Baumol effect

In economics, the Baumol effect, also known as Baumol's cost disease, first described by William J. Baumol and William G. Bowen in the 1960s, is the tendency for wages in jobs that have experienced little or no increase in labor productivity to rise in response to rising wages in other jobs that did experience high productivity growth.^[1][2] In turn, these sectors of the economy become more expensive over time, because their input costs have increased while productivity has not. Typically, this affects services more than manufactured goods, and in particular health, education, arts and culture.^[3]

This effect is an example of cross elasticity of demand. The rise of wages in jobs without productivity gains derives from the need to compete for workers with jobs that have experienced productivity gains and so can naturally pay higher wages. For instance, if the retail sector pays its managers low wages, those managers may decide to quit and get jobs in the automobile sector, where wages are higher because of higher labor productivity. Thus, retail managers' salaries increase not due to labor productivity increases in the retail sector, but due to productivity and corresponding wage increases in other industries.

The Baumol effect explains a number of important economic developments:^[3]

• The share of total employment in sectors with high productivity growth decreases, while that of low productivity sectors increases.^[4]
• Economic growth slows down, due to the smaller proportion of high growth sectors in the whole economy.^[4]
• Government spending is disproportionately affected by the Baumol effect, because of its focus on services like health, education and law enforcement.^[3][5]
• Increasing costs in labor-intensive service industries, or below average cost decreases, are not necessarily a result of inefficiency.^[3]
• Due to income inequality, these services can become unaffordable to many workers when prices rise faster than their incomes. This happens despite overall economic growth, and is exacerbated by rising inequality in recent decades.^[4]

Baumol referred to the difference in productivity growth between economic sectors as unbalanced growth. Sectors can differentiated by productivity growth as progressive or non-progressive. The resulting transition to a post-industrial society, i.e. an economy where most workers are employed in the tertiary sector, is called tertiarization.