Cost disease

How wages rise even when there is no significant increase in productivity

Published - April 26, 2022 10:30 am IST

Also known as Baumol’s disease

Also known as Baumol’s disease | Photo Credit: Getty Images/iStockphoto

Cost disease also known as Baumol’s cost disease, refers to the increase in the wages of certain labourers even though their productivity or skill level has not risen commensurately. This happens because there is competition between various industries for the limited supply of labour. So, even if the productivity of their employees has not risen significantly, employers in many cases have no choice but to pay higher wages in order to prevent the movement of labourers to other higher-paying industries. It should be noted that labour is often a kind of non-specific resource that can be used across various industries.

Let’s take the case of an agricultural economy where wages are at a certain level. Now suppose that a manufacturing industry suddenly crops up and bids labour away from the agricultural sector. This will raise the wages of labourers and employers in the agricultural sector will have no choice but to pay higher wages to prevent all their labour from moving into the manufacturing industry. This process of bidding higher wages for labour will continue until wages rise to a certain level at which there are no profits to be made by entrepreneurs in carrying out the arbitrage of labour from the agricultural sector to the manufacturing sector. In the end, the wages of labourers in the agricultural sector would have risen higher than what they were earlier even though there has not been any improvement in the skill levels of agricultural labourers. Higher wages will reflect in the price that consumers will have to pay for agricultural goods and services. Consumers of agricultural products will now have to pay higher prices in order to retain the labour force that is required to produce agricultural products.

In essence, there is no perfect link between the productivity of labour and wages. Even when there is no increase in the skill level of employees in a certain industry, wages of labourers in that industry may rise significantly due to competition among employers of different industries to hire scarce labour. This is, however, not to say that productivity has no influence on real wages. But the effect of productivity on real wages is on the broader, macroeconomic level: when the productivity of factors of production rises, this leads to an increase in the overall production of goods and services in the economy as a whole, which in turn increases the amount of goods that can be purchased with the wages earned by a labourer.

Different case studies

The idea of cost disease was proposed by American economists William J. Baumol and William G. Bowden first in their 1965 paper “On the Performing Arts: The Anatomy of their Economic Problems.” In this paper the authors studied why the wages of musicians has increased over the centuries even though the productivity of these musicians has not really improved very much over the same time period. The idea has been used to explain several other real-life cases where wage movements have not been in tandem with changes in productivity. For example, Baumol in a 2012 paper used the idea of cost disease to also explain why healthcare costs in the United States have risen while the cost of computers has dropped over time. But the extent to which the cost disease can explain rising costs in certain sectors of the economy is a matter of considerable debate among economists. Many economists believe that rising costs in many sectors may simply be due to heavy regulations and other supply-side factors that may be restricting output in these sectors and causing prices to be higher than they would be otherwise.

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