The Baumol Effect

Why are college tuition, healthcare, and car repairs eating up bigger shares of our budgets? Alex says it's all about the Baumol effect—a deep economic insight about relative prices that explains why labor-intensive services inevitably become more expensive over time. Tyler isn't buying it. He thinks the Baumol effect is often invoked as an ex-post explanation but can’t make predictions.

In this episode, Alex and Tyler debate whether the Baumol effect is profound or overstated. They wrestle with examples ranging from haircuts in India to doggy daycare in Northern Virginia to Soviet-era ballet prices, touching on what poor countries can teach us about service costs and whether we're headed toward a future of AI tutors and robot mechanics. They also explore Staffan Linder's theory of the "harried leisure class"—the idea that as we get richer, we try to squeeze more utility into less time, making even our leisure more goods-intensive and rushed.

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TYLER COWEN: Hello, everyone. Welcome back to The Marginal Revolution Podcast. I’m sitting here, of course, with Alex Tabarrok. This is George Mason University. We don’t call it the cost disease, because we know that so many diseases can be cured, or at least alleviated. We call it the Baumol effect. Alex has written an entire book, or you could say monograph, on the Baumol effect. I’m going to start by turning it over to him, but you’re also going to hear from me why I’m pretty skeptical about a lot of these Baumol effect arguments. Alex?

ALEX TABARROK: Big surprise, you’re skeptical, Tyler.

COWEN: Yes.

TABARROK: I think the Baumol effect is a very deep and important insight, so let me give a very broad overview of what I see as the Baumol effect. The deep insight that I see the Baumol effect giving is that prices are relative prices. Think about a very simple world with just two goods. We have services, and we have manufactured goods. Suppose we just normalize units so that, at the very beginning, one unit of services trades for one unit of manufactured goods. One-to-one relative price. Suppose that the productivity of the manufactured goods increases. Now we are producing twice as many manufactured goods from the same amount of capital and labor as before.

Now, holding all else constant, this means that the price of the manufactured goods has to fall in half. We’re producing twice as much, producing the same number of services as before. The price goes, you could say, from $1:$1 to $1:$0.50. That sounds pretty good because the services are the same price, and the manufactured goods are now a lot cheaper. With inflation and other things, this is also equivalent to having the services at $2 and the manufactured goods at $1. Now you look at this and you think, oh my gosh, what’s going on? Services are twice as expensive as they used to be. They’re now $2. Manufactured goods, they haven’t changed in price. They’re the same. They’re $1. Services are becoming so much more expensive.

And this is true! It is true that the price of services in terms of manufactured goods has doubled. We now have to pay twice as many manufactured goods to get the same unit of services. Yet, we’re, of course, better off. This is a good thing. This is not a bad thing. Also, this idea, it seems totally simple. It’s very, very obvious the way I’ve expressed it. Yet, I think the essence of this idea is what explains all of the hand-wringing over why has healthcare become so expensive, why has education become so expensive, why has daycare become so expensive. It’s all about the fall in the price of manufactured goods, the change in the relative price of services, and actually, this is more of an illusion than an idea that services are somehow becoming less affordable.

Does Baumol Apply to Higher Ed?

COWEN: When I observe something being called the law, the next thing I see is that it stops holding for some period of time. There’s one version of the Baumol effect where you just say different things have different rates of productivity growth, and ex post, we can identify winners and losers. That’s clearly true, but that’s tautologous. The more important version, which is what Baumol and Bowen put forward in the 1960s, is that ex ante we can identify where productivity growth will be high and where it will be low. That I don’t buy.

If you look at higher education, for more than a decade now, the price in real terms has been falling. I’m not sure I know why, but it’s certainly not the Baumol effect. It’s not just for a year or two. It’s funny to think, for instance, that higher education is a Baumol-esque sector. For one thing, the laborers in it—we’re two of them—we work for below-market rates. We get paid these nonpecuniary benefits. We could earn more doing other things. At least, we like to think we could.

The wage effect seems funny, and just the whole way higher ed is organized, how it runs, how it works, it seems to do with factors of organizational incentives, which also account for a lot of the cost inflation. There’s some more unified theory that gets you, well, the costs are screwed up sometimes, and the product quality is screwed up sometimes. It’s not so closely connected to the fact that, oh, in some other sector, the computer programmers are being paid more. When it comes, for instance, to higher ed, I’m quite a skeptic. I don’t think it’s the best place to start to understand the problems of higher education.

TABARROK: It’s funny that you should say that, because our colleague, Bryan Caplan, is always on at me for exactly the same reasons. He’ll be very happy.

COWEN: Of course, he will be. He’ll think he persuaded me. In fact, that’s not the actual story.

TABARROK: Bryan says, as you do, that, “Look, Alex, how can you say it’s the Baumol effect? Look around. Can’t you see that our university is run so inefficiently? It’s a nonprofit. We don’t have price incentives. Of course, the costs are so high.” I have a couple of responses to this. First of all, you could explain, of course, the university is run inefficiently, obviously. That’s a level effect. What we need to explain is why, year after year after year, you have this grinding, ever, it seems, increasing relative price. This has been going on for well over 100 years.

You can go back into as early as the 1920s or even earlier, and people then are complaining about the rising cost of healthcare and also of education. It’s this long-term trend. This long-term trend, it has happened under highly regulated systems. It’s happened under less regulated systems. It’s happened when the university’s education was more free market, when it was less free market. It just seems to go on and on and on. That, I think, is what the Baumol effect explains.

COWEN: Let me do one at a time. Level effects often turn into rate effects because a crummy organization just tends to fall apart. I don’t think the price has been going up for a century and a quarter. First of all, the last 10 to 15 years, it’s clearly falling. In earlier times, especially, product quality is getting so much better. I wouldn’t say product quality is getting better right now, necessarily. If you look at what was taught in 1920 compared, say, to our textbook, just to toss in the obligatory plug or entire areas of science, biology, huge gains in product quality brought by labor, of course, which is supposed to be the stagnant factor. I just think you have a very varied pattern. Sometimes real price goes up. Sometimes it goes down.

TABARROK: Let me take both of those issues in turn. First of all, the last 10 years. Here’s an interesting part of the Baumol effect, which people don’t really appreciate. The Baumol effect actually says that the relative price of these service goods should be going up faster when manufacturing productivity or the productivity in other sectors of the economy is increasing. Actually, you get the biggest Baumol effect in the 1960s and the 1970s when growth is actually quite high. When I look at the fact that, in the last 10 years or so, the price of education has not been increasing in relative terms, I’m actually worried about that because that says that manufacturing productivity hasn’t increased. We know that is true. That’s a sign of stagnation.

COWEN: Now, you’re wanting to have it both ways. The entire premise is that manufacturing productivity grows at a higher rate. In fact, by a lot of measures since 1987, manufacturing productivity hasn’t gone up much at all.

TABARROK: It’s gone up since ’87, but in the last 10 years it’s been actually flat. That explains why the price of education has also been flat.

COWEN: I think that just shows that sectors can go up at higher or lower rates of productivity growth compared to other sectors. There’s not this ex-ante generalization that we ought to hang our hats on.

TABARROK: That’s one point in the last 10 years. Let me get to the second point, quality, and then I’ll come back to the third point.

COWEN: Quality. I’m ready on quality. Let’s hear it.

Product quality and Lancastrian bundles

TABARROK: It’s true in some sense that quality of education and healthcare has gone up. There’s no reason that should imply higher prices. In almost all sectors of the economy, when you have higher quality, you usually get lower prices. Look at electronics and computers, and manufactured goods. You get higher quality and lower prices at the same time. Yes, it’s a little bit difficult to measure quality in some of these service-sector industries. I’ll grant you that. In general, higher quality does not mean higher prices. The fact that we’re getting that, it seems like an excuse. Oh, well, prices have gone up in education, but our textbook is so much better than the previous book. It is better, I grant you. There’s no reason why the price should be higher.

COWEN: That’s not the reason. A lot of the reason might be third-party payment in some of these sectors. Keep in mind, the whole Baumol framework, it doesn’t deal with changes in quality well at all. I once had an exchange with Baumol at a conference in Boston. I said, “Bill, your paradigmatic example of the Mozart string quartet: it took them 35 minutes to play a string quartet back then. It takes them 35 minutes now.” I said, “Isn’t productivity fantastically high in that sector, because people prefer to listen to—well, now it would be Taylor Swift. It’s sad aesthetically that they’re bored with Mozart. The leap from Mozart to Taylor Swift is a phenomenal leap in terms of consumer surplus.” And Baumol said back to me—he got very mad, actually. He insisted it’s all a story about fixed product quality.

Once you say that, you’re just ruling out a priori new ideas as a source of productivity improvements. Of course, labor-intensive sectors will look worse, because the way they do well often is by having new ideas. That, to me, was just a tautology. The fact that once you introduce new ideas, you could push it a bit too far in the other direction and say, well, look, popular music, people get bored by it very quickly. Its value asymptotically approaches zero. Then someone comes along with a new song, and the productivity gain is 1,000% a year. Now, that’s also not quite the right way to think about it. Something about Lancastrian bundles, characteristics. Still, I don’t think the whole framework accommodates changes in product quality very well. Baumol himself knew that. He wanted to rule it out of consideration.

TABARROK: Product quality increases in manufactured goods as well. It’s not at all obvious to me—

COWEN: Yes, it’s not clear where the effect is higher or lower.

TABARROK: No, I think it is clear where the effect is higher or lower. If we do focus, I don’t want to follow Baumol too closely. If we do focus on a fixed good, then it is clear that, for a live performance, the costs have gone way up.

But here’s why I really like the Baumol effect. It’s because it’s a very general theory that explains a lot of different sectors. We’ve talked about healthcare and education. Here’s another sector, just completely different. I bashed my car recently. Nothing, just a little minor fender bender, really. To fix the side panel, which just had a big scratch in it, that was $3,500. It’s a tenth of the value of the entire car.

COWEN: This happened to Natasha too, except someone hit her car.

TABARROK: Just to fix the aesthetic problem. The car was running fine. The engine was fine. The wheels were fine. Transmission’s fine. We’re just fixing an aesthetic problem. It’s one tenth. What’s the general point? The general point is that the price of the car has gone way down relative to the price of fixing the car. The repair services have gone way, way up. It’s not just in relative terms. It’s not just for automobiles. When was the last time you took your shoes to the cobbler? I don’t even know.

COWEN: Not that long ago, in fact.

TABARROK: It’s pretty rare. Or when you take your clothes to the tailor to be fixed. My mother thinks that the new generation just waste products. They don’t know the value of fixing things. Actually, it’s not that the new generation is more wasteful or less concerned about saving money. It’s that the new generation faces different relative prices. It’s much cheaper to buy new clothes than it is to fix the old clothes because the new clothes are basically made in a manufactured process. Repairing the clothes takes a lot of labor. We don’t repair clothes. We don’t repair shoes. Much more expensive to repair cars. There’s an entire sector very different from healthcare and education, and I think Baumol explains it very well.

COWEN: I don’t think that example is going to help you. Recall what I said near the beginning. Ex post, you can always pick sectors with lower productivity growth and say that was the cost disease. Ex ante, if you’re trying to predict where productivity growth rates will be low, car repair is one of the last places I would look. For one thing, electric vehicles, you don’t have to fix the engine anymore. There won’t be an engine in the traditional sense. Those costs will plummet. Engines can be very difficult, very costly to fix.

Robots, of course, if there’s anything they’ll be able to do, probably, we hope it would be car repair with the standard set of repeated problems. I would predict moving forward that you have a lot of productivity growth in that area. From the ex-ante predictive point of view, I don’t think cost disease is so useful there. I’ll grant you the point that, ex post, you can look at low productivity sectors and say it often has to do a lot with labor costs. Of course, that will be true. It could have to do with capital costs as well or land costs. Labor costs, of course, labor is a pretty significant chunk of GDP.

TABARROK: It’s not just that it’s a significant chunk of GDP. It’s the one thing that we do want to go up in price. Economic growth is all about making labor more valuable. It’s not surprising that, with economic growth, that you have higher labor costs.

Music Sector Productivity

COWEN: What do you think’s been the productivity growth rate in the music sector over the last 30 years? Just to test how you would apply the theory. I want to say it’s been very, very high, but I agree this is debatable.

TABARROK: If you think about the changing number of musical genres and so forth, it’s gone up a little bit. Of course, that’s always been true. It’s not entirely obvious to me that the shift to rock and roll or electric music is that bigger than what happened in the 1900s.

COWEN: No, I have the universal jukebox now. YouTube, Spotify, you can add to that list. Even Amazon one- or two-day delivery, for me, is a big productivity boost for music. Not for everyone, but I think it’s a super high-growth sector for over the last 30 years.

TABARROK: Yes, if you define the sector large enough.

COWEN: I’m not defining it that large. Stuff I listen to and enjoy, and it has notes, and melody, and harmony. That’s my definition of music.

TABARROK: Define it as a live performance. Live performance has clearly become much, much more expensive. It now costs $150 to go to a concert. It has become much more in opportunity cost. You have to give up a lot more.

COWEN: People prefer recorded music most of the time, because you do it at home. You’re defining away product quality improvements.

TABARROK: No, because the price is so much lower.

COWEN: If you let me toss out the improvements people care about, productivity has been stagnant, is what you’re saying. Even live performance, you can debate whether that has become so terrible. Most music is heard in bars. You and I may not like it. We may not think of it as real music. I don’t go to bars. I’m not sure what the prices are there. I would just say it’s an open question. The music typically is free. There’s the price of the alcohol, which I have no knowledge of. It’s not the story of, oh, I had to pay so much to hear The Rolling Stones. If you look at live performance music, it’s a very complicated story.

TABARROK: What makes it complicated, I think, is that people are becoming richer. That’s another advantage of the Baumol effect, in that the reason you have the change in relative price from the Baumol effect is always because of productivity improvements. It always comes with people getting richer, so people can want to buy more.

Contrast the story that you want to tell with education, for example, or healthcare, perhaps, where it’s just inefficiency. If it’s just inefficiency, then people should shift away from education. If the price is going up because costs are going up, because it’s becoming more difficult to produce the same value, then people should be consuming other goods. If it’s the Baumol effect, then you can simultaneously have a rising relative price and people consuming more because of the income effect. We’re still going to have income effects, which naturally come with the Baumol effect. I think that’s another advantage of the Baumol effect.

Rising healthcare costs: Baumol or Improved Quality?

COWEN: Now, we haven’t talked about healthcare yet, so why don’t we do that for a few minutes?

TABARROK: Sure.

COWEN: It seems to me, product quality, in many, not all areas, is up a great deal. Life expectancy, if you take care of yourself, a big if, but it’s much higher. You suffer much less. People used to be a wreck at 70. Now you say 70 is the new 55, whatever. I’m not saying that’s all from healthcare, but a lot feeds into the product quality being better. Of course, the prices are a big problem in the United States, in particular. Third-party payment is clearly a major part of that story. Increasing government subsidies, whether you’re for them, against them, clearly a major part of that story.

I don’t start with the Baumol effect as a way of thinking about our healthcare sector. I just think it’s one thing in the mix. Pharmaceuticals, which has been phenomenal. Now GLP-1 drugs. You could say they’re capital, but inventing those is, in turn, labor intensive at some level. They weren’t invented using AI. That, too, is labor intensive, but they’ve been great for productivity in healthcare. I just don’t really see how this story applies in a simple way.

TABARROK: It’s interesting that you are denying the thing which the Baumol effect is intended to explain, which is the rising cost of services. That, I think, is a hard road to hoe, because almost everybody agrees with me that these things have become more expensive.

COWEN: No, not in quality-adjusted terms. I think it’s highly unclear whether my healthcare or my sofa has improved more over the last 40 years.

TABARROK: Right, but one of them has gone up in price, and the other has gone down in price, even with quality improvements.

COWEN: But the price of statins for me has fallen from infinity to whatever it is that it costs now, and that’s a huge price decrease. I don’t want to say that its price has just gone up. When you realize the price of these medications used to be infinity, I don’t know how to put that in the index number, but it gets back to the point that it’s not a simple comparison.

TABARROK: It’s not a simple comparison, but going to the doctor is just much more expensive than it used to be, and people are spending a larger share of their income on these service-sector industries.

COWEN: You’re not being Alex enough here. There are legal restrictions. If you allowed telemedicine to India, which is a relatively new technology, it would be much cheaper. Now, I agree we don’t allow that, but clearly, it could be the price of that has just been falling under a regime of more or less unfettered markets.

TABARROK: I want to pick up on that for two reasons. First of all, you said that ex ante we’re not able to predict which sectors rise in price.

COWEN: Not typically, at times. I’ll predict auto repair is going to do very well, but in general, it’s not the simple story.

TABARROK: I would say that people have been pointing to education, healthcare, also repair sectors for a very long period of time. As I said, I can go back to the 1920s. I can go back to the 1950s, 1970s.

COWEN: They’re right about two of them and wrong about two of them.

TABARROK: No. You go back and look at what Baumol was first talking about. He is able to make the same arguments that he made in 1955. He’s able to make them in 2025. His book, I guess, 2020 or something like that. Those sectors have remained fairly constant.

COWEN: I don’t think this is at all true, but go on.

Why Haircuts are Cheap in India

TABARROK: This relates to the second point, which you raised about India, which I’ll make two points about. First of all, yes, we can reduce the costs of service-sector industries by relying on lower opportunity-cost labor. That’s a good thing. Now, the second interesting thing about labor, this is the more important point, and it goes to predictability, and it goes to whether these things can be explained. When you and I go to India, what do we see that’s really cheap in India?

COWEN: Haircuts.

TABARROK: Haircuts, right. It’s services. Healthcare is cheap if you can afford it. It is cheap for us. Not necessarily cheap for people in India, but it is cheap for us because you can get fantastic 24-hour nursing care, for example. In India, you and I never drive a car. We are always chauffeured. Two reasons for that. One, the roads are insane. Two, it is very cheap to have a chauffeur, to have a home cook. Even people of middle-class incomes in India, they have drivers, and they have cooks. Every single day, they have people clean their houses. It’s very telling to me that exactly the sorts of things which are cheap in India today were cheap in our past. The past is a foreign country, and a foreign country is the past.

I think that the Baumol effect and the Balassa-Samuelson effect are really the same thing. The Baumol effect explains which sectors have been rising in price over time. Balassa-Samuelson explains why services are cheaper in poorer countries. The reason is that, in India, the productivity of a haircut is about the same as here. My barber in India is just as good as my barber in the United States, but my barber in India does not have the opportunity to work in a high-productivity manufacturing sector. His wages are low. That means that the price of a haircut is low in India, so we always get haircuts in India.

COWEN: You love to cite India in this context, but it becomes much more complicated when you think about significant parts of sub-Saharan Africa. India, in part, does so well because they are a mix of fairly cheap labor and extremely well-organized networks, just like that movie from a few years back about the Indian networks that deliver the boxed lunches to everyone.

India has incredible logistics. They have the English language. At least in some sectors, they have standards of quality. Poor countries, in general, they’re not the places you should necessarily go to get your hair cut. There can be problems of sanitation, problems of training, just problems of general safety, getting to the barber shop. A lot of services, manufactured goods for that matter, also in Africa, are really quite expensive, especially when you adjust for quality. India, it’s like cherry-picking or curry-picking, whatever you want to call it. I don’t, in most poor countries, want to do services.

TABARROK: There are many reasons why poor countries are poor. Many services also involve complex networks and technology. For example, it is the case that, technically, electricity, that’s a service. Obviously, it relies not on labor, per se, not on a huge amount of labor. It’s a service which is provided by technology. Some of the other things you mentioned, streaming services for music and for movies and Netflix, and so forth. Yes, those are services. Technically, they’re services in the GDP accounts. They’re not labor-intensive services. It’s quite possible, yes, in many poor countries, the electricity is bad.

It’s not the case that every single service in a poor country is cheap, because a lot of services rely on high-technology and high-productivity sectors. It is the case that you can take a driver from India or from sub-Saharan Africa, and you move them to the United States, and they become a taxi driver. They’re just as good. They’re equally as capable of driving around Lagos as driving around New York City. Probably easier to drive around New York City. Yet, their wages are much higher. Why is that? It’s because they have a higher opportunity cost in the United States.

COWEN: Sure. No one doubts that people are paid more in the US than, say, in India. To give more of a like-versus-like example, I’ll predict you get your hair cut in India and not in Pakistan. Pakistan’s a poorer country. There’s a lot of different factors. Labor cost is one of them. Since labor share of GDP in the US, it’s often between 58% and 61%, of course, wages will be a big part of explanations for everything. These ex-ante predictions about where productivity will grow, I mostly don’t buy them. Has cost disease helped people do better in the stock market because they see where the productivity gains are coming? I don’t think so.

TABARROK: Let me put it this way.

COWEN: You should have, in fact, invested in a lot of labor-intensive stocks, say, 15, 20 years ago, rather than manufacturing. Look at the big winners. Meta, formerly Facebook, it’s becoming more about capital costs now.

TABARROK: Yes, that’s very high-productivity labor.

COWEN: Now it’s shifting to hardware for reasons that are not mainly the cost disease. Now, NVIDIA, it’s worth $4 trillion at the time we’re recording. You need all these big expenditures for data centers, energy. That’s a shift back, you could say, in a more Baumol-esque direction. For 15 years, we had a big shift in the other direction, where it’s about having these smart people like Mark Zuckerberg, who turn their labor into capital and build networks that bring in a lot of people. That’s the big productivity gain. I just think we’ve seen it go both ways in the last 20 years. I didn’t predict NVIDIA, per se.

TABARROK: That’s disappointing.

COWEN: No, I thought there’d be a huge chip demand. I didn’t realize it would be so bottlenecked in one company.

TABARROK: Of course. Let me put it this way. I predict that the price of healthcare and education and home cleaning services and chauffeuring services will all rise in India over the next 20 years. In fact, even if you look today, you’ll find all of these middle-class people in India are starting to complain. It used to be “I was able to hire servants. I was able to have somebody clean my house, and now it’s just so much more expensive.” I predict that that will continue to happen. The relative price of labor-intensive services will go up in India over the next 20 years, let’s say.

COWEN: I’ll predict the price of chauffeuring services in the United States, and eventually India, will decline with Waymo, Tesla, and others.

TABARROK: No.

COWEN: It goes both ways. I’m not saying there are no cases where it goes in your direction. There’s both, and eventually India, will have Waymo and Tesla further away for them, almost certainly. Sometimes, poor countries are actually quicker to adopt new networks, like with biometric scans and the like. No, I don’t buy your examples. I think healthcare in the US, I know less about India, but in quality-adjusted terms, that will become a lot cheaper. There’s a lot of major advances, either recent or on the horizon.

The Difficulty in Predicting Productivity Gains

TABARROK: It’s clearly true. We can think about, if it’s the Baumol effect, then what can we do to compensate or to alleviate the rising costs of services? Now, if you think that it’s inefficiency, or if you think it’s the cost disease, which is a term I don’t like, then, again, you have to look at, well, we need more competition in healthcare, or we need more vouchers for university education, or something like that, more of a free market in education. I’m not against those things for different reasons, but I don’t think any of those things would change the rising relative price over time. If you want to affect the rising relative price over time, then you have to do exactly what you just said, which is you take a labor-intensive service, like being a chauffeur, and you turn it into a capital-intensive service, like having Waymo. You’re agreeing with me that it’s the Baumol effect.

COWEN: No, you’re just trying to win by tautology. If it’s ex-ante labor intensive, I’m just saying it might get a lot of great new ideas, it might not. It can go either way. The new ideas might involve a lot of capital, or say, in the music sector, it might involve just one person with an acoustic guitar in a recording studio, and lower capital costs than Led Zeppelin faced. It can go either way.

TABARROK: Waymo is using capital to replace labor. Robots are capital which replace labor.

COWEN: There’s even there a huge fixed and marginal distinction. Eventually, the nth marginal cost will be pretty low. Yes, it’s high fixed costs to set up the network, get data.

TABARROK: We know it’s low because in India, you can rent a car and a driver for less than it costs to rent just a car here. That tells you that the major cost of a taxi service, of a chauffeuring service, is the labor. It’s so much cheaper in India. That tells you that, in principle, Waymo can be much, much cheaper because the price of the labor is such a large fraction of the price of the chauffeuring services. That’s why all of the effort in AI is to replace labor, because that’s the major cost.

COWEN: They use a ton of labor to do it.

TABARROK: They don’t use a ton of labor. They use a small number of very productive laborers who also, by the way, are worried that they’re going to be replaced. It can sometimes make sense to use a bunch of high-productivity labor to create capital to remove labor. It doesn’t take that many people to create Waymo, where the addressable market of drivers is hundreds of millions of people. We all drive. It doesn’t take hundreds of millions of people. Hundreds of millions of people are driving, but it only takes less than a million very smart people to replace all of those hundreds of millions of drivers with technology.

COWEN: AI is a very good example of how hard it is to predict where the productivity gains will come, because most people were shocked by AI working so well lately. If we take the Alex Tabarrok of 1990, when we first met, you knew the Baumol effect then. If you just had to write down over the next 50 years where the relative price is going to go up and down, quality adjusted, I’m not sure you would have done that well. I don’t feel I would have done that well.

Baumol Explains Childcare Costs

COWEN: Now, one case, here’s a case where I can’t find any grounds for disagreeing with you. I’m surprised you haven’t mentioned it yet. That’s childcare. I may just not be imaginative enough, but if you said, I, Alex Tabarrok, predict childcare, we’re just stuck there because parents dogmatically want humans rather than robots to watch their kids, I’d say, okay, yes, that’s probably going to be explained pretty well by the Baumol effect. Again, I could be missing the point, the new innovation, but there, why haven’t you mentioned childcare?

TABARROK: Actually, I have a post coming up, which will be next week, which will be on exactly this question.

COWEN: It’ll be out by the time anyone’s listening.

TABARROK: Yes, exactly. It’s out now. You can go read the post now. It’s a great post. It actually is looking at exactly this question, childcare. Many people, including people from our group, when they look at why is the price of childcare going up, and everyone agrees it is going up, it’s going up faster than inflation. That much is true. They point to regulation and they say, “Look at all these ridiculous regulations where we’re requiring childcare workers to have university degrees. What a waste.” Again, while I’m not against that, here is my test. I recently had to go on a trip. When you go on a trip, you factor in the price of the airfare and the hotel. I often forget to factor in the price of doggy daycare.

COWEN: I have the same problem now. But you’re paying too much.

TABARROK: I know. Maybe I should bring my dog over to you. Maybe we should swap services or something. It’s extremely expensive. It’s $80 a day for doggy daycare. That is not with the treats and the fancy services and the walking and all of that. That’s pretty standard doggy daycare in northern Virginia. $80 a day, which is about the same as a Motel 6.

COWEN: I accept your general point here. You do need to connect to an ethnically based network of people taking care of dogs. The price will be lower. Side point totally, accepting your general point. Here’s my hope for childcare. Again, I’m not predicting this. I agree with you on the general point. I hope that boarding schools come back as an organizational innovation, including with a lot of AI. That becomes a new form of childcare. Tongue in cheek, I’ll say maybe we can make it a bit like factory farming. It might be cheaper than current childcare, above some age. Obviously, not for three-year-olds. There could still be innovations you and I can’t think of.

TABARROK: Yes, it’s possible.

Debating Baumol's Predictive Power

COWEN: A lot of the Baumol-effect people, they want to define the thing so narrowly. Whenever you give them progress, they’ll either say, oh, that’s a different good or service. Or they want to say, oh, so it was capital-intensive after all. I want to, again, stress the ex-ante, ex-post distinction that childcare and doggy care aside, I don’t feel my intuitions about future productivity are so great. I’m more tuned into these things than most people. Do you think yours are that great?

TABARROK: I do think Baumol made these predictions in 1954, I think it was. They all turned out to be true.

COWEN: No, they didn’t all turn out to be true.

TABARROK: Yes.

COWEN: Quality-adjusted healthcare.

TABARROK: Again, the quality-adjusted, this is just a way of faking the issue.

COWEN: No, you want to slip out of it by saying the good or service changed. It’s just a productivity gain.

TABARROK: In almost all sectors, quality comes with falling prices, not with rising prices.

COWEN: There’s plenty of other reasons why healthcare prices have gone up. Technology is a huge one, and government’s another. We had no Medicaid, Medicare when Baumol first wrote on these topics.

TABARROK: That’s in favor of Baumol because the increase in the price of medical care has happened before there was Medicaid and Medicare. It happened after as well. Here’s an interesting example.

COWEN: Healthcare expenditures really take off in the early ’80s. I don’t pretend to know why. There’s a literature on this. I don’t think it’s because wage growth exploded in the early ’80s. Before then, they go up a bit, but it’s not out of control. Then all of a sudden, you have these several decades where it’s crazy.

TABARROK: No, I don’t think that’s correct.

COWEN: People don’t, in general, say, oh, that’s the Baumol effect.

TABARROK: No, I don’t think that’s correct. I think what happened is the price increase was happening for a very long period of time. You can go back to the 1900s, and the price increase of healthcare is going up and up and up. What happened in the 1980s was not a faster increase in the price. It’s just that the price times the quantity, the revenues became higher. It became a bigger part of people’s checkbook. That’s just because the same price increase on a small base, people don’t notice as much. The same price increase on a larger base becomes something which people talk about, but the actual price increases go back much, much before the 1980s.

COWEN: I’ll predict that for two-thirds of that history, you decided quality-adjusted prices for healthcare have been going down. Even the AMA admits, before year whatever, I forget the number, doctors were more likely to kill you than save you. We have one colleague, our dear Robin Hanson, who thinks that still may be the case, which I don’t agree with that. Partly, it was possible to do without Medicare because there weren’t that many useful treatments before the 1960s. To me, that looks highly deflationary. If you ask yourself the question, you get $100,000 to spend on the healthcare of today or the healthcare of 1950, which one do you order? I know what Alex would do.

TABARROK: Yes, of course.

COWEN: Most of the time, it’s going down, the price.

TABARROK: When you look at all of these multiple sectors, the repair sector, repairing of clothing, repairing of shoes, repairing of cars, repairing of people, it’s not an accident that these are all the same thing. Healthcare is the repairing of people. Repair services, in general, have gone up because it’s a very labor-intensive area of the economy. It’s all the same thing. That’s why I like the Baumol effect, because it explains a very wide set of phenomena.

COWEN: A lot of things are easier to repair than they used to be, just to be clear. You just buy a new one.

TABARROK: That’s my point. You just buy a new one.

COWEN: It’s so cheap to buy a new one.

TABARROK: Exactly. The new one is manufactured. That’s the whole point, is the new one takes a lot less labor. The repair is much more labor intensive than the actual production of the good. When you actually produce the good, it’s on a factory floor, and you’ve got robots, and they’re all going through da-da-da-da-da-da-da. Repair services, it’s unique.

COWEN: I think you’re not being subjectivist enough in terms of how you define the service. The service for me, if my CD player breaks, is getting a stream of music again. That is much easier now and cheaper than it used to be. If you define the service as the repair, well, okay, you’re ruling out a lot of technological progress. You can think of just diversity of sources of music as a very close substitute for this narrow vision of repair. Again, from the consumer’s point of view, productivity on “repair” has been phenomenal.

TABARROK: That is a consequence of the Baumol effect, not a denial of the Baumol effect. Because of the Baumol effect, repair becomes much more expensive over time, so people look for substitutes. Yes, we have substituted into producing new goods. It works both ways. The new goods are becoming cheaper to manufacture. We are less interested in repair. Repair is becoming more expensive. We’re more interested in the new goods. That’s a consequence of the Baumol effect.

You can’t just say, “Oh, look, we solved the repair problem by throwing things out. Now we don’t have to worry about repairs.” Yes, that’s because repair became so much more expensive. A shift in relative prices caused people to innovate. I’m not saying that innovation doesn’t happen. One of the reasons that innovation happens is because the relative price of repair services is going up.

COWEN: That’s a minor effect. It’s not the case that, oh, I started listening to YouTube because it became too expensive to repair my CD player. It might be a very modest effect. Mostly, there’s technological progress. YouTube, Spotify, and other services come along, Amazon one-day delivery, whatever else. For the thing consumers care about, which is never what Baumol wanted to talk about. He always wanted to fixate on the physical properties of the goods, like the anti-Austrian he was.

It’s just like, oh, there’s been a lot of progress. It takes the form of networks with very complex capital and labor interactions. It’s very hard to even tease out what is truly capital intensive, truly labor intensive. You see this with the AI companies, all very mixed together. That just is another way of looking at why the predictions are so hard. You can only get the prediction simple by focusing very simply on these nonsubjectivist, noneconomic, physical notions of what the good has to be.

TABARROK: I think there’s too much mood affiliation there, Tyler.

COWEN: There’s not enough Kelvin Lancaster in Baumol.

TABARROK: Here’s a point which I do agree, is that the initial Baumol and Bowen book on the arts was very pessimistic. As was a lot of the discussion, as is the term cost disease. I think that pessimism was wrong. It’s wrong because of the Baumol effect, actually. Baumol did not completely understand the Baumol effect when he wrote Baumol and Bowen. The part that he didn’t quite grasp is that the rise in the price of services is always caused by an increase in the productivity of the manufactured goods. We’re getting richer. It is absolutely the case that the Baumol effect is not a reason to be pessimistic about the arts.

It’s not a reason to be pessimistic about healthcare or education, even as the price of these goods rises in relative terms. It’s just a relative price change. You can have a relative price change without it being driven by costs, without it being driven by inefficiencies. In that sense, we’re getting richer. Yes, we’re purchasing more art services. That’s great. We can purchase more healthcare, and that’s great. Still, in terms of the shift in the relative price, I think it’s undeniable.

I would give you another, I think, which is a very telling example. We don’t have great data on this, but it’s interesting. Even in the Soviet Union, they were complaining that the price of the ballet had gone up. Now, in one sense, this didn’t make any sense at all, because we’re talking about the Soviet Union. All of the prices are set by fiat, let’s say, in the perfect communist system, so how could they possibly complain about the rising price of the ballet?

Even in the Soviet Union, they had to recognize relative price tradeoffs. Without having a physical price, without having a named price, they recognized that manufactured goods were becoming cheaper. What you had to give up to produce the ballet, to go to the ballet, was becoming more expensive. You had to give up more good stuff to go to the ballet. That’s the ultimate Baumol effect, is what you have to give up in order to get that good of going to the ballet, producing the ballet. The cost of that is going up in terms of the opportunity cost. Even in the Soviet Union, the Baumol effect continued to hold. That, I think, shows how deep and important the effect is.

The Staffan Linder Effect

COWEN: As a final topic for this episode, what do you think of the Staffan Linder effect, sometimes considered a close cousin of the Baumol effect? Linder said in a series of articles, somewhere in the QJE that, basically, because the number of hours in a day is fixed, that over time, as productivity would rise, leisure would become more goods intensive. More snowmobiles is one way to think of it.

TABARROK: The Harried Leisure Class.

COWEN: The Harried Leisure Class. Do you buy it or not?

TABARROK: Yes, I do buy it. The way I would put it is that the richer we become, the more valuable time becomes. People want to squeeze more and more utility into a shorter, shorter period of time. What happens is that people get the dopamine hit on the phones and things like that. They’re looking for quicker and quicker fixes rather than getting their pleasure from things which take a longer period of time. Yes, I think that’s true.

COWEN: There’s two different effects in what you say. One is the quicker-fixes point, which may or may not be true. The other is the more snowmobiles point. A snowmobile may or may not be a quick fix. It may take a long time to learn how to drive it. You go out with it for three hours, whatever. I’m less convinced of the Linder effect. Clearly, in an economy with more goods, leisure will have more goods, but work will have more goods too.

People are more likely to listen to music when they work because you don’t have to bring a stereo into your office. Whether that has gone up more than how goods are connected to leisure, I genuinely don’t know. I think it’s another case where ex-ante prediction is difficult. Certainly, the number of hours of leisure time you have has gone up. Goods have gone up, but you have more hours to squeeze those goods into. I would say I’m not sure. I’m not against the Linder effect. It’s an interesting claim. I’m not persuaded either.

TABARROK: You do have more hours. As working hours goes down, and leisure hours goes up. Still, I think if you would go out and ask people in the street, do they feel more harried even in pursuing leisure? I think the answer would be yes. Part of this, to be sure, is psychological and under a person’s own control, but if you think about the leisure activities of the past, many more of them involved longer hours and more time, like talking with your friends, sitting on the porch. People don’t get pleasure from sitting on the porch and watching people go down the street.

Instead, they want to be right on their phone. They want to be watching a movie. They want to have instant access. People are less likely even to go to the movie theater, because it just takes a longer period of time. You’ve got to drive there. You’ve got to find parking. It’s an hour to get there. You watch the movie, and that’s an hour to get back. It’s two hours of the movie and two hours of your time in getting there. The price is doubled. Why don’t I just watch it at home?

COWEN: Alex, what’s your favorite leisure activity at the margin, of course?

TABARROK: Talking with you, Tyler.

COWEN: That’s what I was going to say. Our favorite leisure activity is “work,” and that’s exactly the ambiguity that worries me about the Linder effect.

TABARROK: At the same time, I suspected many people are watching or listening to this podcast at 1.25 speed.

COWEN: They’re calling it work. They’re doing it at 9:30 a.m. in the morning.

TABARROK: Yes. Well, it’s going to improve their productivity.

COWEN: Alex Tabarrok, thank you very much. Always good talking with you.