Should everyone earn their pay rise?

In a flourishing economy, what counts as a competitive wage is always increasing. Photo / 123RF

Mozart and Haydn were composing string quartets 250 years ago, when the Industrial Revolution was in its infancy. Since then, the scale of the world economy has increased at least 100-fold and material living standards in Western Europe have grown at least 20 times over.

Our ability to travel, build, calculate, communicate or simply produce food has been transformed beyond recognition. And yet the productivity of a live recital of Haydn’s Emperor Quartet hasn’t budged: it still takes four musicians between 25 and 30 minutes to play.

This is the essence of what has become known as “the Baumol effect” or, more dishearteningly, “Baumol’s cost disease”. The basic problem was laid out by economists William Baumol and William Bowen in Performing Arts, the Economic Dilemma in 1966, amid much hand-wringing about the perception that the performing arts were ridden with waste and mismanagement. Whether or not that was true, Baumol and Bowen argued, “The basic difficulty arises, not from any of these sources, but from the basic structure of live performance.”

The Baumol effect describes the challenge that arises when some sections of the economy are rapidly advancing while others are standing still. If you would like to listen to people play Haydn live, you will probably need to pay them a competitive wage. And in a flourishing economy, what counts as a competitive wage is always increasing. If the productivity of musicians doesn’t change, but their wages keep growing to keep pace with the rest of the economy, then paying people to perform Haydn is going to feel more and more like an expensive luxury.

But that is not why the Baumol effect is on people’s lips today. The concern now is not the price of a night at the concert hall, but the cost of healthcare, social care and education. Instead of a cellist, think of a nurse changing a dressing on a wound, or a care worker helping a person with dementia get dressed in the morning, or a kindergarten teacher instilling some of the basics of reading and counting to a class of 4-year-olds. To demand that these people become more productive feels like the same sort of basic error as insisting that the string quartet play louder and faster. Perhaps it cannot or should not be done.

If the Baumol effect is to blame for the woes of public services, we have a choice. We can let the wages of public sector workers fall behind and, over time, lose some of the best of them. We can hope that labour-intensive services, from care work to classical concerts, will be performed on a voluntary or semi-voluntary basis. Or we can decide that, much like live performances of Haydn, we don’t need them as much as once we did.

Alternatively, we can agree the increased cost is something we are prepared to pay for. After all, the Baumol effect is a direct consequence of productivity gains elsewhere in the economy. By definition, it implies that the money is available to pay those higher wages.

Is this story really a good explanation of what is happening to the UK’s struggling NHS or public services more generally? Should we all be paging through our Baumol and Bowen to understand the problem?

Only up to a point. A report from the Institute for Fiscal Studies (IFS), published in May, finds that between 1997 and 2019, public sector productivity grew at 0.2% a year, while in the private sector the productivity growth rate of a broadly comparable measure was 0.8%. Average wages of full-time employees, on the other hand, grew at the same rate in public and private sectors. So far, so Baumol-ish.

But the recent travails of the NHS cannot be laid at the feet of the Baumol effect. Ben Zaranko, one of the authors of the IFS report, suggests that since 2020 the key elements have been the strain of the pandemic and the consequences of a long period of under-investment in capital and management capability. To the extent that this is a story of a string quartet, it’s a group of five stressed musicians trying to organise and promote their own concerts, while sharing three threadbare instruments.

The Baumol effect is a useful rebuttal to those who assume that every worker must “earn” their pay rises by becoming more productive. That’s nonsense; they can always earn their pay by quitting and doing something else.

Still, while we shouldn’t dogmatically insist public sector wages cannot rise unless public sector productivity rises in lockstep, we shouldn’t be too quick to accept the strictures of Baumol’s string quartet. By assumption, Baumol and Bowen ruled out the idea that musicians might record their performances or use amplification to reach larger audiences. They were focused only on traditional live performances and the cost of those performances. Fine. But it would be unwise simply to assume that nothing can be done to raise the productivity of doctors and teachers.

In any case, the Baumol effect is best seen as a good-news story. It is a tale in which parts of the economy become dramatically more productive. Indeed, even if every part of the economy enjoys productivity gains, Baumol effects will apply to the extent that some are increasing productivity faster than others. Those who fret about the Baumol effect should perhaps fret more about the alternative: slow productivity growth everywhere. That is all too easy to imagine.

© Financial Times