William Baumol, RIP

Who was William Baumol?

Source: Journal of Economic Perspectives, American Economics Association

William Baumol was an economist who taught for years at Princeton. He died last week at the age of 95. He had a long and productive career, writing papers and books over the course of seven decades. He is perhaps best known for his theorem on wages, Baumol’s Cost Disease, which explains why cars and computers get cheaper while haircuts and college tuition get more expensive. Essentially, areas of the economy with productivity gains drive up the cost of labor for everyone else, because workers can always change jobs. This also explains why restaurant meals are more expensive in the city: managers have to compete for labor, and that labor is more expensive when it has lots of alternatives.

But some of Baumol’s most profound work has to do with entrepreneurship and capitalism. He once stated that economics without entrepreneurs is like Hamlet without the Prince of Denmark. If you want to understand how an economy works, you have to look at innovation and enterprise. Why, for example, did a society like the Romans invent a steam engine but then used it for nothing but toys and religious ceremonies? The answer has to do with incentives. For the Romans, the route to wealth and prestige was through estate farming and military command. Commerce was left to slaves and former slaves.

Primitive steam engine. Source: Wikipedia

This also explains why big firms tend to produce little innovations, while little firms produce big innovations. Again, it has to do with incentives. If you’re an engineer in the jet engine division at Pratt and Whitney, it’s unlikely you’ll introduce a technology that makes jet engines obsolete. Rather, you’d start a new firm to capitalize on your invention. This is perhaps why stock market returns are positively skewed: most of the market’s returns come from a minority of small firms that make it big, like Amazon or Google. Again, big changes come from small firms, often with a visionary entrepreneur.

Source: Blackstar

Baumol outlined these concepts in clear prose with a minimum of algebraic contortions. Maybe that’s why he never won a Nobel Prize: you didn’t need a degree in number theory to understand him. He was truly a titan when it comes to economic thinking. Economists like William Baumol help us understand the way the world works – or doesn’t. He’s made us all a little richer.

Douglas R. Tengdin, CFA

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