Baumol effect
The resulting transition to a post-industrial society, i.e. an economy where most workers are employed in the tertiary sector, is called tertiarization.
The American economists William J. Baumol and William G. Bowen proposed that wages in sectors with stagnant productivity rise out of the need to compete for workers with sectors that experience higher productivity growth, which can afford to raise wages without raising prices.
As summarized by Baumol in a 1967 paper:[9] If productivity per man hour rises cumulatively in one sector relative to its rate of growth elsewhere in the economy, while wages rise commensurately in all areas, then relative costs in the nonprogressive sectors must inevitably rise, and these costs will rise cumulatively and without limit...Thus, the very progress of the technologically progressive sectors inevitably adds to the costs of the technologically unchanging sectors of the economy, unless somehow the labor markets in these areas can be sealed off and wages held absolutely constant, a most unlikely possibility.
Studying various price series over time, Jean Fourastié noticed the unequal technological progress in different industries.
[10]But what is essential is that very large sectors of economic activity have remained practically unaffected by technological progress.
For example, the men's barber does not cut more clients' hair in 1948 than in 1900; entire professions have not changed their working methods from 1900 to 1930.
Firms may respond to increases in labor costs induced by the Baumol effect in a variety of ways, including:[12] An important implication of Baumol effect is that it should be expected that, in a world with technological progress, the costs of manufactured goods will tend to fall (as productivity in manufacturing continually increases) while the costs of labor-intensive services like education, legal services, and health care (where productivity growth is persistently slow) will tend to rise (see chart).
[9] In other words, the effect predicts that the share of the workforce employed in low-productivity industries will rise over time.
[20][21] In a 2010 study, the economist Talan B. İşcan devised a model from which he concluded that both Baumol and Engel effects played significant roles in the rising share of employment in services in the United States (though he noted that "considerable gaps between the calibrated model and the actual data remain").
[22] An older 1968 study by economist Victor Fuchs likewise concluded that the Baumol effect played a major role in the shift to services, although he determined that demand shifts like those proposed in Engel's law played only a minor role.
[23] The economists Robert Rowthorn and Ramana Ramaswamy also concluded that relatively faster growth of productivity in manufacturing played a role in the shift to services.
[24] The economist Tom Elfring, however, argued in a 1989 paper that the Baumol effect has played a secondary role to growth in demand for services since the 1970s.
[25] Alternative theories for the shift to services include demand-side theories (the Baumol effect is broadly a supply-side explanation) like the three-sector model devised by Allan Fisher[26] and Colin Clark[27] in the 1930s, which posit that services satisfy higher needs than goods and so as income grows a higher share of income will be used for the purchase of services;[21] changes in the inter-industry division of labor, favoring specialized service activities;[21] outsourcing to countries with lower labor costs;[28] increasing participation of women in the labor force;[29] and trade specialization.
The economist Nicholas Oulton, however, argued in a 2001 paper that Baumol effect may counterintuitively result in an increase in aggregate productivity growth.
[36] Sasaki constructed an economic model that takes into account the use of services as intermediate inputs in high-productivity-growth industries and still concluded that a shift in labor force distribution from higher-productivity-growth manufacturing to lower-productivity-growth services decreases the rate of economic growth in the long run.
Likewise, the economists Jochen Hartwig and Hagen Krämer concluded in a 2019 paper that, while Outlon's theory is "logically consistent", it is "not in line with the data", which shows a lowering of aggregate productivity growth.
[41][42] By most measures, productivity growth in the education sector over the last several decades has been low or even negative;[43][44] the average student-teacher ratio in American universities, for instance, was sixteen to one in 2011, just as it was in 1981.
[45] It has been proposed that this is at least partially explained by the Baumol effect: even though there has been little or even negative productivity growth in the education sector, because of productivity increases across other sectors of the economy universities today would not be able to attract professors with 1980s-level salaries, so they are forced to raise wages to maintain their workforce.
Economists Robert B. Archibald and David H. Feldman, both of the College of William & Mary, argued in a 2006 study, for instance, that the Baumol effect is the dominant driver behind increasing higher education costs.
In a 2014 study, the economists Robert E. Martin and Carter Hill devised a model that determined that the Baumol effect explained only 23%–32% of the rise in higher education costs.
[49] The cost disease may also have only limited effects on primary and secondary education: a 2016 study on per-pupil public education spending by Manabu Nose, an economist at the International Monetary Fund, found that "the contribution of Baumol's effect was much smaller than implied by theory"; Nose argued that it was instead rising wage premiums paid for teachers in excess of market wages that were the dominant reason for increasing costs, particularly in developing countries.
[68] Likewise, a 2021 study determined that "Baumol's cost disease ha[s] a significant positive impact on health expenditure growth" in China.
[69] However, a paper by economists Bradley Rossen and Akhter Faroque on healthcare costs in Canada found that "the cost disease...is a relatively minor contributor [in the growth of health-care spending in Canada], while technical progress in health care and growth in per capita incomes are by far the biggest contributors".
[70] Despite substantial technological innovation and capital investment, the healthcare industry has struggled to significantly increase productivity.
As summarized by the economists Alberto Marino, David Morgan, Luca Lorenzoni, and Chris James:[71] Baumol's cost disease is often used to describe consequences of the lack of growth in productivity in the quaternary sector of the economy and public services, such as public hospitals and state colleges.
[38] Labor-intensive sectors that rely heavily on non-routine human interaction or activities, such as health care, education, or the performing arts, have had less growth in productivity over time.
[72] In contrast, goods-producing industries, such as the car manufacturing sector and other activities that involve routine tasks, workers are continually becoming more productive by technological innovations to their tools and equipment.
Examples include offshoring data entry and bookkeeping for health care providers and replacing manually-marked essays in educational assessment with multiple choice tests that can be automatically marked.
In the 1967 paper Macroeconomics of Unbalanced Growth: The Anatomy of Urban Crisis, Baumol introduced a simple two-sector model to demonstrate the cost disease.
A situation similar to this could occur, for instance, "with the aid of government subsidy, or if demand for the product in question were sufficiently price inelastic or income elastic".
