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The Tabarrok rejoinder

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Alex Tabarrok writes,

The problem with Bryan’s critiques is that they miss what we are trying to explain which is why some prices have risen while others have fallen. Immigration would indeed lower health care prices but it would also lower the price of automobiles leaving the net difference unexplained. Bryan, the armchair economist, has a simple syllogism, regulation increases prices, education is regulated, therefore regulation explains higher education prices. The problem is that most industries are regulated.

Suppose that there are two sectors, apples and string quartets. We observe that over the past 30 years, the relative price of string quartets has risen.

Using basic supply and demand analysis, we know that this could be a combination of four things:

1. A favorable shift in the supply curve for apples.
2. A downward shift in the demand curve for apples.
3. An unfavorable shift in the supply curve for string quartets.
4. An upward shift in the demand curve for string quartets.

The “Baumol effect” story says that it’s almost entirely (1). The main claim that Tabarrok and Helland make in support of this view is that the change in relative prices has been steady, so we need a steadily-changing factor to explain it. Regulatory changes are more herky-jerky. Bryan Caplan objected to this, and Tabarrok comes back with some new arguments.

Here, for example, are two figures which did not make the book. The first shows car prices versus car repair prices. The second shows shoe and clothing prices versus shoe repair, tailors, dry cleaners and hair styling. In both cases, the goods price is way down and the service price is up. The Baumol effect offers a unifying account of trends such as this across many different industries. Other theories tend to be ad hoc, false, or unfalsifiable.

Oh, please. In 1950, imports of shoes and cars were low. In later decades, they shot up. But car repair and shoe repair don’t face import competition.

In fact, it could be that the main reason that the prices are relatively high in health care and education is that they do not face import competition. That also would explain why a lot of us don’t feel richer. If the favorable supply curve shift were all due to domestic productivity gains, our incomes would be a lot higher. But a lot of the favorable supply curve shift comes from foreign supply added to the market. That is not a Baumol effect, It is a traded goods/non-traded goods effect.

Questioning the Baumol-effect story

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Scott Alexander writes,

Factory workers are not getting paid more. That makes it hard for me to understand how rising wages for factory workers are forcing up salaries for violinists, teachers, and doctors.

. . .College really does seem to be getting less affordable. So do health care, primary education, and all the other areas affected by cost disease. Baumol effects shouldn’t be able to do this, unless I am really confused about them.

Suppose that the economy consists of apples and string quartets, and productivity doubles in apple picking. The Baumol-effect story is that we are now richer, and we can afford to spend more on both apples and string quartets. The increased spending on apples is more than offset by the higher productivity, so apple prices fall. But the productivity of violinists stays constant, so the increased spending on string quartets causes their prices to rise.

As I see it, Alexander is asking: if this is the scenario, then why does it seem as though the apple pickers have not gotten richer?

In a straightforward Baumol-effect story, when the productivity windfall hits the apple industry, some workers should be released from the apple-picking sector to work as violinists, so that we now have more string quartets as well as more apples. Everyone is richer.

Instead, Alexander’s data and anecdotes seem to indicate that we have had a big redistribution of income away from apple pickers and toward violinists. How do you get that? A combination of very inelastic demand for apples and little ability to shift from apple picking to string-quartet playing? That would seem necessary, but it may not be sufficient.

Note that in our national economic data, concepts like “real wages” may be calculated using price indexes that are constructed in a way that treats the demand for apples as totally inelastic, regardless of whether this is actually true. So perhaps the absence of real wage growth in the data is a mere statistical artifact, which opens up a different kettle of worms entirely.

So here is the issue: if Tabarrok and Helland are correct that the Baumol effect explains rising prices in health care and education, then it seems that we should have observed broad-based increases in real incomes. Instead, what we seem to have experienced is a significant redistribution of incomes toward the providers of services in health care and education. If so, then the Baumol-effect story may not suffice, and we need another explanation.

“Subsidize demand, restrict supply” comes to mind.