Cost Disease

Cost disease, also known as Baumol’s cost disease or the “cost disease of the service sector,” refers to the phenomenon where the cost of labor-intensive services, such as healthcare, education, and the arts, increases over time without a corresponding increase in productivity. It was first described by economist William J. Baumol and economist William G. Bowen in the 1960s.

The concept of cost disease arises from the disparity in productivity growth between the service sector and the manufacturing sector. In manufacturing, technological advancements and automation lead to increased productivity and efficiency, resulting in lower costs over time. However, in labor-intensive services, such advancements and automation are often not feasible, and the productivity growth remains relatively low. Productivity grows only slowly because automation is difficult. As innovation boosts output and wages (let’s say manufacturing) it becomes necessary to pay nurses and teachers more to prevent them from quitting and heading to the nearest factory. Industries that suffer from cost disease over periods of time spend more in real terms in to merely stand still.

Armed forces benefit from the reverse phenomenon known as “Lockheed’s Law”. There are downsides, periods of sudden defense spending tends to cause shortages.

What matters is not the absolute level of a country’s defense capabilities, but it’s strength relative to that of its enemies.

An arms race to upgrade capabilities would result every time there is an innovation that creates marginal advantage over previous weapons. For each of these instances, there will be a rise in spending.

As the overall economy grows and incomes rise, people are willing to pay more for services such as healthcare and education, leading to an increased demand. Since these services require a significant amount of human labor and the productivity growth is limited, the cost of providing these services increases. This cost increase is further fueled by the need to attract and retain skilled workers in sectors such as healthcare and education.

The consequences of cost disease can be observed in rising costs of services relative to goods, which can lead to cost pressures on individuals, businesses, and governments. For example, tuition fees at universities tend to rise faster than inflation, healthcare costs outpace general price increases, and the salaries of professionals in certain fields increase significantly over time.Cost disease presents challenges for policymakers, as it can strain public budgets and lead to concerns about affordability and accessibility of essential services. Efforts to address cost disease often involve finding ways to increase productivity in the service sector through technological innovation, process improvements, and skill development.