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The Cost Disease: Why Computers Get Cheaper and Health Care Doesn't [Hardcover]

William J. Baumol , David de Ferranti , Monte Malach , Ariel Pablos-Méndez , Hilary Tabish , Lilian Gomory Wu

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Book Description

Sept. 3 2012

The exploding cost of health care in the United States is a source of widespread alarm. Similarly, the upward spiral of college tuition fees is cause for serious concern. In this concise and illuminating book, the well-known economist William J. Baumol explores the causes of these seemingly intractable problems and offers a surprisingly simple explanation. Baumol identifies the "cost disease" as a major source of rapidly rising costs in service sectors of the economy. Once we understand that disease, he explains, effective responses become apparent.

Baumol presents his analysis with characteristic clarity, tracing the fast-rising prices of health care and education in the United States and other major industrial nations, then examining the underlying causes, which have to do with the nature of providing labor-intensive services. The news is good, Baumol reassures us, because the nature of the disease is such that society will be able to afford the rising costs.


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Review

"A provocative and timely critique of the fallacies in the conventional wisdom that we can no longer afford good education and decent health care."—Sir Harold Evans, author of They Made America
(Sir Harold Evans 2012-02-06)

“It’s a testament to Professor Baumol’s lucid prose, though, that economists and noneconomists alike will find it easy to grasp his surprisingly comforting argument for why we shouldn’t panic. . . .This book is a quick read, packed with charts and case studies. But it is the author’s command of storytelling that makes it not just digestible but also enjoyable.”—Amy Wallace, The New York Times 
(Amy Wallace The New York Times)

“Health-care costs are huge, and still rising. Based on current trends, in 2105 US health care will consume 62% of our national income.  And this is nothing to worry about. How can this be? Relying primarily on simple logic and storytelling, NYU economist William J. Baumol lays out the answer in his new book.”—Kyle Smith, New York Post
(Kyle Smith New York Post 2012-09-24)

“In this important book, William Baumol and his co-authors have shown how divergent productivity trends have profound implications for how society deals with increasingly expensive sectors like education and health.”—William Nordhaus, Sterling Professor of Economics at Yale University
(William Nordhaus)

“An excellent book that puts to the sword many health care myths. . . . [A] necessary read for anyone who is engaged in health care costs.”—Lancet Oncology
(Lancet Oncology)

About the Author

William J. Baumol is professor of economics and academic director of the Berkley Center for Entrepreneurship and Innovation, New York University, and professor emeritus, Princeton University. He lives in New York City.

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22 of 24 people found the following review helpful
2.0 out of 5 stars The danger of 100 year extrapolations Dec 14 2012
By Gaetan Lion - Published on Amazon.com
Format:Hardcover|Verified Purchase
The basic premise of the book seemed so intriguing. In a nutshell, US healthcare spending is virtually uncontrollable and will go through the roof; but, we will very easily be able to afford those costs.

Baumol projects healthcare spending to rise from 15% of US GDP in 2005 to 62% in 2105. But, not to worry because overall we will be over 8 times wealthier as our GDP per capita will rise from $41,800 to $343,000. Given that, it will be so easy to spend nearly 2/3 of every dollar on healthcare.

However, Baumol's extrapolations 100 years down the road are meaningless if not completely wrong. To understand how he derived his 2105 projections you have to read carefully note 13 on page 187.

For healthcare spending as a % of GDP, Baumol observed that they grew by 1.41% per year over the 1995-2005 decade. So, here is how he got the healthcare spending of 62% of GDP: 15%(1 + 1.41%)^100 = 60.8% (I got a different figure because of decimal figures). This same logic suggests that by 2140 or just 35 years later, healthcare will account for 100% of GDP. This does not make any sense. The 62% by 2105 does not make any more sense than the 100% by 2140. Taxes, housing, other consumptions of goods and services, business investments, Government spending can't so readily be squeezed into our remaining 38 cents on the dollar (1 - 62% allocated to healthcare).

When it comes to real GDP per capita, Baumol took the 2005 level of $41,800 and used the 2.13% average annual growth rate in this measure over the 1950 to 2001 period. His calculation: $41,800(1 + 2.13%)^100 = $343,000. Now do you believe that in 2105 we could possibly be over 8 times wealthier than we are currently? This entails that our prospective economy will be far greater than 2 times the current World economy (when you factor US population growth). If we grasp what that entails in terms of World's resources and industrial capacity, this extrapolation does not make sense. So, what went wrong? It is simple. Baumol used a 2.13% GDP per capita growth rate that captured the post WWII economic boom. And, this growth rate does not resemble at all the relevant current trend. When looking at this same measure over the 1990 - 2011 period, this growth rate plummets to 1.38%. If we focus on the 2000 - 2011 period it further drops to only 0.70%. Using this last growth rate and current GDP per capita level ($42,906 in 2011), you get a GDP per capita of $82,658 in 2105 only 24% of Baumol's level. Instead of predicting we will be over 8 times wealthier; this more realistic projection suggests we will be less than twice as wealthy as currently. And, even this level may be taken with a grain of salt. What will it truly mean in terms of resource constraint, living standard, and purchasing power parity with other countries?

Where Baumol's Cost Disease theory go astray? His basic rational is that labor productivity in the "progressive sectors" (industries with fast labor productivity such as high tech) drive overall wage earnings including the ones within the "stagnant sectors" (sectors with no labor productivity increase such as healthcare and education). This perfectly explains "why computers get cheaper and healthcare doesn't" (subtitle of the book). But, this certainly does not mean that one specific single stagnant sector (healthcare) will inevitably take over the economy. This proposition is absurd in itself given that there are so many other stagnant sectors to begin with. For healthcare to take over, it would need to squeeze out not only all the progressive sectors but also all the other stagnant sectors into this minuscule 38 cents on the dollar slice of the economy.

There is another reason that even all stagnant sectors combined will not take over the economy relative to the progressive ones. That reason is the famous Jevons Paradox. The latter states that increase in efficiency do not lead to increase in savings; they lead instead to increase consumption.

The Jevons Paradox contradicts the Cost Disease theory. Computers indeed got cheaper as the Cost Disease suggests. But, spending on computers and related hi tech appliances has gone way up (think not only of PCs but laptop, tablets, smartphones that did not exist just a few years ago) as Jevons Paradox suggests. So contrary to what Baumol thinks there is no reason for the stagnant sectors to gain share of the economy relative to the progressive sectors. In fact, the opposite is not unlikely.

The Cost Disease theory embeds many other contradictions besides the Jevons Paradox. Regarding healthcare spending, how could our wages be depressed by the rising cost of healthcare benefits since it is our own wage rate increases that supposedly set the cost increase of such healthcare prices?

Baumol's proposition that we can readily afford rapidly rising healthcare cost is laughable. Those costs are bankrupting the US fragile fiscal position as any CBO projections show. They are much reducing the competitiveness of US domestic manufacturers and have lead to off shoring manufacturing capacity. Municipalities, corporations, and household budgets have all felt the crippling impact of rising in healthcare costs.

The rising costs of healthcare and college education are indeed problems. But, it is not so much because of the Cost Disease (which primarily addresses the rising wages of employees within those industries). And, Baumol's own data proves that.

Regarding healthcare, Baumol discloses a graph (pg. 13) that shows that medical employees (doctors, nurses) salaries have grown at nearly exactly the same pace as inflation (3% to 4%). But hospital costs have grown far faster by 8% a year (graph pg. 7). Thus, the staggering rise in healthcare costs is related to factors outside the Cost Disease domain.

Turning to college education, Baumol shows that college tuition and fees have risen at 7% a year or far faster than inflation (graph on page 8). Meanwhile, wages of professors and other employees have risen a lot slower than inflation (graph pg. 13). Thus, college education costs have risen very fast for reasons outside the Cost Disease.

Given that his analytical framework is so off, Baumol's policy recommendations are of little interest. The chapters written by his coauthors in part 2 of the book regarding how to reduce the growth of healthcare costs and other stagnant services are reasonably good and interesting. But, they are lost in Baumol's book whose main thesis is wrong.
11 of 11 people found the following review helpful
4.0 out of 5 stars A Matter of Priorities Nov. 18 2012
By Martha E. Pollack - Published on Amazon.com
Format:Hardcover
Nearly 50 years ago, William Baumol and William Bowen proposed an economic theory--the "cost disease"--to account for the fact that prices in service industries consistently rise so rapidly relatively to the prices of manufactured goods. The cost disease theory rests on the observation that in some industries, especially those that produce goods, ",technology has resulted in dramatic increases in productivity, which equate to decreases in the cost per unit of products. Baumol calls these industries the "progressive sector." When the cost to produce a product decreases, then the wages for the workers who produce that product can increase, without any increase in the price of the product. But when that happens, wages also tend to increase in those industries that have not seen productivity increases, the so-called "stagnant sector". Wages must increase there because if they didn't, then those industries would be unable to compete for workers. Since the increased wages in the stagnant sector are not offset by reduced costs of production, prices in that sector grow more quickly than those in the progressive sector.

Within the stagnant sector are "high touch" service industries, including health care, education, legal services, and the arts. As Baumol and Bowen noted a half century ago, it still takes five musicians the same amount of time to play a string quintet as it did in the 18th century: technology has not changed that. (In fact, as Baumol notes in the current book, technology has led to some productivity increases even for musicians; for example, by reducing the amount of time it takes them to travel to their concert sites. But any productivity gains in the stagnant sector are very small compared to those in the progressive sector.) The cost to attend a musical concert has thus grown at a greater rate than the cost of, say computers: the former has grown faster than inflation overall, while the latter has grown more slowly. And, as with concerts, so with health care, college tuition, and so on.
This much was understood 50 years ago, and has continued to be borne out by the economic facts. What Baumol adds in his new book is a corollary to the cost disease, namely, a claim that despite the out-of-proportion growth in the their costs, services are and will remain affordable at a society-wide level. In some sense, the reason for this is clear: while services cost more in real terms, products from the progressive sector cost more, and so all that is needed is to redirect spending. In fact, because productivity increases have happened everywhere, just more slowly in some sectors than others, the society as a whole has more wealth, and thus can afford more of everything.

Here's an example of the underlying math. As you read it, remember that it's just an abstraction to show how the cost disease works and is not meant in any way to provide realistic numbers. After all, autoworkers produce many more than 5 cars a year and professors teach many more than 5 students; the price of cars must take into account the cost of material and profit for the auto company, not just the salary of the autoworkers; autoworkers and college professors don't typically compete for the same jobs; etc. None of this matters to the core argument.

So: Suppose that at a given time--let's call it Time A--an autoworker can produce 5 cars a year, with each car selling for $10,000. Then each worker can be paid $50,000. And similarly suppose that a professor can educate 5 students a year, and that tuition is $10,000. By the same logic, the professor can be paid $50,000. Now assume that at Time B, as a result of technological improvements, the autoworker can build 6 cars a year, and so can now be paid $60,000. As already noted, competitive forces tend to cause wages to rise consistently across the economy, so now the professor also receives $60,000. But technology has not made the professor more efficient: bigger classes still provide a lower-quality experience to the student. Thus, we assume that the professor can still only teach 5 students and so tuition must rise to $12,000, to compensate.

What's happened? On the one hand, it looks like tuition has gotten more expensive. But note that wages have also grown: everyone has more money to spend: $60,000 at Time B versus $50,000 at Time A. In fact, at time A, after paying for tuition, a worker (autoworker or professor) has enough money left over to buy 4 cars. At time, a worker (autoworker or professor) has enough left over the buy 4.8 automobiles. Not only do the increases in productivity mean that the output of the service section--in this example, education--remains affordable: in fact, it's even "more affordable" in the sense that there's even more money left to spend on other things.

If this seems like economic sleight of hand, it's worth doing the calculations step by step, because it's anything but! Another way to get a feel for what's going on is to consider how long the average worker has to work to purchase various products. Baumol gives lots of examples: in 1940, you had to work (on average) for 27 minutes to purchase a Big Mac; today you have to work 9 minutes. In 1910, you had to work 553 hours to buy a clothes washer, but by 1997 it was only 26 hours. A Ford Model T required 4,696 hours of labor in 1908, versus 1,365 for a Ford Taurus in 1997. And on and on. As Baumol notes repeatedly, "We can surely afford it--cars and computers, as well as health care and education. The quantity and quality of the cost-disease affected services we obtain in the future will depend on how we order our priorities. . . Society does have a choice, but if we fail to take steps to exercise this, our economy could continue to drift toward a world in which material goods are abundant, but many things we consider primary requisites for a high quality of life are scarce, particularly for the poor (pp. 54-55)."

This last point is especially important: because wealth is not distributed equally, Baumol's conclusion that we can afford it all is true society-wide, but not necessarily for every individual in the society. Hence, he argues, it is society as a whole that must commit to shifting some resources from goods produced by the progressive sector to services produced by the stagnant sector. And that, he admits, is a huge political challenge, although a critically important one.

"The Cost Disease" is an important book, definitely worth reading. If you find it interesting, you may also want to read the very lucid "Why Does College Cost So Much?," by Archibald and Feldman, for an extended discussion of how the Cost Disease has played out in the higher education realm.
11 of 12 people found the following review helpful
4.0 out of 5 stars Insightful and provactive hypotheses, despite some oversimplifications Oct. 16 2012
By Sreeram Ramakrishnan - Published on Amazon.com
Format:Hardcover
Building on his research from 1960s on performing arts, Baumol makes an 'assertion' that cost for personal services like healthcare are "condemned" to significantly outperform overall inflation because the quantity of labor to produce the services cannot be reduced easily. This premise may have worked (and perhaps still valid) for their early work in performing arts, but translating it to healthcare and education seems too simplified. Comparisons to manufacturing processes is also oftentimes misleading. Such simplifications significantly understate the vast research around modularity, product design, mass customization, and related topics that led to automation in manufacturing and enabled process improvement techniques such as lean sigma. To assume process improvement methods were the main reason for reduced labor involvement in manufacturing is indicative of incomplete analysis. Furthermore, the impact of extraneous factors - malpractice insurance, people's expectation of healthcare delivery and changing patterns of healthcare consumption - have all contributed significantly to cost inflation in healthcare. In fact, earlier on, the authors claim that these factors are minor compared to the nature of labor intensive processes.

Most of the arguments tend to be US-centric, and very early on in the book, the authors do acknowledge that policy may be attributable to the significant increases in US healthcare than other countries (not withstanding an attempt at re-framing the discussion to "rate of increase" - and arguing Japan has a higher rate than US - ignoring the population shifts to elderly may have contributed to that anomaly in Japan). The definition of productivity in healthcare is also a tad misleading when the assertion that - an increase in number of patients seen will inevitably lead to a decline in quality. The issue in healthcare is not how many patients are seen - but what their clinical outcomes are. That disconnect cannot be fully captured in arguments centered on productivity metrics based on number of patients seen. Plus, it mostly ignores the possibilities of technology and increasing use in analytics to help in risk stratification and personalization of treatment plans (though case studies in the second part of the book partly addresses the role of IT). Perhaps, effectiveness may be more important than productivity in healthcare...Same goes for education. A 2% increase in teacher wages (authors example) doesn't have to yield an increase in productivity - the expectation (and the right metric to measure) is did it improve student engagement and result in better test scores.

Despite that premise that leaves more-than-generous latitude for disagreement (and strong rebuttal perhaps) and examples that beg for a counter-argument, the author(s) does provide some interesting insights on cost inflation in human-centric processes primarily through their arguments centered on productivity growth and its impact on cost trends - in both "stagnant" and "progressive" sectors - and the impact on affordability. Their arguments also center on the relative inelastic nature of healthcare demand. But the general argument that our percentage of our total costs spent on healthcare (it is going to go up) should be viewed in the context of decreasing costs in other categories (manufacturing, food, etc - an assumption) is an intriguing one. In fact, the chapter that expands on this argument the associated caveats is the most thought-provoking part of the book and well-worth the investment.

The last part of the book - contributed by the co-authors - provide a good snapshot of opportunities of cost reduction. None of it would seem particularly new ideas or ones that can scale quick enough to make a meaningful change in cost inflation. With a thought provoking hypotheses, forty pages of notes and citations, and some guest authors adding to the 'story' with different perspectives, this is a very informative read.
4 of 4 people found the following review helpful
2.0 out of 5 stars Disappointing March 30 2013
By R. Albin - Published on Amazon.com
Format:Hardcover
Baumol's cost disease is one of the most interesting and important results of modern economic research. Several decades ago, Baumol and his colleague William Bowen explained an apparent paradox; why do costs, particularly labor costs, rise in industries with stagnant or slow productivity growth? Baumol and Bowen explained this phenomenon as a consequence of productivity growth in dynamic sectors of the economy. Industries with high productivity growth, such as agriculture or manufacturing, experience rising wages in large part because of increased efficiency of production. Wage rises, however, cannot be restricted to one sector of the economy and tend to spread throughout the economy, dragging up costs in sectors with low productivity increases. The result is that costs rise disproportionately in low productivity growth industries, particularly those based on personal services like health care and education, and these industries occupy an increasing fraction of the economic pie. This raises the specter of an economy dominated by inefficient industries. Cost disease, however, has a silver lining. As apparently pointed out to Baumol by the famous Joan Robinson, the fact that cost disease results from productivity growth can imply that while the costs of "stagnant" sectors and the fraction of the total economy will inevitably rise, the continued overall growth of the economy impelled by productivity growth in dynamic sectors will increase (all other factors being equal assumption) to an extent that the stagnant center growth is affordable. Baumol argues well that the cost disease phenomenon is a major part of the inexorable growth of important sectors of the economy, including health care, education, and R&D. He argues also that we should not be overly anxious about this fact because of Robinson's important corollary.

Cost disease, consequently, is an important and timely topic. Cost disease is not widely known and a good general book about cost disease would be useful in helping the public and many policy makers understand the genesis of rapidly rising costs in important areas like health care and education. This book, unfortunately, is not that volume. Part of the book is written by Baumol, parts are by some of his collaborators, and some chapters are co-written by Baumol and a collaborator. The book has a cobbled together feel, the quality of writing is uneven, and the organization is poor. In a book about productivity, for example, the discussion of what productivity is and how to measure it is left to the middle of the book. A couple of chapters are tangentially related to the topic. Some chapters, even those written by Baumol, contain factual errors. Yale University Press produced this book cheaply; the graphs are poor, which really impairs readability at several key points. In addition to these general problems, there are at least 3 major problems with the arguments presented by Baumol and his colleagues.

Baumol has a somewhat contradictory discussion of productivity. In his chapter on this topic, Baumol discusses the different ways of assessing productivity, something relatively difficult in service-oriented industries. He comes out with an assessment of productivity which appears to dismiss assessment of productivity in terms of benefits and focuses on costs-output measures in a way that looks primarily like an arbitrary accounting device. This seems like an odd argument from an economist. If prices in a market economy don't have something to do with the value of the product, then what do prices mean? Is Baumol describing a fairly spectacular example of market failure? Baumol and one of his colleagues appear to implicitly contradict his argument about cost-based accounting of productivity in a chapter discussing business services. These would appear to be an example of a stagnant sector because of their need for expensive labor and personal services. But Baumol and his colleague argue not, because business services are actually "inputs" to economic sectors with dynamic productivity. This argument appears to accept the concept, previously dismissed by Baumol, that productivity shouldn't be measured by cost-output measures but by benefits. This argument would apply, for example, to education, as a well-trained labor force is certainly crucial to "dynamic" sectors of the economy.

A lot of this book is devoted to health care costs, particularly US health care costs. On this topic, Baumol and his colleagues are actually misleading. Baumol makes the surprising assertion that health care costs are rising at approximately the same rate in the US and other developed nations. Many analysts, however, suggest that over the last 40 years, US health care costs have risen at a faster rate than those of other industrialized nations. This can be seen in Figure 1.5 and is supported by a simple statistical analysis. If the rate of increase in US health care costs is an outlier, and cost disease is a universal phenomenon (which I think is correct), the large discrepancy between rising US health care costs and those of other nations must be due to other phenomena. This fact has 2 important consequences for Baumol's argument about health care costs. The first is positive. To the extent that rising US costs are not due to cost disease, we should have good opportunities for cost reduction. In principle, cost containment/reductions should be obtainable without great penalties, as other developed nations provide universal care with aggregate better results. The negative implication is that Robinson's corollary argument will not apply to a large fraction of rising US costs and that rising health care costs are a large economic threat.

Finally, Baumol appears to miss an important connection between "stagnant" and productive sectors of the economy. Baumol's argument stresses that cost disease is a product of rising productivity in dynamic sectors. Baumol indicates that productivity gains derive from 2 sources; large oligopolistic firms with big R&D commitments (think IBM or Intel) and individual entrepeneurs. This is an imcomplete picture as it omits 2 key sources of productivity. One is the crucial state-sponsored R&D efforts which support not just basic research but also a good deal of technology development. The second is the education sector. Large oligopolistic corporations do not, by and large, train their scientists and engineers (though IBM and a few others have research centers with post-doctoral opportunities) and individual entrepeneurs do not just spring from the ground. The dynamic sectors of the economy depend on the "stagnant" sectors for essential intellectual and human capital. Its not just that we can afford the rising costs of the "stagnant" centers, we have to pay these costs if we want the type of productivity growth that Baumol sees as crucial.
3 of 3 people found the following review helpful
4.0 out of 5 stars Feeling overwhelmed by the rising cost of healthcare? Read this. Jan. 23 2013
By Bak Jin-sing - Published on Amazon.com
Format:Hardcover|Verified Purchase
We are constantly informed that our aging societies and spiraling health care costs, eating up ever increasing percentages of GDP, will end in disaster unless we trim the costs of healthcare.
Not true, according to Princeton Economics Professor Emeritus William J Baumol and his contributing authors.
This is a short easy read, but important to all involved in the debates about healthcare, and especially to journalists and doctors, who have an urgent duty to advocate sensible healthcare economics because of the economic illiteracy of politicians and their electorate.
Baumol described his ‘cost disease’ in the 1960’s in the performing arts – arguing that it is difficult to achieve significant labour productivity increases when it takes as many musicians just as long to perform a Mozart symphony today as when it was composed.
Nearly fifty years of data have borne out the predictions he made in the sixties, and the same argument applies to all ‘stagnant’ sectors of the economy, such as healthcare and education, because of the large component of human input.
It doesn’t particularly matter that a modern hip replacement – or any given medical intervention - is better and longer lasting than an earlier one (ie the quality-adjusted cost has fallen) the quality-unadjusted bill is the same.
Meanwhile ‘progressive’ sectors, mostly computing and manufacturing, make impressive productivity gains, with two effects:
1. Stagnant sector prices must rise more rapidly than the Consumer Price Index;
2. Because of the large increase in the overall wealth of society generated by the excellent work of the progressive sectors, we can still, and will always be able to afford, the healthcare (and other labour intensive services) we want.
If we invest in education to continue the productivity and wealth gains.
That’s a big ‘if’ – and this is where informed doctor-advocates are needed.
This is the main thesis of the book, which is written for the general reader.
Doctors may argue that Baumol overlooks some factors which drive up cost, for example the role of third party payers (the patient wants the very best, because the insurer will pay), but he also debunks some myths by means of studying actual data – for example the cost of malpractice lawsuits.
As a doctor, I found some of the discussions of, for example, the economic multiplier effect of developing medical software a little too detailed given that they are not part of the main theme - they felt a little like contributing authors' papers dropped in as chapters without enough editing, but this is a relatively minor criticism and does not really detract from the overall argument.
Many of the examples are from the US, but are applicable internationally, and Baumol makes a cogent argument for broad and deep medical insurance markets in poor societies where it is even more important to pool risk.
Given that the First Law of Healthcare Economics states that healthcare spending in any society will rise as its GDP rises, and that there is no satiety in healthcare (No society has ever said, ‘No more, thank you, that’s enough healthcare…’) the fear of society collapsing under the healthcare bill will not disappear. Baumol argues that if governments cannot be led to understand his ideas, their citizens may be denied vital health, education and other benefits because they appear to be unaffordable, when, in fact, they are not.
His answer to ‘Can’t afford healthcare?’ is ‘Invest in education.…’
I will be giving a few copies to journalists and politicians in my town.

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