The concept of Cost disease in an economy

• There is a question of, How wages rise even when there is no significant increase in productivity.

About the concept of Cost Disease

The idea of cost disease was proposed by American economists William J. Baumol and William G. Bowden first in their 1965 paper “On the Performing Arts: The Anatomy of their Economic Problems.”

• It also known as Baumol’s cost disease, refers to the increase in the wages of certain labourers even though their productivity or skill level has not risen commensurately.
• This happens because there is competition between various industries for the limited supply of labour.
• So, even if the productivity of employees has not risen significantly, employers in many cases have no choice but to pay higher wages to prevent the movement of labourers.
• Here labour is often a kind of non-specific resource that can be used across various industries.

Examples of this scenario

The case of an agricultural economy where wages are at a certain level.

• Now suppose that a manufacturing industry suddenly crops up and bids labour away from the agricultural sector.
• This will raise the wages of labourers and employers in the agricultural sector will have no choice but to pay higher wages to prevent all their labour from moving into the manufacturing industry.
• This process of bidding higher wages for labour will continue until wages rise to a certain level at which there are no profits to be made by entrepreneurs.
• In the end, the wages of labourers in the agricultural sector would have risen higher than what they were earlier even though there has not been any improvement in the skill levels of agricultural labourers.
• Even when there is no increase in the skill level of employees in a certain industry, wages of labourers in that industry may rise significantly due to competition among employers.

Reflection of the Higher wages

Higher wages will reflect in the price that consumers will have to pay for agricultural goods and services.

• Consumers of agricultural products will now have to pay higher prices in order to retain the labour force that is required to produce agricultural products.
• In essence, there is no perfect link between the productivity of labour and wages.

The effect of productivity on real wages

• At macroeconomic level: when the productivity of factors of production rises, this leads to an increase in the overall production of goods and services in the economy as a whole.
• In turn it increases the amount of goods that can be purchased with the wages earned by a labourer.

Conclusion

Many economists believe that rising costs in many sectors may simply be due to heavy regulations and other supply-side factors that may be restricting output in these sectors and causing prices to be higher than they would be otherwise.

Exam Track

Prelims Takeaway

• The concept of Cost Disease
• Effect of productivity on real wages

Mains Takeaway

Q. What do you understand by the term Cost Disease? Discuss the prevalence of this concept in modern day economies.