Why Do Education and Health Care Cost So Much?

Megan McArdle is a Bloomberg View columnist. She wrote for the Daily Beast, Newsweek, the Atlantic and the Economist and founded the blog Asymmetrical Information. She is the author of "“The Up Side of Down: Why Failing Well Is the Key to Success.”
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Ezra Klein says that college and health care have the same problem: You can't do without them, and therefore, they are very expensive:

Saying "no," after all, is how consumers typically restrain costs. If Sony wants to charge you too much for a television, you can walk out. You might want a television, but you don't actually need one. That gives you the upper hand. When push comes to shove, producers need to meet the demands of consumers.

But you can't walk out on medical care for your spouse or education for your child. In the case of medical care, your spouse might die. In the case of college, you're just throwing away your kid's future (or so goes the conventional wisdom). Consequently, medical care and higher education are the two purchases that families will mortgage everything to make. They need to find a way to say "yes." In these markets, when push comes to shove, consumers meet the demands of producers.

The result, in both cases, is similar: skyrocketing costs for a product of uncertain quality. As the Brookings Institution's Isabel Sawhill writes: "We spend twice as much per capita than most other countries on health care and don't get better outcomes as a result. We also spend twice as much per full-time equivalent student on higher education than other OECD countries, and 38 percent more on elementary and secondary education with disappointing results."

I don't think that this can be right. Food and water are far more vital than health care, let alone higher education, which the human race managed to do without for a few hundred thousands of years. You can go quite a while without blood pressure medication or even insulin -- much longer than most people could go without fuel for heating or cooking. Clothing and some sort of shelter would also rank higher on the list of imminent necessities than health care and education. Yet none of these goods displays health care and education's pattern of above-inflation cost increases. It's true that demand for education and health care is what economists call inelastic -- meaning that the demand doesn't decrease very much even when the price rises -- but that doesn't explain why the prices of these two inelastic services, and no others, has risen faster than inflation for decades.

Baumol's cost disease is often identified as the culprit. As the economy gets more productive, the cost of labor-intensive services rises faster than the general rate of inflation, because wages are rising in the more productive sector, and the labor-intensive industries also have to pay higher wages to compete. Since it still takes just as many people to play Beethoven's Fifth as it ever did, the result is more expensive concert tickets.

But Richard Vedder of the Center for College Affordability and Productivity points out that it's not actually clear that college education couldn't get more productive; only that it hasn't. Moreover, a lot of non-teaching research and publishing activity has gotten tacked onto the job of tenured college professor, so that in some sense, we've deliberately depressed their teaching productivity.

So how do we explain health care and college cost inflation? Well, health care economist David Cutler once offered me the following observation: In health care, as in education, the output is very important, and impossible to measure accurately. Two 65-year-olds check into two hospitals with pneumonia; one lives, one dies. Was the difference in the medical care, or their constitutions, or the bacteria that infected them? There is a correct answer to that question, but it's unlikely we'll ever know what it was.

Similarly, two students go to different colleges; one flunks out, while the other gets a Rhodes Scholarship. Is one school better, or is one student? You can't even answer these questions by aggregating data; better schools may attract better students. Even when you control for income and parental education, you're left with what researchers call "omitted variable bias" -- a better school may attract more motivated and education-oriented parents to enroll their kids there.

So on the one hand, we have two inelastic goods with a high perceived need; and on the other hand, you have no way to measure quality of output. The result is that we keep increasing the inputs: the expensive professors and doctors and research and facilities.

President Barack Obama's education plan is an attempt to correct that in the educational field. Right now, elite institutions compete to exclude as many kids as possible, a process that allows them to cherry-pick better inputs (students), and therefore charge more tuition for producing their output (graduates with a valuable diploma).

Outside the elite, many schools don't cherry-pick, but take all comers; they compete on volume, trying to get as many students as possible, even if that means selling worthless degrees to students who are unlikely to complete the program. These two strategies are direct tradeoffs: The best way to maximize volume is to give up on affluent kids with the social resources and preparation to deploy a college degree most effectively; the best way to compete on quality is to get kids who barely need the degree to succeed, which means being as exclusive as possible.

The administration wants to somehow collapse these into one strategy: provide a high quality degree to everyone. They want to rank colleges on both signals of quality -- graduation rates and things like serving lots of poor kids. By measuring both, they hope that universities will strive to maximize both, rather than one.

This strategy strikes me as unlikely to work, not only because of the tradeoffs (I seriously doubt that Harvard is going to tarnish its diplomas by admitting kids who are unlikely to succeed there or become a credit to the institution), but because of the measurement difficulties. We can measure tuition, graduation rates and the percentage of poor kids who attend, but that still isn't going to tell us what we want to know: Is this college taking kids and making them better prepared to be workers and citizens? I suspect that Harvard will happily give up its Pell grants before it gives up the cachet of a Harvard degree. And parents will continue bidding up the costs of the few slots it offers.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Megan McArdle at mmcardle3@bloomberg.net