this creates the illusion that they are no longer affordable. But the rising real incomes that stem from near-universally growing productivity means that the public need only reallocate some of its purchasing power from the relatively lower priced outputs to those that will grow comparatively more expensive, and it will receive more of both types of output.
7. Government Intervention may Make the Problem Worse
The cost disease is not correctly interpreted as an example of market failure. The market does give the appropriate price signals, indicating correctly that the input cost of the personal services, though perhaps even declining slightly in absolute terms, is rising relatively, that is, in comparison to the real input cost of other outputs. But the general public, and government along with it, is likely to misunderstand these signals. The numbers are startling. If current trends continue for half a century, outlays on healthcare and education may well approach half of GDP. Such frightening numbers, along with their current budgetary manifestations, may well lead governments to make decisions that do not really promote the public interest.
For example, because the cost disease drives health-care costs to rise faster than the economy’s rate of inflation, if we want to maintain standards of care in public hospitals, it is obviously not enough to keep health-care budgets growing at the economy’s prevailing inflation rate. Those budgets must actually grow faster if a decline in quality is to be prevented.
Thus, suppose the current inflation rate is 4 percent, but hospital costs are rising at a rate of 6 percent. Then it is to be expected that a political body that increases its hospitals’ budgets by 5 percent per year will feel that something is wrong. For, despite the fact that the budget steadily outpaces the inflation rate, standards of quality at the hospitals are condemned to be constantly slipping in this scenario. If the legislators do not realize that the cost disease is causing the problem, they will look for explanations such as corrupt or inefficient hospital administrators. The net result can be a set of wasteful rules that hamper the freedom of action of hospitals and doctors inappropriately or that tighten hospital budgets below the levels that demands and costs would yield if they were determined by the market mechanism rather than by government.
In many cases, price controls are proposed for sectors of the economy affected by the cost disease — for medical services, insurance services, and the like. But price controls can only eliminate the symptoms of the disease, and they often create problems that are more serious than the disease itself. These, then, are examples of government failure, the public sector counterpart of market failure. But the resulting damage to the public welfare is self-inflicted, and by no means unavoidable.
