Monday, July 31, 2006

Baumol's Cost Disease and the Practice of Law

My last three posts have discussed the important topic of LLM degrees. Thanks to those who have read them and commented on them. If you have not seen them, check them out here, here, and here.

The subject of this post (and one or more posts to follow) is somewhat more theoretical than the pros and cons of LLMs, but it is no less important. The current topic is something called "Baumol's cost disease" or the "Baumol effect," and it is something that every lawyer needs to know about, since it affects all of us in the legal profession in important ways. It is no exaggeration to say that Baumol's cost disease is reshaping our profession entirely, in ways large and small. Every lawyer needs to appreciate and understand its implications for our future. This is not hyperbole on my part.

So what is Baumol's cost disease? It is named after William J. Baumol of NYU and Princeton. Baumol's basic observation is that the cost of some services will rise faster than the rate of inflation. That may not sound so earthshattering, but it is. Let me try to explain.

First, the production of many modern goods is heavily automated. That means that worker productivity in these industries is up--way up. So worker wages may be higher, but productivity has increased in many industries at a rate faster than the increased cost of labor. So there is a productivity gain that lowers the cost of making those goods.

A good example of this is the PC industry. My very first computer, which I got in 1988, was an IBM Model 50. It was state of the art, with a 12-inch color screen (the exception in those days), a built-in 20K (not 20 meg) hard drive, and a 3.5 inch disk drive (5.25 floppy disks were still the industry standard then). And it cost a whopping $3,000 dollars! Today, for around $400 I can buy a low-end computer that trounces my dinosaur IBM. And it would come with a large flatscreen monitor, lots of software (my old computer came only with DOS), and a printer too. Even ignoring inflation and the fact that I am comparing a very old apple to a nice shiny new orange, that is an incredible reduction in cost. My inflation-indexed dollar today buys a lot more computing power than in 1988. In other words, the real cost of PCs has gone way, way down.

Other examples abound, and some are even in service industries. Does anyone know of a secretary or office assistant who still knows shorthand, or an attorney who cannot type? There aren't many. Intermediate steps like shorthand or needing someone to type everything for you have been eliminated, and this has freed up workers like office assistants to deal with other tasks that add more value. In other words, they have become more productive.

This is where Baumol's cost disease comes in. Baumol observed in the 1960s that improvements in productivity are not always desired, and for some activities such improvements might be impossible. The original example given was a string quartet: playing it today takes 4 musicians, just as it did hundreds of years ago. In other words, gains in efficiency are not really possible for this task. In other cases, improvements in efficiency might be possible, but are ill-advised. Education is the perfect example here: you perhaps can increase educational efficiency by increasing the number of students in the classroom, but do you want to? And in fact, would increasing the number of students reduce the output--that is, the quality of education?

So we are left with the insight that some activities can experience increases in labor productivity over time, while others cannot or should not. The result is that the cost of some services will not increase as fast as the cost of other services for which there can (or should) be little or no productivity gains.

This means that the cost of services that do not experience productivity improvements will rise at a rate higher than inflation. Remember that the rate of inflation is an average. Some items, such as computers and other electronic components, actually get cheaper to produce over time. Other services, like live music or medical surgery, experience high cost growth. Baumol's cost disease tells us that services that cannot or should not experience productivity gains will grow more expensive more quickly.

This has enormous ramifications for service industries, including the legal profession. I'll discuss some of the ramifications in my next post, but here are some teasers:

  • Improvements in attorney efficiency regarding administrative tasks are part (although not all) of what have enabled associate salaries to increase so rapidly in recent years.
  • The generally high cost of legal services has led to standardization of legal service packages, which has helped lower the cost of some legal services. For example, form contracts might be used by a law firm to quickly prepare a contract--or the client might even obtain (or develop) its own form and forego using outside counsel altogether.
  • The need to improve efficiency wherever possible has contributed to hyper-specialization in legal practices, with fewer general practitioners in many markets.
  • Increased standardization of legal services may be creating a greater dichotomy between lawyers that charge large fees to address the most difficult and intractable legal problems, and those that handle more prosaic or ordinary legal matters at far lower rates.

This is just a sampling of some of the enormous implications of Baumol's cost disease for lawyers. I'll have more discussion in my next post.


Anonymous said...

Minor irrelevant point: the IBM PS/2 Model 50 in 1988 would have had a 20 meg hard drive, not 20K. Even the original XT, in 1983, had a 10MB hard disk.

Your point is still valid, of course.

Gregory W. Bowman said...

Thanks for the correction. And it's nice to know someone else out there remembers those old machines.