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03-02-2018

Cost disease in defense and public administration: Baumol and politics

Authors: Lars-Erik Borge, Kjetil Hatlebakk Hove, Tobias Lillekvelland, Per Tovmo

Published in: Public Choice | Issue 1-2/2018

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Abstract

William Baumol’s model predicts a steady increase in relative public sector prices (or costs) because of the combination of slow productivity growth and wage growth similar to sectors wherein productivity is growing more quickly. In this paper, we extend the Baumol model with political variables and analyze price growth in defense and public administration using Norwegian data. We find strong support for the mechanism of the Baumol model since manufacturing productivity is the most important determinant of relative public-sector prices. Greater political fragmentation has also contributed to the price growth, but its quantitative effect is smaller than that of manufacturing productivity. An analysis of a labor-intensive private service (restaurants and cafes) supports the broader relevance of the Baumol mechanism and the validity of the estimated effect of political fragmentation on the two sectors considered herein.

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Many private service industries may also have limited scope for productivity growth. See the analysis of restaurant and cafes in Sect. 6.

The view that the cost disease is a threat to the welfare state is challenged in theoretical contributions by Andersen (2016) and Andersen and Kreiner (2017).

Our formulation of the production function is a bit more general than the formulation used by Baumol (1967) because we also allow for productivity growth in the non-progressive sector. A similar formulation is used by Colombier (2012).

Equation (4) implies that the wage level is the same in the two sectors. None of the following results would be affected if we instead made the weaker assumption of proportionality.

We do not allow for a time trend in any of the tests since that would make the interpretation of the test less clear. Trend-stationarity would, for instance, be consistent with a cost disease if the time trend is found to be a significant explanatory variable.

The coefficient of correlation between HHI and Left is 0.61.

The test results are reported in Table 6 in the Appendix.

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Title: Cost disease in defense and public administration: Baumol and politics
Authors: Lars-Erik Borge
Kjetil Hatlebakk Hove
Tobias Lillekvelland
Per Tovmo
Publication date: 03-02-2018
Publisher: Springer US
Published in: Public Choice / Issue 1-2/2018
Print ISSN: 0048-5829
Electronic ISSN: 1573-7101
DOI: https://doi.org/10.1007/s11127-018-0510-z

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