In economics, the Baumol effect, or Baumol's cost disease, first described by William J. Baumol and William G. Bowen in the 1960s, is the tendency for wages in jobs that have experienced little or no increase in labor productivity to rise in response to rising wages in other jobs that did experience high productivity growth. In turn, these sectors of the economy become more expensive over time, because the input costs increase while productivity does not. Typically, this affects services more than manufactured goods, and in particular health, education, arts and culture.
The rise of wages in jobs without productivity gains results from the need to compete for workers with jobs that have experienced productivity gains and so can naturally pay higher wages. For instance, if the retail sector pays its managers low wages, those managers may decide to quit and get jobs in the automobile sector, where wages are higher because of higher labor productivity. Thus, retail manager salaries increase not due to labor productivity increases in the retail sector, but due to productivity and corresponding wage increases in other industries.
The Baumol effect explains a number of important economic developments:
The share of total employment in sectors with high productivity growth decreases, while that of low productivity sectors increases. Economic growth slows down, due to the smaller proportion of high growth sectors in the whole economy. Government spending is disproportionately affected by the Baumol effect, because of its focus on services like health, education and law enforcement. Increasing costs in labor-intensive service industries, or below average cost decreases, are not necessarily a result of inefficiency. Due to income inequality, services whose prices rise faster than incomes can become unaffordable to many workers. This happens despite overall economic growth, and has been exacerbated by the rise in inequality in recent decades. Baumol referred to the difference in productivity growth between economic sectors as unbalanced growth. Sectors can be differentiated by productivity growth as progressive or non-progressive. The resulting transition to a post-industrial society, i.e., an economy where most workers are employed in the tertiary sector, is called tertiarization.
Description Increases in labor productivity tend to result in higher wages. Productivity growth is not uniform across the economy, however. Some sectors experience high productivity growth, while others experience little or negative productivity growth. Yet wages have tended to rise not only in sectors with high productivity growth, but also in those with little to no productivity growth.
The American economists William J. Baumol and William G. Bowen proposed that wages in sectors with stagnant productivity rise out of the need to compete for workers with sectors that experience higher productivity growth, sectors that can afford to raise wages without raising prices. With higher labor costs, but little increase in productivity, sectors with low productivity growth see their costs of production rise. As summarized by Baumol in a 1967 paper:
Origins
Jean Fourastié: unbalanced growth in economic sectors
Studying various price series over time, Jean Fourastié noticed the unequal technological progress in different industries.
He predicted that this would lead to a gradual increase in the share of services in the economy, and the resulting post-industrial society:
In a 2003 article, Baumol noted: "For the origins of the analysis, see Fourastié (1963)." This is a reprint of Fourastié 1949.
Baumol and Bowen: rising wages despite productivity stagnation The original study on the Baumol effect was conducted for the performing arts sector. American economists Baumol and Bowen in 1965 said "the output per man-hour of the violinist playing a Schubert quartet in a standard concert hall is relatively fixed." In other words, they said the productivity of classical music performance had not increased. However, the real wages of musicians had increased substantially since the 19th century. Gambling and Andrews pointed out in 1984 that productivity does go up with the size of the performance halls. Furthermore Greenfield pointed out in 1995 that far more people hear the performance due to advances in amplification, recording and broadcasting, so productivity has increased many-fold.
Effects
Price and output Firms may respond to increases in labor costs induced by the Baumol effect in a variety of ways, including: Cost and price disease: Prices in stagnant industries tend to grow faster than average Stagnant output: Real output in low-productivity-growth industries tends to grow more slowly relative to the overall economy Employment effects: Firms in stagnant industries may reduce employment, decrease hours, or increase non-monetary compensation An important implication of Baumol effect is that it should be expected that, in a world with technological progress, the costs of manufactured goods will tend to fall (as productivity in manufacturing continually increases) while the costs of labor-intensive services like education, legal services, and health care (where productivity growth is persistently slow) will tend to rise (see chart).
A 2008 study by American economist William Nordhaus showed as much, concluding that "Baumol-type diseases" in technologically stagnant sectors have led to "rising relative prices and declining relative real outputs." In the realm of prices, Nordhaus showed that in the United States from 1948–2001 "productivity trends are associated almost percentage-point for percentage-point with price decline." Industries with low productivity growth thus saw their relative prices increase, leading Nordhaus to conclude: "The hypothesis of a cost-price disease due to slow productivity growth is strongly supported by the historical data. Industries with relatively lower productivity growth show a percentage-point for percentage-point higher growth in relative prices." A similar conclusion held for real output: "The real output/stagnation hypothesis is strongly confirmed. Technologically stagnant industries have shown slower growth in real output than have the technologically dynamic ones. A one percentage-point higher productivity growth was associated with a three-quarters percentage-point higher real output growth."
Affordability and inequality While the Baumol effect suggests that costs in low-productivity-growth industries will continually rise, Baumol argues the "stagnant-sector services will never become unaffordable to society. This is because the economy's constantly growing productivity simultaneously increases the population's overall purchasing power." To see this, consider an economy with a real national income of $100 billion with healthcare spending amounting to $20 billion (20% of national income), leaving $80 billion for other purchases. Say that, over 50 years, due to productivity growth, real national income doubles to $200 billion (an annual growth rate of about 1.4%). In this case, even if healthcare spending were to rise by 500% to $120 billion, there would still be $80 billion left over for other purchases—exactly the same amount as 50 years prior. In this scenario, healthcare now accounts for 60% of national income, compared to 20% fifty years prior, and yet the amount of income left to purchase other goods remains unchanged. Further, if healthcare costs were to account for anything less than 60% of national income, there would be more income left over for other purchases (for instance, if healthcare costs were to rise from 20% of national income to 40% of national income, there would be $120 billion left over for other purchases—40% more than 50 years prior). So it can be seen that even if productivity growth were to lead to substantial healthcare cost increases as a result of Baumol's cost disease, the wealth increase brought on by that productivity growth would still leave society able to purchase more goods than before.
While this is true for society in the aggregate, it is not the case for all workers as individuals. Baumol noted that the increase in costs "disproportionally affects the poor." Although a person's income may increase over time, and the affordability of manufactured goods may increase too, the price increases in industries subject to the Baumol effect can be larger than the increase in many workers' wages (see chart above, note average wages). These services become less affordable, especially to low income earners, despite the overall economic growth. This effect is exacerbated by the increase in income inequality observed in recent decades.
Government spending The Baumol effect has major implications for government spending. Since most government spending goes towards services that are subject to the cost disease—law enforcement, education, healthcare etc.—the cost to the government of providing these services will rise as time goes on.
Labor force distribution
One implication of the Baumol effect is a shift in the distribution of the labor force from high-productivity industries to low-productivity industries. In other words, the effect predicts that the share of the workforce employed in low-productivity industries will rise over time.
The reasoning behind this can be seen through a thought experiment offered by Baumol in his book The Cost Disease:
As predicted by the Baumol effect, the proportion of the United States labor force employed in stagnant industries has grown substantially since the 1960s. In particular, the United States has morphed from a manufacturing economy into a service economy (see chart). However, how much of this is due to the Baumol effect rather than other causes is disputed. In a 2010 study, the economist Talan B. İşcan devised a model from which he concluded that both Baumol and Engel effects played significant roles in the rising share of employment in services in the United States (though he noted that "considerable gaps between the calibrated model and the actual data remain"). An older 1968 study by economist Victor Fuchs likewise concluded that the Baumol effect played a major role in the shift to services, although he determined that demand shifts like those proposed in Engel's law played only a minor role. The economists Robert Rowthorn and Ramana Ramaswamy also concluded that relatively faster growth of productivity in manufacturing played a role in the shift to services. The economist Tom Elfring, however, argued in a 1989 paper that the Baumol effect has played a secondary role to growth in demand for services since the 1970s. Alternative theories for the shift to services include demand-side theories (the Baumol effect is broadly a supply-side explanation) like the three-sector model devised by Allan Fisher and Colin Clark in the 1930s, which posit that services satisfy higher needs than goods and so as income grows a higher share of income will be used for the purchase of services; changes in the inter-industry division of labor, favoring specialized service activities; outsourcing to countries with lower labor costs; increasing participation of women in the labor force; and trade specialization.
The Baumol effect has also been used to describe the reallocation of labor out of agriculture (in the United States, in 1930 21.5% of the workforce was employed in agriculture and agriculture made up 7.7% of GDP; by 2000, only 1.9% of the workforce was employed in agriculture and agriculture made up only 0.7% of GDP). In a 2009 study, the economists Benjamin N. Dennis and Talan B. İşcan concluded that after the 1950s relatively faster productivity growth in agriculture was the key driver behind the continuing shift in employment from agriculture to non-farm goods (prior to the 1950s, they determined that Engel's law explained almost all labor reallocation out of agriculture).