Baumol's Cost Disease Explained

[Note:  Derek Ferreira helped edit this article. Additionally, William J. Baumol was my instructor at NYU.]

Background

Here are some background articles for more in-depth understanding of Baumol's Cost Disease:

• Wikipedia Entry 
• Vox article
• The Exaggerated Role Of 'Cost Disease' In Soaring College Tuition

What is it?

Baumol's Cost Disease is phenomenon where real wages increase in a sector or a job that has seen little or no productivity growth. It was first described and analyzed in a study by William J. Baumol and William G. Bowen in the 1960s.

You may be tempted to immediately point to inflation as a simple explanation for this. But note that we have already ruled out inflation by specifying "real wages" above. (You may already know that when economists use the word "real", they generally mean "inflation adjusted" or "excluding inflation".) So you should be visualizing a case where wages for a particular job where there has been little or no productivity gains have increased over and above the rate of inflation.

Prof. Baumol chose for his flagship example the wages of a string quartet rehearsing and playing a Beethoven string quartet. The four musicians would be playing the same piece of music on the same instruments that their predecessors did over 200 years ago -- there's been almost zero productivity increase in their output. And yet our modern musicians would be compensated with much higher wages than they would have been 200 years ago (even in real terms). Why?

Well, first things first: Why is it called a "disease"?  For centuries, classical economics offered a view of the world where real wages would only increase because of increases in productivity. But the phenomenon that Prof. Baumol was highlighting appears to be a relatively common, even pedestrian violation of this premise -- a problematic departure from the normal and expected course of affairs -- a disease.

In recent years, Baumol's Cost Disease has gained more and more attention on a global level, in part because it is highly-applicable to health care, public transportation (think trains and busses), and basic income -- all of which are topics with elevated currency in public policy discussions globally. From this MIT lecturer to this startup in Korea, to this discussion group in Boston, people are increasingly discussing Baumol's Cost Disease.

But how does it work? What is the cause?

One explanation is that producers in the sector in question (in Baumol's example, the person hiring the musicians to play the string quartet) must offer a competitive wage to their musician employees -- a wage that is equal to or higher than the musicians might be offered in some other job -- a wage that entices the musicians to dedicate the necessary time in training and rehearsal to perform adequately. Otherwise the job of live classical musician would simply go away. But that explanation doesn't help us understand why someone would pay more for the same product or where the money would come from.

I'd like to offer you, my steadfast reader, an alternate explanation:  Opportunity cost ... more specifically the opportunity costs of the other jobs that have experienced technological advancement and productivity gains.

Here's a real-world example:  Last summer, Bill (a Software Engineer) needed the A/C in his truck recharged. It's a relatively simple 1-hour job that Bill has done himself in prior years. But this summer, Bill made the decision to pay his auto mechanic to do this simple job instead of doing it himself. 

Why this change in Bill's behavior? An increase in Bill's wages. As Bill's wage rate has increased, so has the opportunity cost of one hour of his leisure time.

 Let's say that last year, Bill got paid $30/hr for the first 40 hours per week and then $45/hr for overtime. His opportunity cost of a 1-hr job working on his truck after working 40 hours during the week would have been $45. At the same time, his auto mechanic quoted him $50 for the same work. Because his mechanic's estimate exceeded Bill's opportunity cost for doing the work himself, Bill decided to do the work himself.

During the ensuing year, Bill has gotten a new job and his wage rate took a big bump up to $40/hr ($60/hr overtime). This means that Bill's opportunity cost jumped to $60 for recharging his truck's air conditioning system and therefore, he is willing to pay his mechanic up to $60 to do the exact same 1-hr job that last year he would only have paid $45 for. Additionally, Bill has more discretionary income to pay the mechanic with.

The result is that, despite no change in the auto mechanic's technology or time required to do the job, his wage is able to increase simply because Bill's wages increased. This is an easily-generalizable conclusion.