Why the Prices Are So Damn High: A Deeper Look

Out of my colleagues in Carow Hall, I’ve learned the most from Tyler Cowen, and I reason the most like Robin Hanson.  But I agree the most with Alex Tabarrok.  I was surprised, then, to find so much to disagree with in Alex’s new monograph (co-authored with Eric Helland), entitled Why Are the Prices So Damn High?  Helland and Tabarrok try to explain why prices in labor-intensive industries – most notably education and health care – have increased so much more rapidly than inflation.  They conclude that William Baumol’s famous “cost-disease of the service sector” story is almost entirely correct:

We have found that the best, albeit perhaps pedestrian, explanation for increasing costs is that the price of the major inputs into education and healthcare—namely, teachers, faculty, physicians, nurses, and so forth—has increased and, secondarily, that we have bought more of those inputs.

But why have the prices of these major inputs increased?  Baumol’s general explanation is that productivity grows far more slowly in the service sector, so when productivity in the rest of the economy rises, wages in the slow-growing sectors go up.  Barbers’ productivity, for example, has barely changed in the last two centuries, but their wages have skyrocketed.  If they hadn’t, no one would be a barber!  In the view of Helland and Tabarrok, Baumol’s explanation isn’t just part of the story of “why the prices are so damn high”; it is the story:

It’s natural to look at high and rising prices in sectors such as education, healthcare, and the arts and to conclude that there is something wrong with these sectors. We have taken a close look at education and healthcare, and Baumol and Bowen examined the arts, and most of the specific explanations for problems in these sectors are either untrue or cannot explain rising costs. Education has not become more dominated by administrative costs or lazy rivers. Medical malpractice costs are not a large share of healthcare costs. Across a wide range of industries, neither regulation nor concentration does much to explain long-run changes in prices.

[…]

The Baumol effect is the best explanation for rising prices in education, healthcare, and other service sectors. In that sense, and only in that sense, is there something “wrong” with the service sector—namely, that it’s hard to increase productivity in services. [emphasis added]

Where do Helland and Tabarrok go wrong?  Their purely factual claims seem solid to me, but their interpretation of these facts is deeply misleading.

Let’s start with the obvious: government spends an enormous amount on both education and health care.  This spending has dramatically increased over time.  Imagine, then, what would have happened if government had practiced extreme austerity instead.  Demand for labor in education and health care would clearly have increased far less, so wages in these industries would have risen far less, so the prices in these sectors would be much less damn high.  So while Helland and Tabarrok are not wrong to invoke the Baumol effect, they are wrong to fail to blame government for dramatically amplifying it.  If paying customers bore the full financial burden of education and health care, prices could easily fall by 50% or more.

In conversation, Alex objected that the growth rate of health care prices did not dramatically increase after Medicare was adopted.  This would be a reasonable objection if my story were speculative.  But “spending hundreds of billions of extra dollars a year on anything will make it much more expensive” is anything but speculative.  Indeed, it’s virtually bulletproof; are we really supposed to imagine that the supply of health care is perfectly elastic despite a thicket of licensing requirements?!  If prices did not grow more rapidly after the adoption of Medicare, the sensible inference is that price growth would have slowed if Medicare hadn’t happened.  “Unfalsifiable”?  No, but it is an application of a general principle so well-established that it’s crazy to doubt it now.

Helland and Tabarrok’s deeper error, though, is subtler yet widely shared.  They assume that something constant cannot cause something to change.  “Bloat” can only explain rising costs if bloat is increasing:

The bloat theory is popular because it is easy enough to find examples of bloat in higher education. The lazy rivers do exist. But to explain increasing costs, the bloat theory requires longer and lazier rivers every year, and the data do not fit that story. Bloat and complaints about bloat are probably as old as the university itself.

Regulation, similarly, can only explain rising costs if regulation is increasing:

One alternative (or potentially related) hypothesis to explain price increases is an increasing regulatory burden.

Statistically, of course, this is right.  But causally, it’s utterly wrong.  Suppose, for example, you impose a maximum monthly rent of $500 for an apartment in 1960.  This is far above the market price, so initially it has no effect.  Over time, however, rents rise; eventually, the rent control law causes a massive shortage of housing.  A naïve statistician could say, “Rent control doesn’t matter; the only thing that explains rising shortages is the rising CPI.”  The reality, though, is that rent control was the cause of shortages, in the most important senses of the word “cause”: if the rent control hadn’t existed, the shortages never would have happened; and if rent control were abolished, the shortages would go away.

Aside: Apologists for European labor regulation have often argued that regulation cannot explain European unemployment, because unemployment stayed low for at least a decade after the main regulations were adopted.  I say the apologists are conceptually confused.  It is because of labor market regulation that European labor markets adapted so poorly to a long series of subsequent economic shocks.  Statistically, the shocks “explain” the changes, but regulation of labor still caused them.

So what?  Well, at least for the two sectors Helland and Tabarrok cover in detail – education and health care – the constant presence of non-profit incentives and regulation clearly cause much of the rise in prices.  If K-12 education were all privately funded, for example, can we really imagine that schools would have continued their strict, insane practice of requiring primary school teachers to have B.A.s?  Gym teachers to have B.A.s?!  Without government licensing, can we really imagine that the use of lower-cost occupations like nurse practitioners would not have sharply grown?  (Picture a world where any nurse could directly sell medical services to willing customers).  Or if you want overkill, imagine the U.S. had open borders for medical workers.  A constant policy – but health prices couldn’t have risen much if the U.S. welcomed any worker on Earth with relevant skills.  (To be fair, Helland and Tabarrok briefly mention immigration reform; but they fail to loudly and clearly state that nefarious immigration regulation – constant though it may be – caused skyrocketing health costs).

The Baumol effect is important.  Even for barbers, though, it’s only one factor among many; after all, every state licenses barbers.  For education and health care, I doubt the Baumol effect causes even half of the price rise we’ve seen.  Helland and Tabarrok carefully present the facts, but I fear that their misinterpretation of those facts will undermine not only our understanding, but an array of vital free-market reforms.

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