Tuesday, 9 January 2018

Economic Myths - NHS spending and the Baumol Effect

This theory (also known as Baumol's cost-disease) is given a lot of credence by e.g. The Economist, the LSE and Tim Worstall/Forbes.

The Economist explains it thusly:

HEALTH-CARE expenditure in America is growing at a disturbing rate: in 1960 it was just over 5% of GDP, in 2011 almost 18%. By 2105 the number could reach 60%, according to William Baumol of New York University’s Stern School of Business. Incredible? It is simply the result of extrapolating the impact of a phenomenon Mr Baumol has become famous for identifying: “cost disease”...

In 1913 Ford introduced assembly lines to move cars between workstations. This allowed workers, and their tools, to stay in one place, which cut the time to build a Model T car from 12 hours to less than two. As output per worker grows in such “progressive” sectors, firms can afford to increase wages.

In some sectors of the economy, however, such productivity gains are much harder to come by—if not impossible. Performing a Mozart quartet takes just as long in 2012 as it did in the late 18th century. Mr Baumol calls industries in which productivity growth is low or even non-existent “stagnant”.

Employers in such sectors face a problem: they also need to increase their wages so workers don’t defect. The result is that, although output per worker rises only slowly or not at all, wages go up as fast as they do in the rest of the economy. As the costs of production in stagnant sectors rise, firms are forced to raise prices. 

These increases are faster than those in sectors where productivity is improving, and faster than inflation (which blends together all the prices in the economy). So prices of goods from stagnant sectors must rise in real terms. Hence “cost disease”.

The theory is that therefore health spending will inexorably rise as a percentage of GDP.

It seems like nonsense to me. For sure, in relative terms the cost of labour-intensive services increases, but only in relative and not in absolute terms. In truth, the cost of labour-intensive services stays constant and the price of automated, mass manufactured products decreases.

Think about the two extremes.

a) Wages rise exactly in line with GDP, in which case, the cost of labour-intensive services, wages generally and GDP go up in step. Health spending stays constant as a percentage of GDP.

b) All the benefits of automation go to the people who invent and own the machines that make stuff and wages stay constant. In this case, wages fall as a percentage of new enlarged GDP and the cost of labour-intensive services also falls as a percentage of GDP.

In neither scenario does the cost of labour-intensive services like healthcare increase! That only happens when there is a sharp contraction in GDP, wages in protected sectors like health being inflexible downwards - the sharpest increase in NHS spending as a percentage of GDP was between 2007 and 2009.
I think that the tried and tested explanations for the increase in healthcare spending are the correct ones, these apply to both extreme types of funding (USA and UK), in no particular order and these all overlap and tie in with each other:

1. Most treatment is paid for by insurance, whether that is private premiums or compulsory mass-insurance via the tax system, meaning that treatment is free or cheap at point of use, it is "other people's money".

2. Healthcare is a victim of its own success. They invent new treatments for non-curable/non-fatal diseases/conditions, which means that such diseases are passed down to more children and people live much longer. So there are more people with those conditions, and healthcare gets more and more expensive the older people are, because there is more that can and will go wrong.

3. Healthcare feels like a necessity from the point of view of an individual (choice between living or dying), but is actually a luxury good i.e. the amount that people are willing/able to spend on it rises disproportionately as a share of income; so healthcare takes up a disproportionate share of GDP growth.

4. They keep inventing new and more expensive treatments. Heart transplants were a novelty fifty years ago, now they are almost routine. Thirty years ago, getting HIV was more or less a death sentence, so people just died. Luckily, the virus itself is nowhere near as virulent as it was, and they have developed medicines that enable people with HIV to live fairly normal lives for decades.

5. Politicians in Europe can always earn a few brownie points with the voters by promising to spend more on healthcare, even though the law of diminishing returns applies and a lot of the increase in health spending just goes into higher profit, salaries and white elephant spending and not actual additional treatments. This is particularly crass in the UK as there is a disconnect between 'spending on the NHS' and 'spending on healthcare'. Compare and contrast - all nurses and doctors get a 3% pay rise vs. the NHS employs 3% more nurses and doctors on the same salaries.

6. There is massive rent seeking in health care. Back in pre-NHS days, GPs would practice discriminatory pricing and charge wealthy people more than poor people for the same treatment. Faced with a choice of life or death, somebody with only a few hundred quid savings can't pay more than a few hundred quid. The GP can hold millionaires to ransom and charge them tens of thousands. Pharma companies love inventing medicines that will alleviate symptoms of long-term incurable diseases/conditions. The bigger the NHS gets, the higher the salaries that all the top dogs can pay themselves and get away with it. And I am sure that the US insurance companies really take the piss.

7. For the benefit of Ralph Musgrave, let's chuck in this phenomenon, this one and this one for good measure.

Here endeth.


Lola said...

Using "Performing a Mozart quartet takes just as long in 2012 as it did in the late 18th century is nonsense. It's not the playing of the music that is more or less productive it is the composing of it. Fords are good illustration. They are made much quicker but it takes the same time to travel from A to B in a speed limited route now as it did in the 1920's, even though the cars are much better and faster. The same is true of the instruments played by the quartet.

Lola said...

Also surgeons have studied F1 pit stops to work out ways to make surgery quicker and better.

Graeme said...

Hang on, don't your examples show that employees are taking higher wages while productivity remains about the same?

Lola said...

Para 6. That is also a form of redistribution. You'd think lefties would love it.

Mark Wadsworth said...

L, your first comment is true, but I can't see the analogy.

L, perhaps they do. Can they swap a heart in two seconds though? That's the best bit of F1 nowadays.

G, by and large, the largest input cost in an economy is labour. Raw materials out of the earth are worth a per cent or two, and real capital is all man-made by labour.

Therefore, we can express GDP of shares of GDP in terms of number of labour-hours. If the amount of healthcare provided is constant, then cost thereof as share of GDP remains constant.

My point is that expressed in terms of man hours, a new car costs a quarter as much as fifty years ago, but having a filling done on a tooth costs the same. It is not that healthcare takes up more of GDP - it is the number/value of new cars/fridges/TVs etc that increases.

i.e. if nurses and doctors are ten percent of all employees, we spend 10% of GDP on healthcare and 90% on X million new cars/fridges/TVs today. Then there are leaps in productivity in manufacturing, if number of nurses and doctors stays the same, we will be spending 10% of GDP on healthcare and 90% on 2X million new cars etc.

L, it is and they do. It looks like universal distribution to keep the voters happy, but half of increases are bungs to their mates - like the company which employs the husband of our new health secretary :-)

Ralph Musgrave said...

I'm honored to be mentioned in dispatches.

Mark Wadsworth said...

RM, you are a valued and reliable commenter, I can half guess when you will say what on what topics :-)

The Stigler said...

The problem with talking about baumol and medicine is that it misses improvements in medicine and processes. if you give a visiting nurse a satnav, they do more visits. If you improve the process for processing prescriptions, you save money for treatment.

One reason I’m so pro-privatisation is that the NHS is really bad at process improvement.

Mark Wadsworth said...

TS, there are always little incremental improvements to be made, the linked articles mention the same things you do, using email, sat nav, computerised records (which the NHS famously fucked up) etc.

Graeme said...

Lola, if you played a quartet in 1790, you got the wage for one night. Today that gig could go on radio - extra pay, - and could go onto a pay for play platform, or even a CD. Thus many times worth the single performance. And you could sell mugs, tea towels, etc. So you can derive more from a performance now than you ever could in 1790. Does that explain it?

Graeme said...

Mark, your logic seems OK but does reality stack up? Costs of goods has decreased but costs of dental services seems constant. In 1990 a scale and polish would not buy a fridge. It does now.

Mark Wadsworth said...

G, that's my point. Healthcare costs the same and fridges are a lot cheaper. Healthcare is not increasing as a share of GDP, fridges are - we get the same number of fillings but many more, much cheaper fridges.

L fairfax said...

It is quite hard to automate fillings - much easier to automate making fridges.

Mark Wadsworth said...

LF, that's the point. But just because fridges are cheaper doesn't mean that filings are more expensive.

Dinero said...

You are missing this

"As output per worker grows in such “progressive” sectors, firms can afford to increase wages" ie the price of fridge remains the same and wages rise.
And then -
" In some sectors of the economy, however, such productivity gains are much harder to come by—if not impossible ....Employers in such sectors face a problem: they also need to increase their wages so workers don’t defect." ie the price of a filling goes up.

summary the Baumol effect -the price of fridge remains the same the price of a filling goes up.

L fairfax said...

Doesn't the price of a filling in reality go down?
Assume that a filling costs £100 and a fridge £100.
Therefore if I have £100 I have to chose between the two.
However if a fridge is £10 and a filling £110 then it is a lot easier to afford both.
Therefore the cost - in what I have to give up - is less.
Which is the only real cost that matters, what you have to sacrifice for good/service x.
I am of course assuming that my wages have gone up with inflation and my figures are made up for clarity.

Mark Wadsworth said...

Din, I am not. Of course price of fillings goes up - but only in line with wages generally and GDP.

See also LF's example.

Dinero said...

Maybe its still affordable a percentage of wage but it is still a price increase , and a issue for government , paying NHS wages.
The Worstall piece summarises it
"Yet average wages are determined by average productivity across the economy: thus services will rise in price relative to manufactures or farm products over time"

And so , due to sociological effects, increase in wages in mass production sectors increase the wages across all sectors, and the ones products of sectors without the productivity increase goes up in price. With the advent of the minimum wage council it can be seen to be Sociological and Bureaucratic.

Mark Wadsworth said...

Din, you not understand maths?

If wages go up 10%, GDP goes up 10% and cost of healthcare goes up 10%, then cost of NHS as a share of GDP remains CONSTANT.

Dinero said...

"thus services will rise in price"

That doesnt contradict the share of GDP remaining constant although the GDP share is a red herring, The Baumol effect is new to me but from your quotes and links its not about share of GDP, it is the price of services rises as wages settlements there are influenced by wages increasing in rising productivity sectors.

Mark Wadsworth said...

Din, the whole concept has to do with share of GDP. Read the linked articles. That is exactly not a red herring.

Mark Wadsworth said...

Din, I have expanded the excerpt.

Bayard said...

"Employers in such sectors face a problem: they also need to increase their wages so workers don’t defect."

This is stated as a given, but is it true?

Mark Wadsworth said...

B, of course it is true. Doctors' pay is decided between insider club of doctors and TPTB, but every other actual or potential NHS worker compares NHS pay with equivalent and vaguely similar job in private sector.