We except prices to go up over the time. But why then some sectors’ prices are relatively higher than other sectors, like difference of prices in health care and manufacture? The theory of Baumol effect will explain you everything.

What is Baumol effect?

Baumol Effect refers to rising cost of labor-intensive services with little or zero productivity growth in regard to rising wages in sectors with relatively higher productivity growth. Also known also as Baumol's cost disease, this famous theory was proposed by the American economists William Baumol and William Bowen in 1960s.

Let's see several examples to better understand the theory.

Think about, a musical performance, string quartet in 1850s. It takes four people 40 minutes to play this string quartet. Now, let's think about the same string quartet in 2023- live performance, same four people. It still takes them 40 minutes to produce the music. But the price you pay to see performance has gone up way more than the price in past. The reason is, Baumol himself was trying to understand and noticed, even if productivity of performance remained the same for several decades, cost of attending performance and musicians’ salaries have become higher, since worker productivity and wages of people increased in many other sectors of economy, like manufacturing for instance.

Increase in labor productivity tends to result in higher prices. If the manufacturing company implements modern practices, better equipment and technologies and hire more people to rise productivity and profits, salaries of people will also increase considerably, rather than staying stagnant. Baumol effects says that sectors, whose productivity growth is slow and not efficient at producing their goods or services, will still rise wages of workers. Otherwise, they may quit the jobs and positions, where they much needed.

The health care and education sectors fall into this category. In USA, these services offer employees high prices even knowing that labor-productivity doesn’t go up much from year to year. The health care and education sectors still have to pay wages that can compete with other sectors of the economy that do have fast productivity growth because, otherwise, not enough people would become doctors, nurses, teachers and professors. You may be wondering, how the wages are covered in slow productivity growth sectors like health care, education or music services. The way that these sectors pay those higher salaries is by raising the prices of what they sell, like tuition fees, medical supplies and services, ticket prices and etc.

Baumol’s cost disease has more implications far beyond example above. It implies that in a world of rapid technological progress, we should expect the cost of manufactured goods — cars, smartphones, T-shirts, bananas, and so forth — to fall, while the cost of labor-intensive services — schooling, health care, child care, haircuts, fitness coaching, legal services, and so forth — to rise. (Data). These services are necessarily expensive because it takes a lot of human labor, time and perseverance to provide them, and those human workers deserve to be paid well.

Conclusion.

But why then there is still innovation along with slow productivity in some developed countries like USA. As manufacturing sector becomes efficient, it provides more cheaper products (thanks to competition among companies). At some point we may not need several T-shirts or 4-5 different types of televisions. The savings that are coupled in our bank account, we rather spend on things like education, health care, child care and others. As a result, more and more of our economy is devoted to producing these services, and more and more workers are focused on providing them.

You may think about rise of robotics and AI, which may replace many jobs in many sectors, equally in health care and education. But it doesn’t mean that everything will be automated. We rather want to have hands-on services from doctors and nurses, or nannies to take care of our children, instead of modern technology with diverse capabilities. Hence, Baumol helps us understand not only today’s economy but economy in the future will still experience Baumol effect. Cost of health care and education highly-likely will continue to increase as it has increased in the past 2-3 decades and there will be still a need for these labor-productive services in the future.

If you would like to further understand this theory and get valuable insights, we encourage you to listen this 3-minute podcast.

Thank you for attention.

Capitalism is an economic system in which private owners and individuals control property and businesses in accord with their interests, with minimal government interventions. Prices and the distribution of goods are feely set according to the demand and supply in markets. The core idea of capitalism is motive to make a profit.

Capitalism is ideally meant to function as a free market economy, in which competition among several companies and businesses result in the cheapest and highest quality products.

The term capitalism originates from word capital which takes its roots from Latin word “capitale” meaning “head”. It basically referred to sum of money, funds, stock of merchandise.

But how capitalism actually emerged? History of capitalism.

Capitalist practices existed for many years in different forms. For example: in the form of merchant, renting and lending activities and occasionally as small-scale industry with some wage labor and trading.

The modern form of capitalism emerged from agrarianism in 16th century England and mercantilist practices by European countries in the 16th to 18th centuries. Globalization of Capitalism continued during 19th-20th, with Industrial Revolution and World War I, II playing essential role in its development.

Adam Smith is often identified as the father of modern capitalism. Smith believed that economic development was best fostered in an environment of free competition and each individual would choose to engage in the economic activity in which they had a comparative advantage and that would best benefit them.

What countries are capitalist?

·        The United States of America.

·        Canada.

·        Australia.

·        Germany.

·        The United Kingdom.

·        Japan.

·        South Korea.

As you can see most developed country adopt capitalist economy, since there are more opportunities to compete and make a profit in global scale.

In the US, big corporations like Apple, Microsoft, and Google are owned by private individuals and, thus, have unleashed productivity in many industries. Even though these companies are quite profitable, they are still pursuing programs that benefit their employees, the environment, and all of society.

Benefits of capitalism

Capitalism is driver of innovation, wealth and prosperity in modern era. Since there is huge competition between private owners and companies, both will try to constantly make innovation, adopt new practices, implement state-of-the-art technology and improve quality of production and services. Capitalism meets the needs of the people and is beneficial for societies as a whole. Importantly, there is opportunity for taking risk which is essential in development of both businesses and economy.

Another positive side of capitalism is that it is self-regulated through competition, which means government will not set restriction for setting up new company or business. It allows choice and freedom, where consumers have rights to choose products they need or desire.

Market is more flexible and mobile. Position of individuals in the wealth hierarchy can change and is not established by law or custom. There is more chance for economic prosperity and improvement.

Drawbacks of capitalism

Capitalism is based upon economic inequality and does not promote equal opportunities for everyone. Some big firms and companies may control production sector, overshadow small one and weaken competition, essential feature of capitalism, and may result in monopoly.

Capitalism sometimes ignores social needs, which means people who are disabled or unable to work (retired) may end up with fewer opportunities or money, because main priority here is profit over the needs of people.

Capitalism may be harmful for environment as private owners aim for monetary gain and promotes mass consumption and extensive usage of natural resources.

In conclusion, even though there are disadvantages of capitalism, it is main factor in the prosperity and development of country. In capitalist economy, people can own and control private property such as land, houses, stocks and bonds, since central government will not take away property and set restrictions on performances of businesses. Capitalism facilitates freedom and opportunity and consumers have rights to choose and decide what and how much to buy. Price of goods and services may rise and drop (fluctuate) as much as quality, since competition between companies will contribute to better, cheaper and high-quality products.