Baumol’s Cost Disease Comes to Britain

Britain’s incoming Labour government got a nasty welcoming present in July when independent pay review bodies told ministers that millions of public sector workers should receive a 5.5% pay increase. The cost of this accounts for about half of the £20 billion “black hole” in the budget which Chancellor Rachel Reeves claims to have inherited. 

Some noted that these increases were not conditional on increases in productivity. This is true, but that illustrates a phenomenon which will put increasing pressure on budgets across the developed world. It is known as “Baumol’s cost disease.” 

This states, as economist William J. Baumol explained, that:

To see why, consider two workers; one works in a car factory, the other is a teacher. The car manufacturer’s output of cars per year can be increased with more or better machines or with a more efficient combination of the capital (the machines) and labor (their work) inputs into production (this “entrepreneurship” falls under “Total Factor Productivity”). This increase in productivity will, ceteris paribus, drive an increase in the car manufacturer’s wage. Baumol called this “the progressive sector.” 

For the teacher, it is much harder to increase productivity. Their labor is a much greater share of the factors of production – indeed, the labor largely is the product, or service – and it isn’t as easy to substitute it for capital. A teacher with 20 kids in his or her classroom could send recordings of their lessons to 100 kids to watch at home, but this would be an inferior service. Likewise, we could cram 100 kids into the teacher’s class and increase “kids taught per year,” but, again, this would be an inferior service. Baumol called this “the stagnant sector.”    

This is where the “cost disease” comes in. If we want people to teach, we must pay them at least what they could get in other sectors, and those other sectors include those, like car manufacture, where productivity increases are driving wage increases. Productivity driven wage increases in these other sectors will, then, drag up wages in sectors where there have not been the productivity increases to justify the wage increases by themselves. 

This disease is especially acute in sectors which are labor intensive and cannot be made much less so, like education or personal care. Britain’s pay hikes cover more than 500,000 teachers and about 1.3 million National Health Service staff. We can, and should, embrace measures like telehealth which could increase productivity in the healthcare sector, but these are unlikely to be more than marginal when the service is so inherently “hands on,” or labor intensive.     

‘Stagnant sector’ industries are often government monopolies or include a significant element of government provision. But not always. The cost of the average cremation in Britain increased by 43% between 2011 and 2020, for example, while the overall Consumer Price Index increased by just 16%. When you see that famous chart showing price changes in different sectors of the economy grouped as private or public sector, you might be seeing the effects of the Cost Disease at least as much as the effects of relative government inefficiency. 

Baumol sounded an optimistic note, writing:

“The only thing that will change, in terms of the cost to us,” Baumol writes:

Table 1 illustrates this. With growth of 1.5% annually, GDP per capita rises from $66,814 to $296,121 by 2023. If health spending rises from 15% of income to 40% over that period, health spending rises from $10,022 to $118,449. But, because of the overall growth in per capita GDP, non-health spending can also increase – from $56,792 to $177,673 – while decreasing as share of all spending – from 85% to 60%. If that growth doesn’t materialize, neither will the wage increases in the progressive sector required to drag up wages in the stagnant sector. “The only thing that will change, in terms of the cost to us,” Baumol writes, “is how we will have to divide our money among these items.” 

One implication of Baumol’s analysis is that the public sector share of GDP will increase dramatically. “The experiences of planned economies indicate that this is not a promising arrangement,” he notes. A gifted economist, Baumol was also a master of understatement.