Baumol’s ‘cost disease’ applies to labour-intensive industries

William Baumol will not likely win the Nobel Prize in Economics next month (the award will be announced Monday, Oct. 10). That’s a shame. Bill, all of 94, has written 40 books, seven while he was over 80, together with some 500 articles. While volume alone should not sway the Nobel Committee, he has made path-breaking contributions to many areas of economics.

His most famous, the “Baumol cost disease,” describes the plight of the performing arts. He and a colleague pointed out that the performance of Mozart’s String quintet in G Minor (K. 515) needs the same five musicians—two violinists, two violists and a cellist—and takes the same time to perform today as when composed in 1787. The musicians’ productivity has not improved for more than two centuries! The same is true for ballet dancers, opera singers and visual artists.

Things are quite different elsewhere in the economy. The time needed by GM workers to assemble a car has fallen from 41 hours to less than 24; retailers have boosted their sales per hour by 60 per cent; and computer-makers raised their productivity by 60 per cent each year.

The cost disease arises when employers enjoying increasing productivity raise wages that force those employers with slower productivity growth to pay higher wages to keep their workers. The disease refers the upward pressures on cost in industries with slow productivity growth.  

While developed to explain problems in the performing arts, the disease applies to other labour-intensive industries. It helps explain soaring tuition at universities and larger class sizes and use of more non-tenure stream faculty when universities struggle to offset cost pressures. It also helps explain mounting costs and longer wait times for health care.

Baumol has also reshaped economists’ views of competition. Traditionally economists judged competition in a market by the number of sellers and by the concentration among them. From this perspective, sellers in highly concentrated markets with few other sellers could charge high prices.

He suggested instead that sellers’ prices can be limited by their fear of new entrants into their market attracted by high prices and profits. Markets are deemed contestable when new sellers can freely enter and leave a market. The threat of entry means that markets with even a single or few sellers can act like competitive markers.

The theory of contestable markets has heavily influenced the application of competition policy. No longer is the presence of a small number of sellers used as the indicator of insufficient competition. Instead account must be taken of the presence of other potential sellers that can enter the market. Competition authorities must pay attention to the factors that influence entry into markets.

Finally, Baumol has built on Schumpeter’s famous work from the 1930s that elevated entrepreneurship as the key in determining economic progress. Schumpeter’s insights, however, left a crucial question unanswered: why does entrepreneurship thrive at some times and some places but not in others?

For Baumol, the question was not so much the quantity of entrepreneurial activity, but whether entrepreneurship is used in productive activities such as product or process innovation or in unproductive activities such as crime or seeking favour from government.

Where entrepreneurship efforts go depends on the payoffs society offers, and its use can change in response to changes in the payoffs. Obstacles to productive entrepreneurship can come from tradition (caste or class system), religion (usury prohibitions), institutions (lack of secure property rights) or government actions (creation of monopolies).

Medieval China offers a case in point. Commercial activity was discouraged and the surest way to wealth was to rise to a high rank in the bureaucracy. Those seeking high government posts needed to excel in the imperial examinations requiring years of laborious study that stressed Confucian philosophy and calligraphy. Surprisingly, even after passing this hurdle the successful civil servants were not well paid. Not surprisingly they became corrupt, using their powers to loot wealth from the public.

This diversion of entrepreneurial effort from productive uses stalled the progress of the Chinese economy for centuries. Its technological lead in the invention of paper, the development of printing processes, and the harnessing of power from waterwheels was squandered by diverting entrepreneurial effort into unproductive uses.

The list of possible Nobel laureates in economics includes many names. Baumol deserves to be at the top. I hope he’s awakened next month by a phone call telling him he’s won the Nobel Prize in Economics.