My Thoughts on Cost Disease

Scott Alexander writes

Any explanation of the form “administrative bloat” or “inefficiency” has to explain why non-bloated alternatives don’t pop up or become popular. I’m sure the CEO of Ford would love to just stop doing his job and approve every single funding request that passes his desk and pay for it by jacking up the price of cars, but at some point if he did that too much we’d all just buy Toyotas instead. Although there are some barriers to competition in the hospital market, there are fewer such barriers in the college, private school, and ambulatory clinic market. Why hasn’t competition discouraged administrative bloat here the same way it does in other industries?

1. At any given time, you will have sectors where demand is growing faster than productivity (think of health care and education) and other sectors where productivity is growing faster than demand (think of manufacturing). In the sectors where demand is growing faster than productivity, you have rising relative prices, or “cost disease.”

2. In health care and education, you also have a lot of government intervention, and government intervention almost always takes the form of subsidizing demand while restricting supply. Of course, that is going to cause relative prices to be higher, thereby exacerbating “cost disease.”

3. I would argue that there are plenty of barriers to competition in the college market. Accreditation is one such barrier. But there are natural incumbent advantages as well. You may be able to enter the market for high school graduates who are in no way prepared for college. But trying to enter the market at the level of a top 100 college is nearly impossible.

4. There are plenty of barriers in health care, also. Clinics are a good innovation, but the real expenses in health care are in chronic illnesses, and clinics do not compete to treat diabetes, Alzheimer’s, and so on.

5. It is in the nature of organizations for middle managers to try to build empires, adding to cost without necessarily creating value. In for-profit businesses, the owners have an incentive to check this, because the owners want to maximize profits. In non-profits, the natural checks operate only when revenues are not rising to cover the cost of expansion. Non-profits only worry about the bottom line when it threatens to go negative.

In short, some “cost disease” is natural. At any given time, some industries will have demand growing faster than productivity. However, much of it is artificial, as government subsidizes demand and restricts supply. Finally, some of it results from the fact that non-profits are less efficient than for-profit firms.

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11 Responses to My Thoughts on Cost Disease

  1. BenK says:

    It is closely tied to systems where one person buys, one person sells, and a third person pays.

  2. Roger says:

    Well said. Much better than reading through the hundreds of comments in Scott’s blog.

  3. Jeff R. says:

    To me, it seems like the restrictions on supply have to be a big part of the story here. Other sectors of the economy are, in contrast to your #1, increasing productivity faster than demand rises and therefore produce the same output with fewer inputs over time. On net, then, we’d expect workers to be moving out of those sectors (at least on a per capita basis) and into the sectors with stagnant productivity and rising demand, which would at least have the effect of increasing supply and thus keeping prices from rising. We’re not seeing that, of course.

    There are some obvious problems here, of course, in that an unemployed coal miner is not likely to go and get a job as an economics professor for reasons having nothing to do with government fiddling in the market for either education or coal, but in general, I still think restrictions on supply are perhaps the major part of the story. High levels of skilled immigration, for example, ought to have helped control costs in these sectors, one would think. In practice, this hasn’t happened, as, say, doctors trained elsewhere can make substantially more money working in the US, and so of course doctors from all over the world would like to move here, and many have, but then we force them all to do a residency before they can practice medicine here, the number of residency slots is heavily rationed, and thus the increase in supply of doctors amounts to virtually nothing.

  4. Lord says:

    There are areas where cost and quality, or price and value, can be readily distinguished and markets work well in such areas. In areas they can’t, cost becomes the measure of quality and price that of value. Competition then shifts from increasing supply to increasing price. The only bound on price becomes the available income and the price and importance of other such goods.

  5. Luke Edwards says:

    Berkeley’s office of Equity and Inclusion employed 150 people as of 2014. You can get away with a lot of bloat when you’re selling scarce prestige financed on someone else’s dime.

  6. Tom G says:

    Huge college costs are quite different than huge medical costs, and far more “signalling” than true value for high tuition (and hundreds of administrators). There really are ways to educate most folks much cheaper, while their ability to think afterwards will be as good as or better than now. MOOCs and other lower cost alternatives are coming, tho slowly.

    A true complaint of markets is that they often get the good result far more slowly than fast gov’t action orders would have gotten there. Tho with markets, the there you get to was gotten to peacefully, and voluntarily.

    In health care, it’s very disappointing how few med schools there are in the US — with far more college grads willing and able to go than there are slots. The limits on supply of medical care are far more clear — and the demand is insatiable.

    At every level of expenditure, there will be sick people dying who, with more money spent, could have been kept alive longer. This is likely to remain true for the rest of our lives.

  7. MichaelG says:

    Does any of this explain why subway construction (one of his examples) is more in the U.S.?

    • Handle says:

      1. The NYC example seems to be a particularly bad outlier, and

      2. What does the legal process of designating property for public infrastructure look like in other countries?

      People are used to thinking of legal costs as being a small portion of total expenses, but my guess is that poltical/law-related costs can really multiply the cost of certain big projects and special services by an order of magnitude or more.

      That’s one reason competition can’t bring down prices, because every bidder faces the same legal burdens, and those can’t be reduced without breaking the law. When legal costs are 10%, that gives you some room to trim costs in the 90%. But when they are 90%, there is no slack to discover meaningful new efficiencies.

      And it’s also the reason why the problem is so impossible to change. Because, in isolation, each law-related requirement is marketed as “protecting people’s rights” or “protecting the environment”, which not only numbs cost-benefit thinking in each individual case, but makes it impossible to complain about the aggregate cost-ballooning and paralyzing effect of their combination, because in our system each legal issue must be addressed and debated one at a time.

      You end up with a lot of legal straws on the camel’s back, and each straw is precious, so the camel groans under his burden. Until his back breaks.

      • Paul Ralley says:

        New York is also very complicated below ground. There are many, many pipes, wires, tunnels, sewers, graves etc. London has a similar problem.

        If the cost of getting through all that is too high, the subway won’t be built at all.

        NY and London can afford the lines, so they get built at high cost. Rome (where every building has an undiscovered Roman god underneath it seems) the cost is effectively infinite – there are only 3 lines in Rome (that don’t go to the airport).

  8. Handle says:

    I would like to propose the creation of a new research project or center dedicated to “comprehensive international comparative auditing and forensic accounting”. In other words, follow the money flows, for all kinds of markets, and show the buckets into which the pipes of more expensive systems are leaking.

    On a different note, your use of the term productivity is apt in the abstract, but I think there’s a danger of people misinterpreting it in this case of the discussion of cost disease.

    Partially that’s because cost disease seems to vary a lot internationally, but much of the real work in similar trades is being performed using similar techniques, practices, and methods. Indeed, if it were just a matter of differential mechanical or organizational efficiency, then firms in cheap places would compete across borders and eat expensive firms’ lunches. But that doesn’t happen. Instead, the bulk of surplus costs seem to have a lot to do with geography and little to do with efficiency, and that points to law/politics as the culprit.

    We can think of productivity in terms of production functions that transform real inputs into real outputs, or in terms of functions that transform nominal costs into nominal revenues.

    For a real example, we could say it takes one man and one tractor to make one apple per year. Let’s also say the demand for apples is very price inelastic.

    For a nominal example, we could say the prices of men and tractors are $1 each, and the current price of apples is $2.40 each (i.e. 20% profit).

    Ok, now let’s say the government taxes each apple sale by $2, and redistributes it to someone else. The price of apples goes up to about $4.40 because demand is so inelastic.

    Is this really “cost disease due to decreased productivity”?

    Well, on the real side, nothing changed at all. In fact, we could practically double efficiency (that is, ‘real productivity’), with one man and one better, but same-priced tractor now making two apples a year. And yet prices would still rise.

    On the other hand, if the apple sales tax is considered a cost just like wages and interest, then nominal ‘productivity’ has plummeted.

    And my guess is that various kinds of law-related requirements operate in a similar fashion to the theoretical tax in the example above. That is, the law requires firms to spend more money than they need to, and this money is redistributed to people who don’t really contribute anything important to output.

    The difference is, when this process is operating explicitly as a government tax-and-redistribute scheme, then we usually don’t say that productivity has changed. When the law has an equivalent effect, but is more obscure and subtle in that it requires firms to internalize these transfers, then it looks like a productivity issue.

  9. andrewknoor says:

    One good aspect of 3H (housing, healthcare, higher ed) cost inflation is that each is mostly avoidable. You don’t have to pay for expensive college, buy an expensive house, or pay for a cadillac plan (although Obamacare made that more difficult). It/s not that difficult to live cheaply in the US, as long as you are willing to self-insure.

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