Add Solow to Baumol and you’ve really got something

An interesting line from Andrew Sissons about Baumol’s Cost Disease. Maybe it’s not entirely cost? One interesting part of it being this:

Baumol’s version of his “disease” actually combines two effects. The first is the famous finding, outlined above, that productivity gains in one sector lift wages in all sectors. The second, less positive part is that productivity growth will necessarily be slow or stagnant in some parts of the economy — typically the service sector. The combination of these effects, according to Baumol, is that the stagnant sector takes up a larger share of the economy over time, and that it gradually drags down overall productivity growth. Because services get more expensive, we have to spend more on them. Because they then make up a larger share of the economy, the economy gets less productive over time. Sounds bad.

And Baumol’s pessimistic theory matches the empirical data since 1967 (when he first published) pretty well. The rate of productivity growth has slowed down in advanced economies, and the service sector has grown as a share of the economy. The prices of many services have risen, while prices of many manufactures have fallen.

If you’re looking for an explanation as to why growth has slowed down in advanced economies, Baumol provides a simple, almost mechanical explanation, which presents the slowdown as inevitable. Maybe it’s Baumol’s world and we’re just living in it?

As so often we’d not insist that this is everything but we would insist that it’s some part of that everything. If productivity is more difficult to improve in services and we’ve a more service oriented economy then obviously, growth - dependent as it is upon increasing productivity - becomes slower.

We would though go on to point out one more thing. We should add Solow to Baumol:

It is a tautology that economic expansion represents the sum of two sources of growth. On one side are increases in "inputs": growth in employment, in the education level of workers, and in the stock of physical capital (machines, buildings, roads, and so on). On the other side are increases in the output per unit of input; such increases may result from better management or better economic policy, but in the long run are primarily due to increases in knowledge.

The basic idea of growth accounting is to give life to this formula by calculating explicit measures of both.

…..

While the growth of communist economies was the subject of innumerable alarmist books and polemical articles in the 1950s, some economists who looked seriously at the roots of that growth were putting together a picture that differed substantially from most popular assumptions. Communist growth rates were certainly impressive, but not magical. The rapid growth in output could be fully explained by rapid growth in inputs: expansion of employment, increases in education levels, and, above all, massive investment in physical capital. Once those inputs were taken into account, the growth in output was unsurprising--or, to put it differently, the big surprise about Soviet growth was that when closely examined it posed no mystery.

….

How, then, have today's advanced nations been able to achieve sustained growth in per capita income over the past 150 years? The answer is that technological advances have led to a continual increase in total factor productivity a continual rise in national income for each unit of input. In a famous estimate, MIT Professor Robert Solow concluded that technological progress has accounted for 80 percent of the long-term rise in U.S. per capita income, with increased investment in capital explaining only the remaining 20 percent.

Baumol does not tell us that increasing services productivity is impossible, he just says it’s more difficult. We also have that historical evidence, via Solow, that planned economic systems do not increase productivity but market based ones do.

Ah, so therefore we need to have more - and more more - markets in services in order to be able to increase productivity in services. As Sissons points out:

The Baumol effect is like a tide that lifts all boats. It brings higher wages to everyone, sharing the benefits of productivity growth across the economy.

Improving productivity anywhere in the economy increases wages for everyone. Therefore the reason to have markets in healthcare, in trains, in education, the reason to have markets everywhere they can possibly be crammed in, is to make everyone richer by improving labour productivity.

QED.

Tim Worstall