Just like Covid, economic ailments could be mutating into something worse

With Covid so prevalent, most people have sickness at the front of their minds. Within economic theory, there are also ailments that get economists thinking One in particular, Baumol’s cost disease, points out why wages in sectors with low productivity can rise even though the theory suggests that productivity gains are needed for this to happen. Yet, just like Covid, this illness may have also mutated into something different and perhaps more malignant.

The economic malady in question is named after William Baumol who wrote in the 1960s about rising wages in jobs where there have been no improvements to boost output of workers. Being paid more for producing no extra goes against the basic notions of economic theory which argued that workers are paid relative to their output. Baumol used the clever example of a string quartet which still took the same number of musicians and the same amount of time as it had always done (hence no increase in productivity) and yet the pay for a performance had increased.

The reasoning he gave to explain this was that the parts of the economy that did experience gains in productivity were pushing up wages across the whole economy. If pay were to only increase in the sectors in which productivity was improving, then the higher wages would attract workers from elsewhere. So, to retain their workforce, employers in the sectors without any improvements would need to pay more for their labour costs and increase the prices that they would charge their customers.

The result of wide-spread pay increases with only partial productivity gains was that the relative cost of goods from low-productivity sectors became more expensive relative to goods produced by more productive workers. The typical manifestation of this change in relative prices is the increasing cost of services relative to goods. The manufacturing sector continues to make products cheaper and cheaper as technology allows more to be produced with less labour. On the other hand, people often need to be present for any service to be offered and hence each person can only do a limited amount of work.

The most obvious examples of Baumol’s cost disease are the rising amount of money spent on education and health care. In most cases, teachers and doctors are required to be in the same room as students or patients to do their job. Covid has resulted in much of this work being done remotely, but health and learning has suffered as a result. There has been some technological improvement in these sectors, with university courses being offered online and lots of new-fangled equipment to fix us when we are sick. Yet, we still expect teachers in the classrooms and doctors at the hospital whenever we are there.

This trend means that the economy increasingly becomes geared towards the service sector as employment in manufacturing falls. There also seems to be greater demand for services such as entertainment and travel as our general level of income increases. But the flipside of this is that it is increasingly difficult to generate gains in productivity when more and more people are employed in the service sector. Slower wage gains also mean that the amount of money we have to spend is also rising less than in the past.

It could even be the case that the shift to greater employment in services has acted as a damper on wages not only among those specific service-sector workers but across the whole economy. Just as gains in productivity in some sectors had lifted wages everywhere else, the opposite could now be true. That is, stagnating productivity in most jobs acts to depress wages for all workers. One piece of evidence for this is how much of the gains in productivity have not fed through into higher wages since the 1970s.

The shifts in employment may have pushed the economy passed a tipping point to where wages no longer rose if per-worker output increased. So instead of a cost disease pushing up the wage bill for all companies, the effect might have flipped to instead be something that could be labelled as “Baumol’s wage disease” involving low wages irrespective of productivity. The original idea of Baumol may have just been relevant to the labour market at a time of abundant manufacturing jobs.

The “wage disease” may have set in with relative scarcity of high productivity jobs dissipating the need to compete for workers through offering higher wages. Manufacturing work may have also allowed workers to build up skills on the job, making them more productive and difficult to replace. On the other hand, employees could be seen as being more interchangeable with less chances to develop skills in the expanding service sectors such as workers in Amazon warehouses or drivers for Uber.

As with Covid, we can only treat a disease once we know what it is. Yet, the predominance of low-wage work typically just prompts calls for more education and “better jobs”. As well as being a misdiagnosis of the problem, technology is already making both of these measures increasingly redundant. We instead need to figure out a way of making work pay more, not only for the sake of the individual workers themselves but also for the economy as a whole. Without bigger pay packets, the “wage disease” will result in sickly levels of spending and leave the economy in an afflicted state.