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The Cost Disease

Yale UNIVERSITY PRESS

Chapter One

This strange disease of modern life.

—Matthew Arnold

In 1980, it cost $3,500 per year, on average, to attend a four-year undergraduate school in the United States (including room and board). By 2008, that figure was ancient history: a single year of undergraduate study cost nearly $20,500. That's an average annual increase of more than 6 percent—well above the rate of inflation. If this trend continues, by 2035 annual tuition at a top-tier private school could cost nearly $200,000.

College tuition is not an isolated case. Medical care and live theatrical performance are also victims of a widespread pattern of increasing costs that has come to be called "the cost disease," "Baumol's disease," or in educational circles, "Bowen's curse." The data are striking in both their magnitude and their persistence.

The Cost Crisis

The exploding cost of health care is the focus of widespread concern. There is rarely an election in an industrialized country in which every candidate is not expected to proclaim a commitment to containing these costs. In the United States, contenders in the 2008 presidential election repeatedly stressed this issue as one of the most critical facing society. Participants in these debates often point out that people in other nations pay far less for health care than Americans do, yet they live longer and enjoy better health. But as we will see, even though their total costs are lower, those nations also are beset by strikingly rapid and persistent increases in the cost of their health-care programs. The cost disease is universal.

Those of us with children or grandchildren in college are only too painfully aware that education suffers similar problems, which also elicit growing political attention. The National Center for Public Policy and Higher Education reports that nearly two-thirds of Americans "believe that college prices are rising faster than the cost of other items." Data from the Bureau of Labor Statistics confirm the accuracy of these perceptions. Since the early 1980s, the price of college tuition in the United States has increased by a much greater percentage (up 440 percent) than the average rate of inflation (110 percent), median family income (150 percent), and even medical care (250 percent).

My purpose in this book is to show not only that health care, education, and a number of other service fields share the problem of growing costs but that these increases have a common source. Until that source is recognized, programs to deal with the issues are likely to prove ineffective or worse—but once the problem is understood, promising courses of action become visible. The beginnings of this discussion will appear suitably grim, but the rising-cost portion of the story will have a rather happier ending—though that ending still depends on the rationality and insight of policy makers.

My argument, in brief, is that the cost disease is largely a product of the unprecedented and spectacular productivity growth that the world's industrialized nations have achieved since the Industrial Revolution, commonly said to have begun in the eighteenth century, which has contributed so much to standards of living and reduction of poverty. This unprecedented productivity growth—carried out primarily by the partnership of inventors and entrepreneurs and expanded to a large scale by companies, governments, and nonprofits—has all but eliminated famine in wealthy countries, created technology unimaginable in earlier eras, given us ever rising standards of living, and greatly reduced poverty in both extent and severity. But it has also brought the rising costs of health care, education, and other important services. The argument here is that the productivity growth that gives rise to the cost disease also gives society the means to deal with it.

Rising Health-Care and Education Costs in the United States

It is often noted that Americans pay considerably more for health care than citizens in most other industrialized countries. Judging by the statistical evidence, we can be fairly certain that this is true, despite the well-known pitfalls besetting cost comparisons among different countries with different currencies. The main shortcoming of this conclusion is not that it is factually incorrect but that it focuses on the wrong issue. The pain society experiences from the costs of health care and education does not derive primarily from their levels at some particular date, but rather from their growth rates. As expensive as health care and education may have been yesterday, they are considerably more so today, and will be costlier still tomorrow.

Here it is important to note that I refer not to price inflation but to what economists call "real price increases"—that is, price increases above the rate of general inflation in the economy. (For noneconomist readers, an explanation of "real" versus "nominal" prices appears in the appendix at the end of this chapter.) The magnitude and persistence of these real prices' growth rates are sufficiently striking as to leave little doubt that even if they are not the only difficulty, they are surely a major component of the problem.

Consider that between 1948 and 2008 the consumer price index (CPI), which measures overall price rises in the U.S. economy, increased by nearly 4 percent per year. In comparison, the cost of physician services rose by about 5 percent annually during that period (Figure 1.1). This difference may seem trivial, but it signifies an increase in the price of a visit to the doctor of approximately 230 percent (adjusted to eliminate increases due to inflation) over that sixty-year period.

In the last thirty years, the cost of hospital services, as reported by the U.S. Bureau of Labor Statistics, rose even more sharply—nearly 8 percent a year between 1978 and 2008. In comparison, as shown in Figure 1.2, the costs of physician services and overall CPI grew by rates of just over 5 percent and just under 4 percent, respectively, during that thirty-year period. Corrected for inflation, this represents an increase of nearly 300 percent. In comparison, during that thirty-year time period, the real cost of physician services grew by almost 150 percent. Increases of this magnitude clearly constitute a serious threat to the quality and quantity of medical care that middle- and lower-income Americans can afford. In an affluent society that is dedicated to promoting the general welfare—including a minimum standard of acceptable medical care—the rising cost of health care clearly represents a pressing problem. (Later, however, we will see that this problem may be less serious than it seems.)

When we look at similar data for educational costs, we find very similar patterns. As Figure 1.3 shows, the average consumer's expenditures on college tuition and fees, for instance, have risen steadily at rates markedly outstripping inflation. According to the Bureau of Labor Statistics, college tuition and fees increased by just over 7 percent per year during the last thirty years. Measured in dollars of constant purchasing power, tuition increased by more than 250 percent during this period—a growth rate that lags behind the increase in hospital services costs but easily surpasses that of physician services.

Global Comparison: Rising Health and Education Costs

Are these steadily growing real costs peculiar to the United States? Several commentators have suggested that other countries exercise firmer control over their health-care costs and thus continue to offer better and more affordable public services. There is undoubtedly much truth to this contention, which reflects, among other influences, differences in public policies. Chief among these are other nations' greater commitment to social services, financed by tax rates that are far higher than those in the United States, and stricter controls on physicians' fees. Even so, the rates of cost increases in health care and education affect other industrialized countries as well as the United States (for data on health-care costs in low- and middle-income countries, see Chapter 7).

When we compare U.S. health-care and education costs with those elsewhere, we see that between 1995 and 2004 educational expenditures per student increased significantly in every one of the seven industrialized countries for which we have data. American expenditures on education were consistently higher than those in the other six countries, but three others—the United Kingdom, the Netherlands, and Denmark—were not far behind. As shown in Figure 1.4, the rate at which U.S. expenditures grew was also the highest—at nearly 5 percent each year. The United Kingdom, Denmark, and the Netherlands again followed closely behind. As for health care, virtually every major industrial nation has tried to prevent these costs from rising faster than its rate of inflation—and all have failed. Between 1960 and 2008, as shown in Figure 1.5, the United States spent more on health care per capita than Canada, Germany, Japan, the United Kingdom, and the Netherlands. But as Figure 1.6 shows, the United States did not have the highest rate of increase in real health-care spending per person during that period. Japan's growth rate, for instance, easily exceeds that of the United States. Although health-care spending in the United States is comparatively high, its rate of increase resembles that of other affluent industrialized countries.

Finally, although real health expenditures have increased faster than inflation in the United States, the wages of employees in health care professions have not. Over the last fifty years, according to data from the U.S. Bureau of Labor Statistics, health-care workers' salaries have barely kept up with inflation. The wages of employees at American colleges and universities, meanwhile, actually failed to keep pace with inflation, starting in the mid-1970s (Figure 1.7). The rapid rise in health-care and education costs cannot be blamed on the people working in these sectors.

The first lesson to draw from this is that other countries' systems suggest no quick fix for the problem of rising health-care costs in the United States. The universality and persistence of the problem—the fact that it has endured for more than four decades and affects countries throughout Europe, North America, and Asia—indicate that its roots go far deeper than America's particular administrative or institutional arrangements. There are many reasons for increased spending on health care, including an aging population, technological change, perverse incentives, supply-induced demand, and fear of malpractice litigation. The broader point is that the basic underlying problem does not entail misbehavior or incompetence but rather stems from the nature of the provision of labor-intensive services.

Appendix: "Real" versus "Nominal" Costs

Economists have adopted two ways of looking at changes in cost. One is called nominal change, and the other is called real change. The nominal change in cost is the cost modification that meets the eye directly. If the price of a newspaper goes from $1 to $2, we say that the nominal cost to the consumer rose by $1—a 100 percent increase. But if all costs and wages in the entire economy (that is, inflation) also happened to rise 80 percent during that same year, we must take this into account. Though we are paying more dollars for our newspaper, each of those dollars is worth less than before.

These two changes partially offset one another. To evaluate how much the newspaper's real cost has risen, we subtract the increase attributable to inflation (80 percent) from the nominal increase (100 percent), which gives us the real increase in cost. In this example, the real cost increase is 20 percent (100 percent – 80 percent = 20 percent).

It is important for many purposes to be able to separate out these two influences on costs. Failure to distinguish between them can lead to poor policies that, rather than ameliorating a problem, actually make it worse. For example, suppose the cost of automobiles rises by 15 percent in one year, but in that same year wages double for all workers. Workers everywhere will be able to afford to buy a new car more easily than they could the year before, even though the nominal cost of buying a car increased. If we were to punish the automobile manufacturers for their greed in raising prices, it might force them to build inferior cars or even drive them out of business—their workers' salaries, remember, have increased along with all others. Real cost is an economic concept created to avoid such misunderstanding.

How to Calculate Changes in Real Cost

The method economists use to calculate changes in real cost is straightforward and not deeply interesting in itself, but it is worth explaining here to make it easier for noneconomist readers to follow the analysis in this book. The real cost of any commodity is calculated simply by taking its nominal cost and dividing that by a measure of the average change in cost for all of an economy's products (or a representative sample of its products, such as the consumer price index, or CPI). Thus, to calculate the real cost in 2010 of product X, simply use this equation:

Real Cost of Product X in 2010 = Nominal Cost of Product X in 2010/ Index of Costs for the Whole Economy in 2010

Note that if the percentage increase in the cost of product X is less than the percentage increase in the index of costs for the whole economy, the real cost of product X will fall, even though its nominal cost has risen. From this, we deduce an observation that is quite obvious, though generally overlooked: in any economy in which the costs of the various goods rise at different rates, the costs of some goods must rise more rapidly than average, while the costs of others must rise more slowly than average. This must be so because, by the definition of an average, some cost increases must be higher than average, while others must be below average.

Inevitably, then, there always will be some commodities whose real costs are rising and others whose real costs are falling. Commodities whose nominal costs are increasing at rates that are less than the average of all costs in the economy, for instance, will see their real costs decrease. There should be nothing surprising, therefore, in the fact that some goods and services, such as health care and education, are characterized by rising real costs, while others, such as computers and telecommunications, have falling real costs.

(Continues...)

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Excerpted from The Cost Disease by William J. Baumol David de Ferranti Monte Malach Ariel Pablos-Méndez Hilary Tabish Lilian Gomory Wu Copyright © 2012 by William J. Baumol. Excerpted by permission of Yale UNIVERSITY PRESS. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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