The Cost Disease and its Implications for an Ageing Society

Policymakers should be more circumspect about some of their long-held assumption in healthcare such as their belief that healthcare is always a form of consumption spending to be minimised;

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Policymakers should be more circumspect about some of their long-held assumption in healthcare such as their belief that healthcare is always a form of consumption spending to be minimised; that competition and market-mimicking reforms in healthcare improve efficiency among providers; and that emphasising individual responsibility keeps the health financing system sustainable. Donald Low and Yeoh Lam Keong argue for these assumptions to be re-assessed.

Ageing societies, especially in the developed world, are confronted with the prospect of ballooning healthcare costs amplifying pressures on their stretched fiscal resources. Combined with an anaemic recovery from the crisis and high levels of public debt in many of these countries, it seems that governments would be well-advised to consider how they can trim their state-financed safety nets in healthcare, pursue efficiency gains and cost savings, introduce tight caps on public spending, and even find ways to privatise parts of healthcare so as to shift more of the costs to citizens and improve cost discipline. Only with such drastic measures, it is often argued, can these countries avert a looming fiscal crisis, a crisis that would otherwise be unavoidable because of ageing populations and the shrinking base of workers to support them.

An excellent new book by William Baumol of New York University’s Stern School of Business challenges much of this orthodoxy and suggests that many of the policymaker’s instinctive reactions to rising healthcare costs may in fact be quite misguided. His book, The Cost Disease: Why Computers Get Cheaper and Health Care Doesn’t, is also quite timely for Singapore’s policymakers as they grapple with a complex array of issues: an ageing population, rising healthcare expenditures, the allocation of risks between state and citizens, and how the country’s foreign labour policies should be adjusted in the context of ageing and the need to sustain economic growth. The responses to the cost disease which Baumol suggests are somewhat counter-intuitive and surprising, but are extremely important for Singaporeans to consider as the city-state navigates a vastly different socio-economic context created by an ageing population.

Rising relative costs

Baumol’s analysis begins with the seemingly trivial observation that for any given average rate of productivity growth, some industries will outpace others in productivity growth. Not surprisingly, those industries which are less likely to benefit from labour-saving technologies – education, healthcare, social services, the performing arts and many other service industries where human contact determines the quality of the service – have seen their labour productivity grow at a slower clip than average productivity. Conversely, in manufacturing and some service industries (most notably the ICT industry), standardisation, automation and mechanisation have enabled large productivity gains, allowing for the same level of output to be produced with much less labour input.

But while productivity growth in the relatively stagnant sectors may be slower, wages in these sectors tend to rise as fast as they do in the rest of the economy, as workers would defect if wages elsewhere were rising faster. As wages rise, producers in the stagnant sectors have to raise prices. These increases are faster than those in the more productive sectors where productivity gains are large enough to offset their rising costs. Consequently, prices in the stagnant sectors must rise in real terms. That is, the prices of services produced in the industries which are afflicted with the cost disease would rise faster than the average inflation rate. So while higher productivity growth would enable goods such as mobile phones, DVD players and cars to be produced and sold more cheaply than before, lower productivity growth in health care and education means that their prices will rise in real terms. Over time, these services will command an ever larger share of our incomes – at both the household and national levels.

Historical data confirms that the cost disease is real. Between 1978 and 2008, the cost of hospital services in the United States rose by nearly 8 percent a year while the overall consumer price index (CPI) rose by just under 4 percent a year. This meant that in real terms (that is, the increase in prices over and above the general inflation rate) the cost of physician services increased by 150 percent over that 30-year period. Since the early 1980s, the price of college tuition in the United States has increased by 440 percent, more than five times, and the cost of medical care by 250 percent, both much faster than the rate of inflation (110 percent) and the median family income increase (150 percent) over that period.

Baumol also provides data showing that this pattern of increasing real costs in healthcare and education is not peculiar to the US, but is also strongly observed in countries where governments are more committed to healthcare and social spending, financed by higher tax rates and supported by stricter controls on the fees charged by providers. He notes that although virtually every industrialised nation has tried to prevent healthcare costs from rising faster than average inflation, none has succeeded.

This, in itself, is revealing. Health economists have, for the most part, tried to explain why different financing regimes produce widely differing levels of national healthcare spending. It is often pointed out by health economists that the US has a much higher level of healthcare spending because its system of relying mainly on private insurance creates (perverse) incentives that encourage excessive consumption of healthcare resources among physicians, patients and employers. Baumol’s analysis takes a different tack. It suggests that whatever the financing regime, and regardless of who bears the burden of financing healthcare, costs in this and many other service industries will increase faster than the average inflation rate. So although the US’ healthcare spending is high in absolute terms, its rate of increase resembles that of other affluent industrialised countries.

Should Singapore be concerned with the cost disease?

In Singapore, the availability of cheap foreign labour has delayed the need for us to confront this question. In most developed economies, as wages rose, middle class households could afford less of those services requiring a high degree of human contact and personalisation, even if employees in those industries were not becoming more productive to “justify” their higher wages. Many of the things that middle class Singaporean households take for granted – eating out regularly, maids, cheap cleaning and maintenance services – are not usually found in other developed economies. Singapore’s relatively more liberal foreign worker policies have softened the impact of the cost disease, allowing an affluent society access to personalised services that would cost much more in rich countries with tighter immigration policies. But there is a price for affordable access to these middle class comforts: middle and lower-end wages in Singapore are lower than in countries with a comparable GDP per capita. Indeed, it is precisely because wages in many of our service industries are low that Singaporeans enjoy relatively low prices for them.

As foreign worker policies are tightened, Singaporeans will increasingly be confronted with the choice of cutting back on those services which are less amenable to automation and standardisation. But no matter how much we cut back, there will always be a large part of education, healthcare and other social services that are resistant to productivity gains. If so, the cost disease predicts that the costs of these services will take up an ever larger share of our incomes – individually and nationally. Should this be a source of concern?

Baumol argues that it need not be. He notes that if productivity growth is maintained at its long term rate of around 2 percent, US incomes would rise fast enough to allow Americans to afford more of everything. So although he estimates that US healthcare spending as a share of GDP would rise to an eye-popping 60 percent by 2105, this would be a share of a much larger pie. And the larger pie is, of course, made possible by productivity gains in the productive sectors.

Policy Implications

If the cost disease is incurable but quite manageable and ultimately survivable, should policymakers still care about it? There are three important reasons why they should, and these apply with particular salience in Singapore’s context.

First, the cost disease underlines the importance of sustaining economic growth that is driven primarily by productivity improvements. Productivity-driven growth, as opposed to labour-driven growth, is the only sustainable way of raising incomes per capita. Only with rising incomes per capita can we afford the inexorably rising costs of healthcare and other essential social services without reducing our consumption of other goods and services.

In much of the economic policy discourse in Singapore, there seems to be a focus on maintaining GDP growth, regardless of the sources of that growth. That is bad economics. What matters is per capita GDP growth (actually what really matters is consumption per capita since it is consumption, not income, that predicts well-being). The emphasis on GDP is misguided and misleading because how this growth comes about matters more than just more growth. If GDP is increased by 3 percent as a result of a 3 percent increase in our labour force, in per capita terms residents are not better off. Meanwhile, there is increasing congestion and greater competition for public goods. Individual well-being is actually reduced by GDP growth generated only by labour force growth.

Second, the cost disease provides a powerful reason why aggressive fiscal redistribution by the state is needed more than ever. Even if one accepts the prediction that productivity will grow fast enough to enable us to afford more of everything, it is quite likely that the gains of that productivity growth will be concentrated in the hands of the highly skilled. This concentration of the benefits from productivity growth suggests that economic growth may not necessarily increase general purchasing power. The combination of rapid technical advances, skills-biased technical change and competition from the cheap labour forces of emerging economies is likely to result in median and lower-end real wages in developed economies to lag the overall productivity growth for a long time. Indeed, the rising income inequality we have observed in the past two decades – in almost every rich country – is largely a consequence of the highly uneven distribution of the fruits of technical progress and productivity growth.

The real danger of the cost disease, Baumol argues, is not that we cannot afford the rising costs of healthcare in the aggregate. Rather, in the context of wage stagnation for lower-wage workers and rising income inequality, it is whether lower-income citizens can afford the inexorably rising costs of healthcare (and other essential services afflicted by the cost disease). If they cannot, it is incumbent on the state to redistribute the gains of productivity growth aggressively. This includes ensuring that real wages rise more in line with overall productivity increases via effective collective wage bargaining arrangements, redistribution via transfers to less advantaged groups, and providing equitable access to good healthcare for the lower and middle-income groups that may not otherwise find it affordable. Singapore’s old mantras of individual responsibility and the reliance on savings and family support to meet health care expense will have to be seriously rethought in light of the cost disease.

Thirdly, the cost disease suggests that policymakers would have to think quite differently about how all segments of society can continue to afford good healthcare given the inherent tendency for costs to rise faster than inflation. Most of our policy measures in healthcare have been focussed on “getting incentives right”, on preventing moral hazard and over-consumption by patients, and on preventing over-servicing by providers. All this is necessary, it is argued, to keep healthcare spending “sustainable”. But the cost disease phenomenon suggests that these measures, while useful, do not prevent healthcare costs from rising faster than general inflation.

Baumol thinks that the real problem is not the cost disease but possible knee-jerk reactions to it by policymakers. As healthcare costs rise, governments may well respond by shifting more of the costs to patients, providers or private insurance in the (vain) hope that this would instil greater cost discipline in the system. It will not: such a shifting of costs is misguided as it will not cure the underlying disease. Even if public spending in healthcare is “not sustainable”, it is not clear how passing the costs and risks to citizens or providers makes it so. It is more likely that citizens, facing higher out-of-pocket expenditures, will cut back on necessary healthcare. The higher costs in healthcare could also lead to excessive rationing by the state, resulting in poorer health outcomes or unequal access to good health care.

While the cost disease is not lethal, misguided thinking and policy responses by policymakers could be damaging. Policymakers should also be more circumspect about some of their long-held assumption in healthcare. This includes their belief that healthcare is always a form of consumption spending that should be minimised; that competition and market-mimicking reforms in healthcare will make providers more efficient and keep costs down; and that emphasising individual responsibility keeps the health financing system sustainable. All these assumptions ought to be re-assessed and rethought in light of a rigorous analysis of the cost disease and its implications.


Donald Low is Senior Fellow and Assistant Dean (Research Centres) at the Lee Kuan Yew School of Public Policy. He has administrative oversight of the School’s research centres and leads the School’s case writing efforts.

Yeoh Lam Keong is an Adjunct Senior Research Fellow at the Institute of Policy Studies. His email is yeohlamkeong33@gmail.com