Goff on the Cost Disease

While touring Japan, I re-posted two pieces critiquing Alex Tabarrok’s work with Eric Helland on the so-called “cost disease” (also known as the “Baumol effect”). (Here’s Alex’s old reply to me). Soon afterwards, Brian Goff of Western Kentucky University, one of GMU’s most distinguished econ Ph.D.s, sent Alex and me this email. Reprinted with Goff’s permission.

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Alex & Bryan,

I was quite interested in the “Cost Disease” v. “Regulation” debate about medical and higher ed prices/expenditures in Bryan’s recent “Bet On It” posts.  While both of these influences are likely at work, here are alternative and maybe more basic economic explanations.  I hope that in being invested in the other two, you will give these some serious thought. I’ll give a quick synopsis of the alternatives. If you are interested, I give a little more detailed defense of them below. In both cases, these views reversed earlier ones that I had that were very similar to those that you two express.

On medical care the view that prices and expenditures are incredibly high and wasteful overlooks two important points: i) that prices and expenditures need to be adjusted for quality; and ii) income levels and growth accounts for almost all expenditure differences across countries and over the long run.  On higher ed, the underlying problem is that economists (myself included) almost always treat it as single product industry (education) with everything else on campus treated as a type of input. For better or worse, higher ed has developed into a multi-product bundle that includes entertainment/recreation (workout facilities, rec teams, collegiate athletics, drama, …), networking, counseling, and just hanging out with peers (and probably other stuff). A useful analogy would be to a year-round version of a (very upscale) summer camp.

As economists, we all are aware of the problem of quality adjustment in price indexes. For the most part, however, the profession just proceeds like it doesn’t matter.  I’ve come to view the assumption that quality of services hasn’t changed that underlies most applications of Baumol’s Cost Disease idea as incorrect. Most services have improved in quality over the past several decades. This is true even for the “go to” example of haircuts. The 15-minute clip & buzz in the barber chair that I grew up with has been replaced by 30-minute wash/condition/rinse/massage and stylish cut, all in a nicer atmosphere. The closest thing to the old barber shop experience would be something like SuperCuts, which is quite cheap. Why did old fashioned barber shops nearly vanish? Because consumers valued the new amenities. Andy Kessler wrote an excellent WSJ article this topic in June 2018, focusing on all the services/products replaced by iphones and how hedonic price adjustments within price indexes don’t come close to capturing these improvements.  

Nowhere is that lack of adjustment for quality of services more consequential than with health care. This isn’t merely anecdotal. Murphy and Topel’s 2006 JPE article (in what may be the most underappreciated article in the last 50 years) estimates that from 1970 to 2000, the gain in life-years from medical advances added $3.2 trillion PER YEAR to national wealth. While that figure may off, the order of magnitude of their estimate is intuitively in the ballpark, when considering the number of life years gained and the value of a life-year at or above $1 million. Their estimate does not factor in any value from improved quality of life from things like joint replacements, asthma treatments, and so on. Cutler & McClellan (also very under-appreciated) generated related results in a series of articles.  Their 1998 QJE piece indicates that after adjusting for quality, the price of heart treatments actually fell.   

The other important data observation that steered me away from my reliance on regulation and supply restrictions as the primary explanation for medical prices and expenditures in the U.S. is that these expenditures per capita are almost completely explained by one of our two most basic variables in economics – income (more precisely disposable income or the OECD’s Actual Individual Consumption). The Random Critical Analysis blog has extensive and compelling material on this.  The upshot is that health care expenditure is, over the long run, a highly income elastic good and that various differences in “systems” are not needed to explain the high U.S. expenditures, income does. The big expenditures in health care tend to come from areas such as heart, cancer, and surgical or intensive care treatments that are (and will be) expensive under any system, but these are treatments that an affluent society wants to make to keep “mom” and “dad” alive and well for 25 more years, “grandma” for 5 more years, and the “pre-me” baby alive 85 more years.

On the growth of higher ed expenditures, for years, I bought into the lagging productivity view as forwarded by Richard Vedder and others. In fact, William Poole, while still president of the St. Louis Fed, delivered a speech on this topic to a small luncheon group at WKU with our university president sitting right there. It was fairly humorous seeing our president’s reaction. However, I realized that in assessing productivity, Vedder, Poole, and others (like myself) routinely treated education as the sole product/service.  Yes, we had always acknowledged a “consumption” component to student demand, but we treated that as a nuisance element, not as an integral feature of the market. That was probably not a bad assumption back in the mid-20^th century and earlier.  Over the last 50ish years, the consumption element has become increasingly important but remains ignored as merely a nuisance factor. Even the educational part itself has taken on more of a consumption aspect as students have opted into degrees that are more about avocation than serious academic study or vocation.

For all my grousing about the lack of student interest and “why are they even here,” the puzzle existed only because of my underlying, single-product assumption. There is a large demand for the consumption aspects of the higher ed “experience.” The U.S. is a rich society, and students (and their families through intra-household economics) want to consume the college product/service bundle – the “college experience” as even this verbiage began to reflect the shift toward non-educational, “summer camp”/ consumption. It is related to what we have observed at lower levels of education where the reason there isn’t more learning has little to do with teaching methods or school systems but the lack of interest by students and their parents in the educational component. For many parents, school is mainly about cheap day care. That’s a point that I make in my 1999 Spoiled Rotten: Affluence, Anxiety, and Social Decay in America.

Yes, $1.5+ trillion in student loan guarantees helps bolster this demand, but $1.5 trillion in loan guarantees is not the same as handing out $1.5 trillion in direct subsidies (grants), at least not yet. During most of this growth period in demand, the majority of students/parents expected to repay these loans. That may have changed more recently.

A couple of additional items support this view. For one, students and their families have lower cost alternatives available, but most don’t utilize them. They could live at home. They could attend lower priced schools. Do we really think that all of these students and families are being duped? Do we really think that the guy getting a degree in art history is doing so because of how great the university is marketing the job market for that degree?

Even more telling, loan guarantees don’t explain the decisions of financially well-off students/parents that aren’t seeking loans, or if they do obtain loans, it is merely a question of optimal financing and short-term liquidity.  What I have in mind are people like myself as well as many much wealthier than me. Both my daughters went to a private university in Nashville that isn’t at Ivy League expense levels but much more expensive than attending WKU. They wanted to go there, and, in all honesty, I wanted them to go there, not so much for the different educational value (there is some), but for the different peer group. My well-off friends here in town send their kids to Vandy but also UK, IU, UT, Ole Miss, and various state schools that are substantially more expensive than WKU.  They do so not because of any loans they are receiving, but because that’s the “experience” that they or their kids desire.

Maybe the most vivid expression of this is the case of Lori Loughlin and related celebrities and very wealthy individuals who not only paid incredibly high tuition but also (what were deemed) illegal under-the-table payments to get their kids not just into Harvard or Stanford but places such as USC. They made these payments not because they or their kids were fixated on education, but because that’s the “experience” that they wanted.

Maybe my (and the profession’s) reluctance to accept quality adjustments to medical care or income growth and consumer demand as the primary contributors to medical and educational prices because these explanations don’t feed a political agenda of the interventionists or non-interventionists.  In any case, I hope that you will give these ideas a chance.

Sincerely,

Brian