The Difference between Hamilton and Healthcare

Why pricing basic human needs like scarce luxuries isn't sustainable

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"The true measure of any society can be found in how it treats its most vulnerable members."

M. Gandhi

Anyone who has spent more than ten seconds hanging out with me in the past few months knows that I’ve got some bones to pick with the American version of capitalism. But…I also like to buy stuff! And there is no better place in the world to be a consumer than the US, and New York City in particular.

This is in no small part because of New York’s full-throated embrace of the price-based rationing mechanism, which dictates that if you really want something and have the cash to pay for it, in this city, it’s yours.

As economist Greg Mankiw controversially spelled out in the New York Times, it’s the ruthlessness of the price mechanism that allowed his family to see the hit Broadway musical Hamilton on short notice:

“Two weeks before our trip, I logged into StubHub, the online ticket marketplace owned by eBay. I found the performance we wanted, located some great seats and within a few minutes was printing our tickets...The rub is the price. Including StubHub’s fee, I paid $2,500 a ticket, about five times their face value.”

If I know my readership well, your gut response to Mankiw’s story is probably the same as mine—this is slightly gross / evil / insane (and, this guy really loves Broadway!). But prices allocate scarce goods to those with a combination of high incomes and high desire for the good, and for all its flaws, this system works better than any other for distributing luxuries like Broadway tickets.

Prices gone wild

But price-based rationing doesn’t work as well for basic needs—stuff like college education and healthcare. Even the most capitalism-loving among us would agree that the premise of the system is a level playing field for all participants, and that equal access to quality education and good healthcare are prerequisites. The problem is that these prerequisites are increasingly being priced like Hamilton tickets.

Over the past forty years, the price of college education and healthcare have soared, but the bottom 40% of American households have not experienced any income gains to help offset these costs. It goes without saying that these households have the same human needs as the top 60%, whose incomes have risen. As a result, spending on healthcare is a major driver of American poverty.

If the trends of income inequality and high prices continue, this will increasingly become a problem for the middle class, too. According to surveys from Pew Research, Americans who identify as Republican and Democrat are far apart on most issues, but agree that high healthcare and education costs are bigger problems in America today than racism, jobs, drug addiction, or climate change.

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Why are healthcare and education so expensive?

There are many theories about what is driving up costs in these two sectors. But they all seem a bit flimsy to me.

Take education: one theory about the cost of higher education is that rising tuition is due to administrative bloat: too many administrators pushing paper. But this is belied by the fact that in K-12, where administration is not growing, costs are rising at the same pace. In fact both teacher and college professor pay has lagged behind the increase in general prices since the 1970s.

Another theory is that college costs are rising because of an arms race amongst private colleges to attract students with fancy amenities. As Elizabeth Warren put it:

“Some colleges have doubled down in a competition for students that involves fancy dorms, high-end student centers, climbing walls and lazy rivers—paying for those amenities with still higher tuition and fees”

Elizabeth Warren

But tuition costs are rising at the same pace at public colleges, where such facility arms races are largely absent.

And while the amenities arms race seems to be a recent phenomenon, college tuition has been rising rapidly for much longer. The amenities arms race can’t explain the persistent ballooning of tuition over time. As economist Alex Tabarrok writes:

“The lazy rivers do exist. But to explain increasing costs, the bloat theory requires longer and lazier rivers every year, and the data do not fit that story. Bloat and complaints about bloat are probably as old as the university itself.”

The conventional explanations for rising healthcare costs are also unsatisfying.

Is the villain those blood-sucking insurance companies? Actually, their profit margins are quite small. In fact, health insurance companies are much less profitable than almost every single other American industry.

Another explanation about the uniquely expensive nature of US healthcare focuses on our litigiousness: malpractice lawsuits drive up costs. But medical malpractice payments account for about $12 of the $10,000 spent annually on healthcare per person. As Tabbarok writes,

“A bloated little toe cannot explain a 20-pound weight gain.”

This is not to say that administrative costs in education, or the profit motive in healthcare, or other sector-specific drivers are not partly to blame for high prices. But there is something deeper at play: prices for education and healthcare have gone up quickly, year after year, for decades, and not just in the US but around the world. And it seems the richer any society is, the more they have to spend on these items.

We need a better explanation for what’s going on here.

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Baumol’s cost disease

Sometimes I come across an economic idea that is so useful and elegant that I am reminded of why I studied economics at college and grad school despite my, er, questionable math skills. That’s the case here: “Baumol’s cost disease” is by far the best explanation for high prices for education and healthcare. (As an aside, I think Baumol might be my spirit-economist; he made “computer art” and wrote a lot about the economics of artistic fields.)

His theory is straightforward: technology helps us become more productive in making things—like cars, TVs, and clothes—but doesn’t help much in making us more efficient in providing services, like healthcare or education. Over time, these differences in productivity show up in lower prices for goods, and higher prices for services:

“The items in the rising-cost group generally have a handicraft element—that is, a human element not readily replaceable by machines—in their production process, which makes it difficult to reduce their labor content. Items whose prices are falling are predominantly manufactured via more easily automated processes. Their steadily falling real costs simply reflect their declining labor content.”

William Baumol, The Cost Disease

Real-world examples are not hard to find. Look at auto production. When Ford started making cars in the early 1900s, it took 12 hours to produce one car. When Ford created the production line in 1913, production time dropped to under 2 hours. Today, Tesla barely even uses humans to make cars; at their assembly plant in Albuquerque they have 600 different kinds of robots that do most of the heavy lifting. As a result, the few humans that do work there are insanely productive.

This is the case across all manufacturing industries: technology has boosted the productivity of labor.

By contrast, it’s difficult to use technology to boost productivity for most services. Baumol illustrated this with the example of a Mozart quartet: it took them 7 minutes and thirteen seconds to play the Piano Concerto number 21 in C major in 1785, and it takes them the same amount of time today. They’ve become no more productive!

The fact is that in the services sector, most of the time what we are paying for is the labor itself. Labor-saving technology doesn’t work. We can’t ditch the violin player in Mozart’s quartet, or have them play the concerto faster.

And so there is nothing fundamentally different about healthcare and education. They have grown more expensive because, like all services, they are resistant to technological efficiencies—which is to say, they are powered by human beings, specifically, teachers and doctors. It’s no coincidence that we describe insufficiently empathic doctors as having a robotic bedside manner. A robot can’t replace your child’s third grade teacher.

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The Baumol-based solution

Now that we have a decent understanding of what’s driving up prices, a solution becomes clearer. The most important takeaway is this: prices don’t matter, incomes do. Prices merely tell you about tradeoffs: because we have become so much more efficient at making cars, but only slightly more efficient at providing healthcare, one unit of healthcare now “costs” many more units of car than it used to. But our efficiency at car-making made the whole country wealthier. The steeper tradeoff between healthcare and cars doesn’t actually matter: overall, the country can have more of both.

So the problem isn’t so much about us not being rich enough for healthcare and education—it’s that the gains from higher productivity have been unequally distributed. Sure, wealthier households are enjoying more cars and more healthcare, but the bottom 40% of US households haven’t participated in the income gains. Yet they still need to pay the high cost of healthcare.

So far, this has been a problem primarily for poorer households. Over the past forty years, the median household has seen incomes rise enough, and a big enough cheapening in food, clothing, and other items, to offset the higher price of basic services.

But Baumol’s logic predicts that, unless we reverse income inequality, or become much more productive in producing healthcare and education—and both seem very unlikely anytime soon—these things will become increasingly unaffordable to even the middle class.

I’m from the government and I’m here to help

We need to reframe our understanding of the correct degree of government funding for these services. If government is in the business of providing all households, regardless of income, with access to basic human needs—and these human needs are disproportionately in the less productive sectors of the economy, where costs are growing—then government will naturally grow larger. To prevent this growth, to ‘starve the beast’, as many conservatives would like, would curtail access to the basic needs that the country—overall—can amply afford.

Baumol himself argued that, although his “cost disease” is actually a reflection of efficiency gains in some parts of the economy, and is not problematic for the wealthy because of their accompanying rise in incomes, the government will still have to intervene—and increasingly so:

“Even if this analysis is correct, and society will be able to enjoy an increasingly abundance of health and educational services, their rising real price can nevertheless deny them, increasingly, to the poor, and even more likely, to the middle classes. In a rich economy, that is hardly acceptable, and government will no doubt have to intervene to provide the means for the economically underprivileged to get their share of these and other vital services affected by cost disease.”

William Baumol, Children of the Performing Arts: the Economic Dilemma

But he also foresaw that people would have a hard time getting their heads around this, and that explaining it to the general public would be key:

“One can hardly blame such persons for their reluctance to be taken in by what appears to be a sleight of hand or mere theoretical gobbledygook...yet the task of explanation to the public should not be beyond the most skilled of journalists and others who specialize in the art of effective communication. And an indispensable task it is, for without it effective budgetary reorientation along the lines described will undoubtedly be impossible in a democratic society.”

The risk is that economists are not in fact gifted communicators, and that although 90% of them agree that immutable productivity differences in the economy are driving up prices for basic services, the general public sees rising subsidies as government ineptitude and waste.

In that case, it may not be until the real costs of underfunding public services becomes painfully clear that we start to make provisions for universal access to them.

As British economist RH Tawney feared:

“It is not till it is discovered that high individual incomes will not purchase the mass of mankind immunity from cholera, typhus, and ignorance, still less secure them the positive advantages of educational opportunity and economic security, that slowly and reluctantly, amid prophecies of moral degeneration and economic disaster, society begins to make collective provision for needs no ordinary individual, even if he works overtime all his life, can provide himself.”

I hope we make that collective discovery sooner than later.