On May 4th, Professor William J. Baumol died at
the age of 95. He was a prodigious writer and innovator in economic theory,
author of some 500 papers over the more than half a century he taught at
Princeton University and NYU. At least
once, he was reportedly on the shortlist for the Nobel Prize in Economics, and
if anyone deserved it, he did. I’ve read a couple of the obituaries of Prof.
Baumol and I thought they missed the point of much of his work so I’d like to
add my own.
Baumol was born in 1922 and raised in the Bronx section of
New York City. Like many who grew up in
the Depression, he became interested in political and social issues at a young
age. He studied economics at the City College of New York (CCNY), and then
applied to do a Ph.D. in economics at the London School of Economics. As Baumol later told the story, his
application was rejected but he applied again. Professor Lionel Robbins, an
eminent economist and then (1947) the dominant figure at the LSE, took pity on
the young American and condescended to let him enter and study for a master’s
degree. Baumol joined a seminar taught by Robbins in which aggressive debate
was encouraged. Aggressive debate was a way of life at CCNY, and Robbins and his
colleagues were impressed by Baumol’s style. According to Baumol, “the Oxford
Debating Society was composed of amateurs and children by our standards…so
whenever I disagreed with something, I would wait for the appropriate moment
and come in charging with my sword drawn, and they’d never seen anything like
it.” Within two weeks, Baumol was moved into the PhD program. Three weeks later
he was lecturing, giving two courses to students. Baumol became good friends
with Robbins, a conservative, and with Harold Laski, a former chairman of
Britain’s Labour Party. In those days Ph.D.s were not common in Britain so
Baumol’s oral exam was a bit improvised. It took place over whiskies at the
Reform Club, a gentleman’s club, and lasted five hours, during which time many
different topics were discussed. When Baumol got home, his wife asked him if he
had passed and he replied: “I have no idea.”
I’ve read several obituaries of Professor Baumol and they
all focus on Baumol’s cost disease, which I find to be the least interesting
part of his work. So I thought I would write this essay to correct those
misleading impressions of who he was.
The Baumol cost disease is an important and very familiar
idea these days. If one compares goods and services production in a modern
economy, constant productivity growth in goods production reduces their
relative cost compared to services, where productivity cannot have as much of
an effect. Services like providing health care or education cannot experience
as much productivity growth because the human element is an essential part of
those services. As a result, we should expect services to get steadily more
expensive over time, and this is indeed what has happened. College tuition and hospital bills have
skyrocketed. Noneconomists like this sort of economic theory because it explains
a phenomenon we see in our daily life.
Market Imperfections
But that’s not really what William Baumol was all about. The
thread that ran through Baumol’s 50-plus years of teaching and writing was a
focus on market imperfections. These
are cases where the free market fails to operate as it is predicted to in basic
economics. This may sound like a technical detail, but it’s not. If markets
don’t deliver optimal levels of prices and production, then a national economy
is failing to deliver the best outcomes. If economic theory unrealistically
assumes perfect markets, then it provides a flawed basis for making decisions to guide
or manage the economy.
I first became aware of Prof. Baumol’s work as an
undergraduate economics student at Harvard in the early 1970s. Environmental economics was just emerging as a
new discipline. Baumol wrote some of the foundational academic articles on the
externalities of pollution that would lead directly to ideas like the carbon
tax. Pollution, and externalities in general, are examples of market
imperfections because they mean that the price set by the free market is wrong
(typically too low). The “market” price doesn’t take into account the costs
imposed on nearby individuals and communities by the pollution.
Baumol wrote about the use of taxes to correct for the
underpricing. Pollution taxes were originally proposed by an earlier British
economist, Arthur Pigou. But Baumol went further and showed that the pollution and
the pollution tax could potentially affect the supply and demand for the
polluting good in such a way that there might be no single equilibrium price
for that good. This sounds a bit theoretical, but what it means is that the
market could fail, i.e. could result in the wrong price being agreed by buyer
and seller, with serious inefficiency. In that scenario, government
intervention might be required to make the market function efficiently.
I was so impressed by the newness and excitement surrounding
environmental economics that I considered doing my graduate studies at the
University of Virginia—there were other professors at U.Va. which made it a
sort of hotbed of environmental economics. In any event, I decided to continue
my studies at the LSE (where I met many Oxford graduates, whose debating skills
impressed me much more than they had impressed Baumol, and some of whom are
still friends today).
By the early 2000s, I had left economics and was working in
the technology industry, specifically fiber-optic networks. As I observed
growing foreign competition from Asia, usually with inferior technology but
heavily subsidized by Asian governments, I became once again interested in
economics, and in international trade issues. I joined a Department of Commerce
industry committee, known as ITAC, to advise the Obama Administration on these
issues. I looked around for books to read to refresh my knowledge of international
trade economics. The most impressive book I found was “Global Trade and
Conflicting National Interests” by Ralph Gomory and William J. Baumol. The same
Baumol who had made an indelible impression on me 30 years before! The book is
on my bookshelf now, close by Keynes’s General Theory.
In the book, Gomory and Baumol argue that economies of scale
in industry are very powerful. As nations compete for market share in major
industries, if one nation achieves a leadership position in an industry, it can
effectively “crowd out” competitors from that industry and establish dominance.
Once again, this is a case of market imperfections. Basic economics presumes that
there are no scale economies in industry, because competition between many
companies (decreasing returns to scale) is needed to achieve a truly
competitive low-cost market price. But in most major industries, economies of
scale are large, sometimes overwhelming. Here is Baumol explaining the
significance of the book, soon after its publication:
“I’m very excited
about the book, I think it offers significant new analytic approaches and
important conclusions for policy. It shows that where…production of the traded
goods involves scale economies, then there generally are a vast number of
equilibria, many of them far from the optimum. So where this is true, the
market does not automatically and consistently point things in the right
directions. The analysis also shows that…what is good for one nation may at the
same time be very damaging to its trading partner.”[1]
The book played a key role in convincing me that “free
trade,” as it is practiced in our modern world is not free and does not produce
optimal results for all trading nations. The book’s argument also accords with
what most business people are very aware of, that scale economies dominate many
industries. Winning companies tend to be big winners and losing companies tend
to fade away.
Gomory and Baumol’s book played a role in my decision to
move back into economics and go to work at the Coalition for a Prosperous
America (CPA). After a career as a mathematician at Princeton, head of IBM’s
research labs, and the Sloan Foundation, Ralph Gomory is today Research Professor at NYU's Stern School of Business but we are
fortunate to have him on the Advisory Board of the CPA. I asked Ralph for a
comment on William Baumol and he said, “Will was both reasonable and kindly. He
could listen to almost anything, even things he strongly disagreed with, and
he would give a thoughtful and reasoned response.”
Fundamentally, what Professor Baumol’s work on market imperfections
shows is that economic theory is rife with shortcomings and inadequacies,
because of the hugely unrealistic assumptions underpinning it. Those problems ought
to make economists eager to re-work the theory to make it more realistic and
applicable. Unfortunately, it seems that only a minority of economists do that.
Many others instead obscure the shortcomings under a stream of self-confident
assertions and unjustified advice, mainly because seeming to know more than you
do is an effective way to win lucrative government jobs or private consulting
contracts.
Only a very few economists try, like Professor Baumol, to
improve the theory and make it more relevant and useful. He will be missed.
[1]
Alan B. Krueger, An Interview with William J. Baumol,
Journal of Economic Perspectives, Vol. 15, No. 3, Summer 2001.
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