What's the Baumol Effect that Vice Premier Liu He recently mentioned and how to overcome it

Jiang Xiaojuan, former Deputy Secretary-General of the State Council, writes about it.

This newsletter features a translation of a recent article from Jiang Xiaojuan, former Deputy Secretary-General of the State Council, the Chinese government cabinet. Jiang is currently Dean of the School of Public Policy and Management, Tsinghua University.

Long-time subscribers may recall that Pekingnology in June published a select translation of the Academic Autobiography of Jiang Xiaojuan, where the senior official revisited her works on China’s foreign investment policy, accession to the WTO, China’s industrial policy, and the dire medical services in the Cultural Revolution times.

More recently, Politburo Member and Vice Premier Liu He mentioned the “鲍莫尔病” Baumol’s cost disease/Baumol Effect in a September 26 speech. Jiang wrote an article about the concept, which previously was little-known in China.

(Credit: Theresa Zabala/The New York Times)

Towards the end of her article, Jiang wrote that using digital technology to overcome the Baumol effect requires updated concepts in (understanding) servicing and consumption - China is still influenced by the Soviet idea that only material wealth is wealth and the production of physical products as productive labor; if one thinks that "goods" and "services" are equally important in economic development, one must understand that material consumption and spiritual & psychological consumption are equally important.

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Overcoming the Baumol Effect with Digital Technology

by Jiang Xiaojuan, on Oct. 25, 2021

Recently, in his speech to the 2021 World Internet Conference, Vice Premier Liu He said that digital technology has profoundly transformed the production function and continuously created new business formats, and it is necessary to overcome the Baumol Effect taking advantage of digital technology. This is a proposition rooted in profound academic theory and with great significance. It also relates to the issue of whether China can continue to maintain stable growth after entering the era of the service economy, and it is necessary to conduct an in-depth analysis and discussion.

What is the Baumol Effect

William Baumol was an American scholar who mainly studied economic growth, especially the growth of the service sector. He published several well-known articles on the service sector in the mid to late 1960s, studying why the economic growth would slow down in countries where the service sector is the main development drive.

Baumol’s research categorizes sectors from the perspective of technological advances into two sorts.

One is the "progressive sector" strongly impacted by technology. In this category, innovation, capital accumulation, and economies of scale bring about an increase in output per capita. 

The other is the "non-progressive sector" or the stagnant sector, usually much less impacted by technology. Because of the little application of new technologies, labor productivity in this sector remains stagnant.

The so-called "progressive sectors" refer to those manufacturing sectors that can apply advanced technology and equipment, can produce on a large scale, and take advantage of the economies of scale and economies of scope. The non-progressive sector mainly refers to the service sector. When the service sector is the main development drive in the economy, the labor force would shift from the progressive sector to the non-progressive sector, and the economic growth rate of the entire country would gradually decrease to zero. This is the famous Baumol’s cost disease, also known as the Baumol Effect.

Baumol then continuously revised his theory and switched to more complex explanations, but until 2006, he was still studying service sector issues based on this idea and expanded (the example of) the live art performance sector to a wider cultural sector. Baumol’s research has had an important impact on service economics studies later on and has become one mainstream standard model for service sector researches.

The traditional service sector has several characteristics: First, the "results are intangible," that is, the service process does not produce tangibles. The second is "simultaneous production and consumption," that is, service production and service consumption occur at the same time and at the same place, and the service has been provided to consumers when the production is completed. The third is "non-storability." Because it must be simultaneous, the service process is the service result. When the process ends, the service ends and cannot be stored. The fourth is the "personality difference." (For example,) Every student or every patient has a different situation, and it is impossible to use a single, automated mode to provide services repeatedly.

The characteristics above determined that these service sectors have the following important economic features. First, they have no economies of scale, and the other is that they involve low-end technology. Because of this, the main factors that have contributed to the increase in labor productivity since the Industrial Revolution have not been reflected in the service sector.

Although labor productivity in the service sector has increased slowly, the law that labor income from all sectors tends to converge still applies. Since public services are a typical labor-intensive service sector, and service costs per unit have shown a long-term upward trend, more and more fiscal expenditures are required to provide the same services. Government finances are particularly under great pressure.

The Baumol’s cost disease’s impact on China’s increasingly service-oriented economy

In 2012, the service sector exceeded the manufacturing sector in China's economy. In 2015, the service sector accounted for more than 50% of China's total economy for the first time and has continued to rise, marking that China entered the service economy era.

In the last decade, China’s economic growth has entered a steadily slowing path. Although there are many factors that contributed to this downward trend, the rising proportion of the service sector and the relatively low production efficiency of the service sector are important factors.

Looking at it across the globe, after entering a period when the service sector makes up the majority of the economy, the decline in the economic growth rate is also a relatively common trend. This author has studied the performance of many economies that have successively entered the service sector-majority period after World War II. Before and after the year when the service sector accounted for more than half, the growth rate of these economies showed a downward trend. It is one of the relatively rare regular patterns in the history of economic development.

As China has entered a development stage dominated by the service economy in the information technology era, some service sectors have partially changed to have new industrial characteristics. For example, distance education can greatly increase the student-teacher ratio in education, thereby increasing the labor productivity of the educational service supply. Another example is the electronic security system, which, taking advantage of advanced technology and equipment, can do away with the ever-increasing cost from security personnel.

However, as services is still a sector with low labor productivity, the downward pressure on economic growth is still relatively high. It is safe to say that if there is no continuous strong empowerment of internet technology and digital technology in the future, as the proportion of services continues to rise, China’s economic growth will experience a longer period of sustained downturn, and the growth rate could only stabilize after the economy reaches the relative balance between services and economic growth in leading countries

Using digital technology to promote the overall improvement of the efficiency of China's service sector

In recent years, the widespread application of digital technology has led to crucial changes in the service sector, which to a large extent has changed the basic features of low production efficiency in services.

Nowadays, many service subsectors use digital technology at a high density, resulting in extremely significant economies of scale in all aspects of consumption, production, and communication. This is due to the high initial cost and the low marginal cost of many internet services, especially in cultural and information services that can be replicated.

Overall, the productivity of the service sector has increased significantly, and some even exceed the level of modern manufacturing. For example, educational programs and text messages on the Internet can be viewed unlimitedly. The marginal cost is extremely low, the economies of scale are extremely prominent, and the increase in marginal benefits meets almost no boundaries. No manufacturing industry can compare in this regard.

Take the cultural subsector as an example. Digital technology fully empowers the entire chain of creativity, production, communication, transaction, and consumption in the subsector with extreme speed and great energy, bringing efficiency improvements from all links.

First, it has gone beyond the barriers of time and space. The portability and mobility of mobile phones and tablets enable various cultural consumption anytime and anywhere, expanding the scale of consumption.

Second, it has broken through the barriers of limited information. The search technology on the consumer side enables consumers to freely select the content they are interested in from massive cultural products on the Internet and enhances the consumer's sense of satisfaction per unit of consumption time.

Third, it has broken through the barriers in the "marketing" of new creative works. For example, the number of registered authors of online literature in China has reached 14 million. With such a large group of authors, it is difficult to find a platform to present their works offline, but they can be accommodated in the online market.

Fourth, it has broken through the barriers to knowing the market demand. Digital technology has the powerful ability to detect consumer interest. Based on consumer demand analysis through big data and meeting consumer demand, digital technology enables production that would be popular in the market and help expand the consumer groups.

Fifth, it has broken through the barriers of precise communication. Now that people produce a large number of cultural products, how producers can find consumers who love their products has become a problem. Intelligent algorithms process consumers' willingness and their potential tendencies, which can achieve an information distribution model where production and consumption are highly compatible.

Sixth, it has broken through the market entry barriers for small- and medium-sized enterprises. Sometimes small and micro enterprises and individuals create good cultural products, but they cannot accomplish large-scale publicizing on their own. Large platforms encourage all kinds of creators to use the platform to publicize and provide diversified services accordingly, servicing consumers around the world.

Using digital technology to overcome the Baumol effect also requires updated concepts in (understanding) servicing and consumption. The Soviet accounting system has had an influence on our country for a long time. This system regards only material wealth as wealth and the production of physical products as productive labor. Services that cannot create material wealth, therefore, are not viewed as productive labor. This theory retains its influence now.

Based on international experience, there is an equilibrium point for the proportion of college graduates in the population of their age and after that equilibrium point, the income of college graduates cannot exceed that of non-college graduates.

However, going to college meets the spiritual and psychological needs of many parents and children, and it is a sign of a lot of non-income "qualities" such as intelligence, ambition, and caliber, and they are willing to pay for the "satisfaction."

There is also cultural consumption that is purely for fun, which also brings the satisfaction of spiritual consumption to people.

If one thinks that "goods" and "services" are equally important in economic development, one must understand that material consumption and spiritual and psychological consumption are equally important: Cars and electrical appliances improve the quality of human material life, while "happiness consumption" improves people’s spiritual pleasure and psychological satisfaction. Therefore, they are both effective demands.

There is also some unhealthy content in human spiritual needs, such as showing off wealth, hunting for peculiarity, vanity, and even jealousy, etc., which will induce the production and dissemination of information such as prying into the privacy of others, creating and spreading rumors, ridiculing and slandering others. The problem of inappropriate content should become the focus of government and social supervision of the sector, which is also an important feature of the development of services in the digital age.

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Before you go, read the select translation in Pekingnology of Jiang’s academic autobiography where she revisited her works on China’s foreign investment policy, accession to the WTO, China’s industrial policy, and the dire medical services in the Cultural Revolution times. Both translations are unauthorized by Jiang.