The Baumol Effect

When I was in university, a one minute telephone call across the country cost 99¢. Today, a call to most places in the world is about 5¢ a minute or less. Taking inflation into account, that means a long distance phone call costs about 1/60 of its price some 30 years ago.

The same trend is observable in many other products and services such as clothes and food. However some products and services stubbornly resist price collapse and not because of their scarcity: I could buy a new car with 1000 hours of work at minimum wage in 1980. Today an equivalent car would likely cost me 3000-4000 hours of work (not including payroll deductions). Granted, cars are more more reliable now--I hardly even need to take mine for repairs any more--and loaded with new features. Car manufacturers have become more productive however this productivity has translated into value instead of cost.

On the other hand, realtors, bankers, accountants, and lawyers have not shared much if any price reductions in their fees nor have they produced any significant increase in services or features.

The theory behind these price reductions is that productivity improves with the introduction of new technology, business processes, market consolidation, and economies of scale. This in turn reduces the cost to create a unit of product or supply a service. Provided there is not a monopoly in the marketplace, the remaining competitors in a market are in a struggle to capture market share by passing these savings on to their customers.

The Information Technology industry is one of these cost-reducing enablers. Combined with "Moore's Law", one would expect the productivity in collecting, managing, extracting, and utilizing an organization's data--the "spice" of any enterprise--to improve.

And indeed Information Technology does this. When properly managed and aligned with the organization's strategic needs and directions, an IT department should be able to deliver continuously improved and enhanced services at the same if not a declining cost of service. That productivity could in turn be passed along to the enterprise's customers.

So what accounts for the exceptions to this productivity curve? For one, many industries have been reluctant to use technology to improve productivity. Law firms and the education sector are probably some of most laggard adopters of automation. Perhaps there is a sense that digital searching the legal annals minimizes the value of legal professionals or that digital content delivery threatens the sacrosanct teacher-student relationship. Similarly, some industries are protected by legislation, professional protectionism, or the cloak of a public sector essential services. These sectors often feel little need to manage their costs as they have a protected market that allows them to impose price structures on their customers.

This inelasticity of pricing in a product or service in the face of declining prices across the economy has become the subject of "Cost Disease Theory." The "Baumol Effect" or "Baumol Cost Disease Theory" was first describe by William Baumol and William Bowen in 1966. It described those economic sectors where the productivity of labour did not increase over time. For example, in the 1800's, it took four accomplished musicians to play a Beethoven string quartet in an evening. Today, the production of classical music has not become any more efficient. In 2015, it still takes 4 accomplished musicians to produce this same music. The economic models of performing arts is a typical application of the Baumol effect.

Granted, we can now enjoy music at a much lower cost than the live performance. Rather than paying admission to hear the concert at the Met, I can buy the CD or acquire it from digital download at a fraction of the cost of the live performance. But the point is that the cost of live performances is at least as high as ever.

This leads us to a couple of questions. First, are there some products and services for which we're prepared to accept the Baumol effect? Are we so committed to having individual attention from our university professors, nurses, doctors, lawyers, judges, realtors, and politicians that we are prepared to pay an increasing labour rate to support the services they provide?

Second, if we aren't, then what can we do to restructure our healthcare, legal, political, and educational systems so that they can avail themselves of new tools for efficiency and re-examine the current practices that confines a service provider or professional to his or her current level of productivity?