Is Baumol's Cost Disease Really a Disease? Healthcare Expenditure and Factor Reallocation

Expenditures on healthcare and employment in the healthcare sector have been steadily increasing across OECD countries for many years. This shift of expenditure and employment towards a consistently found to be less productive sector has often been associated with the idea of Baumol’s (1967) cost disease. This paper investigates if diagnosing the healthcare sector with suffering from a cost disease is an apt description of the observed reallocation. The novel feature of the paper is to introduce a microeconomic foundation to the theoretical analysis of the healthcare sector. We show analytically in a model that the demand side is very important in determining equilibrium quantities and prices. Even if there is unequal technological progress in the two sectors, the unchanged demand of households dictates that the output level of the two sectors remains constant. This leads to the prima facie unintuitive result of factor allocation towards the less productive sector, in this case, healthcare. We show that this is the case under innocuous assumptions if goods are complements. We supplement the new theoretical results by testing implications from the model empirically. Specifically, we use household-level data to estimate the elasticity of substitution between healthcare consumption and all other consumption. We find robust evidence for the complementarity of healthcare consumption and all other consumption.