Thursday, December 4, 2008

Econ 101: Cost Disease

This provocative picture from the New York Times show just how quickly college costs are outpacing inflation. [Though it is important to note that this is the sticker price, many students get some form of financial aid which reduces their cost considerably]

This type of data is not new and always begs the question, are colleges and universities to blame for not being able to keep costs under control?

Perhaps not. In economics we talk about something called cost disease. Cost disease refers to industries that do not see productivity gains over time similar to other industries. Take a simple example (and the classic example of Baumol who coined the term): A string quartet takes the same amount of time and the same amount of people to perform a piece today as it did 100, 200 or even 300 years ago. Compare that with, say, the amount of time it takes to produce a knit sweater - a fraction of the time on a big mechanical loom than it did 200 years ago. Thus the string quartet has become relatively more expensive over time - in the same amount of time it takes to perform the piece we could now knit 100 sweaters, rather than 1/2 of one we could have knit 200 years ago. So what we would experience over time is the cost of performing by this quartet would vastly outpace inflation. Why? Well, inflation, or the CPI, is a measure of AVERAGE price increases. So industries that have below average productivity gains, like string quartets, will see their prices rice faster than average, or outpace the CPI.

To restate this more generally, over time most industries see productivity gains, some faster than others. How cheap or expensive a product becomes in relative terms is largely a function of this productivity gain. And this works both ways as well. For example, personal computers today are a much smaller purchase as a part of a budget then they were 10 or 20 years ago. If I were to draw a graph like the one above with computing power per dollar versus the CPI, the CPI would be going up but computing per per dollar would be going down sharply.

Universities have economized in many ways (for example the use of computers in registration) but the essential function of teaching and learning is still relatively the same as it was 100 years ago. Sure we have bigger lecture halls aided by microphones and video screens, this helps a little but, but the process of teaching and learning is not conducive to huge productivity gains over time. Since most of a college or university's budget is tied up in professors, there is not a lot of economizing that can be done.

Which is to say that it is natural for university costs to increase faster than the CPI. 30 years ago, an Apple IIE might cost the same as one semester's tuition. Now, you can buy about about 10 desktop computers that are about 100,000 times more powerful than that Apple for the price of one semester's tuition.

The point is that there is nothing necessarily sinister about this increase, and, more importantly, it will NEVER go away. What we must do is accept it, while being ever vigilant to get as much efficiency improvement as possible, and start coming up with better policy solutions for it.

In the end it is all a matter of perspective. For $300 I bought an iPhone that is more stocked with technology than I could have even imagined 20 years ago - that is the payoff to living in the 21st century - I get to pay much less for this stuff. The other side of this coin is that classroom based learning is pretty much the same as always and so I have to pay more for that. The hard part is that what is by far most important in the 21st century is the hard stuff - the education - and not the iPhone.


Oliver said...

Does "cost disease" also explain why the cost of healthcare has exploded?

Radies Man said...


The string quarter is considered art. Arts appreciates over time. You to consider value instead of productivity in measuring something abstract like so.

Now, if you were to compare the reproduction of painting from 1700s to that of 2009, you can see immense productivity gain.

Sure the universities cost more today than in the past, and in cases, increase faster than CPI. (But you and I both that know the government removes anything that increases the CPI too much, like energy but that's another story).

You said that the teaching and learning process is the same now as it in the past. I agree. But you neglected to mention the tools that are used to teach. In the past, if you learn computer science, you can share the computer with 100 other people. Nowadays, every student has a computer in the lab. And instead of 10 students dissecting a pig, each student has his own pig or two.

Another example is that in the past, professors have not a lot of professional options to go. Today, with businesses competition for their talents, they can command higher salary.

Fine, if you don't want to pay that finance professor 250k, a company will. Thus, in order to attract top talent, schools usually have to offer very high calibre professionals. And these guys' salary appreciate much higher than CPI.