Question

Explain Baumol’s disease using graphs

Answer 1

Baumol's cost disease, also termed as Baumol effect refers to an increase of salaries in jobs that have experienced low or no rise in labor productivity, in response to increasing salaries in other jobs that have gained higher productivity growth of labor. It provides an explanation on why prices for the services offered by people especially the dependent professions with low growth of productivity such as (arguably) health care, education, and the arts; keep increasing, even though the amount of products and services each worker in those industries generates hasn’t performed the same necessarily.

Example: Assume we have a two-good economy, Bikes and Education. The production possibilities frontier depicts the various combinations of Bikes and Education that an individual can afford at a given technology and resources at time 1 (PPF-1). Let us assume that society prefers to consume the bundle of goods depicted by point (a). The slope of the PPF at that point provides the relative price of Bikes and Education. At time 2, productivity has increased thus indicating that with the same resources the consumers can have more of both goods; thus the curve shifts out more towards Bikes than towards Education. In case the society continues to consume at point (b); i.e. Bikes and Education in the same proportions, price of education is likely to increase. To know and determine it a detailed analysis of the special factors of education on it's government purchases, insurance, regulation, unionization, international trade, and so forth need to be done. Moreover in society it appears that with greater wealth we are likely to consume more of the goods such as health care and education that have relatively slow productivity growth. Therefore, preferences have magnified the effect of Baumol disease.