Baumol’s “cost disease” comes to Minneapolis

Photo: Robert Matthews, Office of Communications, Princeton University

Yesterday, I wrote about how soaring city spending coming on top of plummeting commercial property values and consequent declines in commercial property tax revenues were going to lead to steep hikes in Minneapolis’ residential property taxes. It is hard to see a solution to this problem. It is certainly impossible to see a painless one.

The City Council will have to restrain, if not cut, spending, but that will be difficult given that many of its employees work in occupations affected by what economist’s call “Baumol’s cost disease,” named after the economist William J. Baumol.

To grasp this, consider two workers; one who works in a car factory and another who is a teacher. The car manufacturer’s output of cars per year can be increased with more or better machines or with a more efficient combination of the capital (the machines) and labor (their work) inputs into production (this “entrepreneurship” falls under “Total Factor Productivity”), with Henry Ford’s methods of mass production providing a famous example. This increase in productivity will, ceteris paribus, drive an increase in the car manufacturer’s wage.

For the teacher, by contrast, it is much harder to increase productivity. Their labor is a much more dominant input into production — indeed, the labor is the product, or service, to a large extent — and it isn’t as easy to substitute it for capital. If we think of a teacher with 20 kids in his or her classroom, we could send recordings of their lessons to 100 kids to watch at home, but this would be an inferior service. Likewise, we could cram 100 kids into the teacher’s class and increase “kids taught per year,” but, again, this would be an inferior service.   

This is where the “cost disease” comes in. If we want people to teach, we have to pay them at least what they could get in other sectors, and those other sectors include those, like car manufacture, where productivity increases are driving wage increases. Productivity driven wage increases in these other sectors will, then, drag up wages in sectors where there have not been the productivity increases to justify the wage increases by themselves.  

This disease is felt most acutely in sectors which are labor intensive and cannot be made much less so, like education or personal care. We can, and should, embrace measures like telehealth which can bring productivity increases in the nursing sector, for example, but these are unlikely to be more than marginal when the service is so inherently “hands on,” or labor intensive.

This is a pressure which will become more acute as aging populations demand more people employed in labor intensive sectors like personal care where the scope for productivity gains is limited. Where Minneapolis leads, the West may follow.