The Baumol Effect And Rising Health Care And Education Costs

Oct 4, 2019
Originally published on October 4, 2019 10:03 am
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DAVID GREENE, HOST:

So we expect prices of goods and services to go up over time, right? But why has the cost of health care and education risen far faster than things like TVs, cars and everyday consumer items? Well, you can trust economists to come up with a theory. They call it the Baumol effect. Cardiff Garcia and Danielle Kurtzleben from our daily economics podcast The Indicator From Planet Money explain how this works.

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CARDIFF GARCIA: Alex Tabarrok, an economist at George Mason University, is the co-author of a new book called "Why Are The Prices So Damn High?" And the answer, he says, starts with an economist named William Baumol.

ALEX TABARROK: He says think about a string quartet in 1826. It takes four people 40 minutes to play this string quartet. Now, let's think about the same string quartet in 2019 - live performance, same four people. It still takes them 40 minutes to produce the music.

DANIELLE KURTZLEBEN: But the price you pay to see that live string quartet has gone up way more than the price of everything else in the economy. The reason why is the Baumol effect.

GARCIA: Some sectors of the economy get better at making stuff every year. In other words, productivity grows really fast in these sectors.

KURTZLEBEN: For example, let's say an electronics company can make more flat-screen televisions this year with the same number of workers as last year, and those workers work the same number of hours. More is produced for each hour of work; maybe because there's better equipment for the workers to use or new technology that makes producing flat-screen TVs more efficient.

GARCIA: When a sector of the economy has fast productivity growth, that means it can afford to raise the wages it pays to its workers without raising the prices of the goods they make. There are also some sectors that have very slow productivity growth. They do not become more efficient at producing their goods or services from year to year. Kind of like the musicians in a string quartet, these workers do not produce much more of the same product.

KURTZLEBEN: The health care and education sectors fall into this category. Doctors, nurses, teachers, college professors - their productivity just doesn't go up much every year.

GARCIA: The reason they don't get more efficient over time is largely because a big part of what their customers want from them is their time, their presence.

KURTZLEBEN: The health care and education sectors still have to pay wages that can compete with other sectors of the economy that do have fast productivity growth because, otherwise, not enough people would become doctors, nurses, teachers, professors or play in string quartets.

GARCIA: The way that the health care and education sectors pay those higher salaries is by raising the prices of what they sell.

KURTZLEBEN: Since the workers in these sectors are not making more stuff to sell each year, the businesses that hire them - the schools, the colleges, the hospitals - they have to raise their prices so they can afford to pay those rising salaries.

GARCIA: Yeah. And when Alex analyzed what was happening in the health care and education sectors, he found that not only had salaries for education and health care workers climbed year after year for decades, but also we have more of them than we used to.

TABARROK: Because teachers are fairly well-educated and skilled, we have to pay them at least as much as they could earn elsewhere.

GARCIA: The costs of health care and education would still rise faster than the costs in other parts the economy simply because productivity growth in health care and education is slower. That is the mechanical relationship explained by the Baumol effect. Cardiff Garcia.

KURTZLEBEN: Danielle Kurtzleben, NPR News.

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