What do People Spend all That Extra Money on?

Dietrich Vollrath on Baumol’s cost disease, in response to Scott Alexander:

"Alexander goes through education, health, and government services, effectively documenting the cost disease. He crystallizes this by asking the following kind of question. “Which would you prefer? Sending your child to a 2016 school? Or sending your child to a 1975 school, and getting a check for $5000 each year?” ...

"Alexander’s implicit answer to all these questions is that you would choose the the second option; the older level of service plus the cash. Much of the post is spent explaining that the service offered today is of no better quality than the service offered a generation ago. ... Let’s stipulate that the quality of healthcare and education have not changed in a generation ...

"Here’s the question that Baumol implicitly asked himself. What do people spend all that extra money on? They could use it towards a new car or a major appliance, both manufactured goods. ...

"But they might spend that extra five or eight thousand dollars to finally take a well-deserved vacation, meaning it is spent on tourism and hospitality services. Or they may well decide to spend that money sending their kids to a better (and more expensive?) school, or putting them in a full time daycare rather than part-time. …

"From Baumol’s second insight, the demand for these kinds of services is income elastic and price inelastic. Which means that a huge part of the money people get back from Alexander’s thought experiment is plowed right back into education and healthcare. What does that do? It shifts the demand curve out for healthcare and education. And then what happens? The price goes up, and the actual amount of new health care or education acquired is not that large. Moreover, there is no appreciable decline - and there may be an increase - in the share of total GDP accounted for by healthcare and education.

"This is the same outcome Baumol described, even though for him the origin of this was a productivity increase in the goods sector. But the origin of the productivity increase is unimportant, what matters is the structure of demand for services. So long as our demand for services is income elastic and price inelastic, the share of healthcare and education in GDP are going to rise as we get more productive ...

"I think Alexander’s post is one example (of many) taking the “disease” part of “cost disease” too literally. Rising costs in education and healthcare do not always represent a pathology. In a lot of ways we are the victims of our own prosperity and preferences here. There is nothing about Baumol’s analysis that implies living standards are lower or welfare is impaired by the cost disease. Remember that the cost disease is a consequence of productivity improvements in the first place."