What Gets Expensive, and Why?

Why are we seeing dramatic declines in costs in many areas of the economy and such steep increases in others? How much of the cost growth is unmeasured improvement in quality and how much is growing inefficiency? How should one predict a priori whether a sector will exhibit increasing or decreasing costs relative to inflation? What do we do about it all?
Patrick Collison

Think of yourself as the entire economy. You consume everything, and you produce everything. Your demand for pizzas is the share of revenue that you devote to pizzas. Your productivity in, say, pizza production, is the number of pizzas you can produce in an hour.

The Baumol Effect

As the years go by, the stuff that gets more expensive is the stuff where your demand goes up faster than your productivity. The stuff that gets cheaper is the stuff where your productivity goes up faster than demand. But for everything that gets cheaper, something else has to get relatively more expensive. If efficiency shoots up in one sector, then in relative terms it has to decline elsewhere. Economist William Baumol called attention to this.

Suppose that your productivity goes up very rapidly in computers, following Moore’s Law. This makes you wealthier (remember, you are the economy’s sole producer and consumer), and that allows you to increase spending on computers and on knee replacements. But what you spend on knee replacements raises demand faster than your productivity in doing knee-replacement surgery. Thus, you end up having to spend a larger share of your time doing knee-replacement surgery. In relative terms, the cost of knee replacements goes up.

Category creep

Measurements of the education and health care sectors also are affected by what I term category creep. What we call a college education now includes nice dorm rooms, fancy gyms and performing arts centers, extensive psychiatric counseling services, and many more choices of courses and majors than was true 50 years ago. If a college today were limited to the same amenities, courses, and instructional techniques used in 1968, the increase in tuition since then would not have been as great.

Health care now includes many diagnostic procedures, pharmaceuticals, and medical specialties that did not exist 50 years ago. Even if the cost of every single medical procedure were to decline, spending on health care could increase as new procedures are introduced and existing procedures are modified to make them safer and less uncomfortable. In other words, if health insurance only covered the medical procedures that were available in 1968, it would be much more affordable today.

Demand de-linked from outcomes

Category creep is not the same as quality improvement. It is not clear that there has been a great deal of quality improvement in health care and education, because careful attempts to assess differences in outcomes often fail to find much.

Our spending on health care and education is driven by hope.

Years ago, W. Edwards Deming, an expert on quality control, pointed out that the earliest interventions in a process provide the greatest returns in terms of quality. You can inspect items as they come off the assembly line and throw out the bad ones, but that is less efficient than instituting improvements in the the manufacturing process. And it is easier to have a high-quality manufacturing process if the product is designed in the first place to be simple to manufacture.

From that perspective, health care and education come relatively late in the process of trying to improve human capital. We hope for dramatic results from late-stage interventions. We expect medical heroics to alter the effects of age, genetics, and unhealthy lifestyles. We expect education to alter the effects of culture, native ability, and early childhood environment, all of which come earlier in the process.

It may seem puzzling that the demand for health care and education keeps rising while measurable outcomes, such as longevity or skill attainment, show little response to higher spending. One reason is that the perceived benefits of health care and education may be high relative to their effects on outcomes. You may not be cured of your ailment, but the effort is what matters to you, so you seek treatment. Sending your child to an expensive college may not improve her skills, but your own sense of status depends on it, so you fork over the tuition.

Subsidize demand, restrict supply

Another explanation for price increases in some sectors is derived from what economists call public choice theory. In reality, you do not produce everything in the economy. You are much more specialized in production than in consumption. This makes you much more motivated to affect public policy in the sector where you produce than in the sector where you consume.

In theory, government policy is supposed to promote the general welfare. But as a producer, your goal for government policy is to increase demand and restrict supply in your industry. If you are in the field of education, you want to see more government spending devoted to education, tuition grants and subsidies for student loans, in order to increase demand. You want to make it difficult to launch new schools and colleges, in order to restrict supply. If you run a hospital, you want the government to subsidize demand by providing and/or mandating health insurance coverage. But you want to restrict supply by, for example, requiring prospective hospitals to obtain a “certificate of need.” If you are a yoga therapist, you want the government to mandate coverage for yoga therapy, but only if it is provided by someone with the proper license.

Of course, producers in every sector would like to see government help them by subsidizing demand and restricting supply. Why is lobbying more effective in some sectors than in others?

The answer may get back to the disconnect between demand and outcomes in health care and education. In other industries, where goods and services provide outcomes that are clearly discernible for consumers, policies that lead to waste will be somewhat easier for the public to spot . In health care and education, where the outcomes depend on many factors outside of the producer’s control, it is much harder for the public to catch on to the way that subsidizing demand and restricting supply is driving inefficiency.

In fact, there may be an element of willful ignorance in these areas. If our interventions in health care and education are not as effective as we would like them to be, perhaps a lot of us would rather not know.

Conclusion

It could be that the answer to Patrick Collison’s questions is that we get what we want. When we can easily discern how well goods and services meet our goals, products become better and cheaper. On the other hand, when goods and services are related to important goals but their marginal effects on achieving our goals are difficult to separate out, we are willing to throw more resources at them — and just hope that we get something out of it.