On Cost Disease

A primer on what it is and how it works

There are two types of American industries: one that has had rapid innovation and falling prices, and one that has had the opposite.

In the first—e.g. software, manufacturing—consumers have grown accustomed to paying less for more. 

In the second—e.g healthcare, education, construction—they pay more for the same (or less).

As you can see, industries like electronics, media, food, and clothing have had spectacular productivity growth. Productivity is growing, prices are declining, and wages are exploding, mostly because workers in those sectors, thanks to technology, can produce a lot more with less input.

However, we can also see health, education, and construction costs rising. To put this in perspective: over the past fifty years, university and health insurance costs have gone up 10x, and housing costs have increased by about 50%.

You’d expect these industries to get cheaper because of technology and globalization, but instead they’re getting far more expensive (much faster than inflation) while the product doesn’t improve.

Why is this the case?

One explanation is Baumol’s cost disease — the idea that wages in stagnating industries rise in response to rising wages in industries with positive productivity growth. 

Basically, these industries are getting more expensive because wages are rising even though labor productivity isn’t, largely to offset gains in other industries.

Put differently: as technology increases productivity for workers in productive industries, unproductive industries have to pay their workers more to compete. That’s why salaries rise even though labor productivity doesn’t.

Since workers can migrate from sector to sector and wages get set across industries, you now see industries with neutral (and sometimes negative) productivity growth setting wages as if they had positive productivity growth. So prices for consumers in sectors like healthcare, education, and housing just explode, and the same stuff gets more expensive every year without getting any better. In some cases, those same things may even be getting worse. And there’s no reason why this would ever stop.

But this can’t be the entire story. 

Another explanation is poorly implemented government intervention — examples being occupational licensing in healthcare and education subsidies via loans. 

In these cases, the government uniquely distorts markets in ways that makes them neither market driven nor government provided (like other countries have). This results in:

1. Opaque markets with no transparent pricing

2. Entrenched industries in which we can’t modify regulations

3. Intermediated markets where the patient isn’t the customer

Yet another explanation, and this one positive, is that we simply give more people access to these services. More patients & more students means more staff — total cost goes up because we serve and employ more people.

Alongside explanations, we try to justify cost-disease in numerous ways. 

One claim is that cost disease is endemic to service sectors — but we don’t see skyrocketing prices in other service industries where people pay out of pocket (e.g restaurants or fast food places).

Others try to reframe it entirely by saying it’s less of a cost disease and more of a “wage bonus.” They say our teachers and doctors get to make more money, and we can thus attract great talent to those professions too (which is great!).

Zooming out: In the 1930s, Keynes predicted, based on the rate of GDP growth, that his grandchildren would only work 15 hour weeks because that’s all that would be required in a richer society.

But looking at where we are today, we’ve gotten as rich as we expected, but we’re nowhere near where Keynes' predicted — partially because the cost of basic needs (healthcare, education) has gone up faster than wages have.

Think about how big of a deal cost disease is: If we didn’t have technological and productivity growth, would healthcare be 50x as expensive as it is now? 100x?

Our problem isn't too much technology or people being too excited about technology — it’s that we don't have nearly enough of it. These cartel-like legacy industries are way too hard to disrupt.

Indeed, because of the lack of disruption, a lot of what doctors are doing today is the equivalent to what farmers were doing 300 years ago: if you took a modern farmer with modern technology and told them they had to go back to how farming used to be, it would lead to much worse food produced at higher prices, with many more people going hungry. 

Hopefully we’ll look back in horror at how expensive and ineffective our current healthcare system is relative to what it will be in the future.

More market-based solutions would likely lead to more technological growth, and we see this in LASIK eye surgery. It’s actually quite inexpensive, and the price has been dropping over time. This is no different than heart or brain surgery, and yet the quality of improvement and cost reduction curve are completely unlike any other surgical procedure. This is because it’s paid out of pocket and not through the insurance system. It’s not something that other people pay for, so there isn’t as much politics around it. 

And that’s just one example. We’re also seeing others in education and housing, which are absolutely critical. Software must eat the world or else these unproductive industries will eat the economy and we’ll have no option but to have the government redistribute wealth across the board to allow workers (99% in healthcare, education, etc) to afford the services they provide, which we obviously need.

Effectively, we need a call to arms that acknowledges cost disease and the need to see technological innovation bend the cost curves in these unproductive industries.

After all, technology is what allows us to feed billions of people, lift people out of poverty, and provide goods & services for 10x the number of people for 1/10th of the cost. Technology allows us to do more with less, which gets us out of our zero-sum competition and into a positive-sum world.

This should have bipartisan support. Liberals should love this, since they want cheaper education and cheaper healthcare, and conservatives should love this too, since they understand that without rapid innovation the government will rush to fill the gap.

It’s only a matter of time before we realize this, but I hope it’s soon lest we remain stuck with the cost disease.

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Read of the week: Katherine Boyle on Seriousness. I also had her on my podcast this week.

Watch of the week: RIP, DMX. Classic freestyle with him and friends

Listen of the week: Alex Kaschuta’s podcast w/ Patrick Deneen.

Cosign of the week: Kyla Scanlon, who makes great finance content and also launched On Deck Investing this week

Until next week,

Erik