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UHY Hacker Young | Chartered Accountants
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Do you suffer from Baumol’s cost disease, and is there a cure?

14 January 2020

We start our new year with an apparently inconsequential observation about the rising price of services, which, on further investigation, reveals some fundamental principles that underlie the workings of our businesses and our economy.

Hair-raising

A former colleague, who admits to being follicly-challenged, recently made this thought-provoking observation: why had his customary pre-Christmas haircut cost him £8 this year but only £6 last year, whereas he had purchased a memory-stick on the same day for only £6.99, the identical item having cost £12.99 only a year ago?

This seemingly minor grumble about the cost of a haircut has many ramifications for us as consumers and entrepreneurs. It has implications for productivity, government spending policies, taxation, and the future of the western model market economy.

It’s not just memory sticks that cost less, or just in barber shops that prices are rising faster than inflation. Since 1950 the cost of new cars has fallen by half (and the quality has improved considerably). The price of clothing has fallen by 75% and the cost of household appliances by 90%. But whereas cars are cheaper, car maintenance is more expensive. Other services that depend on labour also cost more: the cost of medical care and education have risen fivefold in the same period. The reasons are obvious. Technology in the form of automation, and more recently robotics and AI, means that far fewer people are needed to make a car, but the number of teachers required to educate any given number of pupils has remained roughly the same.

The Disease

The economist, William Baumol, developed a theory to explain this in the 1960s. During investigations into the economics of the arts he posed the question: why were musicians getting paid a lot more than 100 years ago but not getting any more productive? Playing a piece written for a string quartet took four musicians the same amount of time in 1965 as it did in 1865. The answer was, and is, that unproductive people’s wages are pushed up by rising productivity in more productive sectors of the economy. For example a factory manager who uses technology to reduce his labour costs and thereby increase his productivity, will be remunerated for his success with higher pay. If he is consequently paid £10,000 p.a. more than a medical consultant, this will encourage more young people to train to be factory managers and fewer to train as doctors. So to maintain the required number of doctors their salaries have to rise. Economists call this Baumol’s Cost Disease.

The effect is magnified when we ask what happened to all the people who in previous generations would have worked in manufacturing industry but whose jobs are now done by robots. They have become personal trainers, professional entertainers, university lecturers, hoteliers, and others whose jobs are valued by society but whose productivity is low if measured by the standards of manufacturing industry. And, in a further twist to this theory, as the price of goods and gadgets continues to fall and salaries continue to increase, there comes a point where people own enough “stuff” and so dedicate more of their surplus wealth to buying services such as education, entertainment, travel and leisure pursuits, further pushing up salaries in such sectors.

Side-effects

These theories are relevant today for several reasons. First they have a bearing on our assessment of productivity in the economy. Despite all our efforts to improve training, management and supply chains the rate of productivity as measured across the whole economy stubbornly refuses to improve. Baumol’s theory explains that this is because of an inevitable migration of people from high productivity occupations to those with low productivity.

Second, it challenges the view of many politicians that the rise in the costs of services provided by government – typically low productivity services, like law enforcement, justice, health, social care and education – is due to poor management and inefficiency. This widely held misconception often provokes reductions in public services, austerity measures and strict spending caps. But perhaps the rising costs of public services are instead a consequence of a thriving, growing economy. There is indeed much evidence that indicates that in rich countries the cost of health care rises faster as a proportion of GDP than in poorer countries.

The cure?

So, there is little prospect of a cure for Baumol’s Cost Disease, indeed the cure would be worse than the disease, but there are important lessons to be learned.

If you have any views on this subject why not share them with us on Twitter? Or if you would like to start the New Year with a review of your business structure and finances please don’t hesitate to contact me at a.hulse@uhy-uk.com.