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Economic Growth: Theory and
Policy
Macroeconomics
Prof. Rushen Chahal
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Today
The three pillars of productivity growth
Convergence hypothesis
Encouraging economic growthThe productivity slow-down and speedup in
America
Why is college so much more expensive todaythan it was 20 years ago?
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Economic Growth
Question: Why does college education keepgetting more expensive?
College tuition rose 674 percent between the
years 1978 and 2003, as compared to a 182
percent rise in overall CPI
We will return to this question later.
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The Three pillars of Productivity
Growth
1. Capital (Physical)
2. Technology
3. Labor Quality (Human Capital)
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Copyright 2004 South-Western
GROWTH IN WORLD REALPER CAPITA GDP
-200
0
200
400
600
800
1000
11th 12th 13th 14th 15th 16th 17th 18th 19th 20th
Growth
inPerCapitaRe
alGDP
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A Review of Capital
Capital is all of the stuff required to produce things
Examples of Capital:
Factories
Roads
Power Plants
Trucks
Computers
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A Review of Capital
Labor input(hours)
RealG
DP
L1
Y0K0
K1
Assume an economy has aproduction function whenthe capital stock is somelow number, K0Suppose labor is constant
and does not grow over time,staying at point L1
At labor L1, total output is atYo, which is equal topotential GDP.
But what if a change in thecapital stock pushes theproduction function up?
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A Review of Capital
Labor input(hours)
RealG
DP
L1
Y0
Y1
K0
K1
An increase in capital stockwill push the productionfunction upNow, with the same amount
of labor input hours, outputis increased to point Y1 dueto the new productionfunction
For a given technologyand labor force, laborproductivity will behigher when the capitalstock is larger
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A Review of Technology
What happens to output when technological
advances are made in a society?
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A Review of Technology
Labor input(hours)
RealGDP
L1
Y0
Y1
PF0
PF1
Here you can see a shiftupwards of the productionfunction, due to
technological improvementin an economy
An improvement intechnology will push theproduction function up,thus increasing outputFor given inputs of laborand capital, laborproductivity will behigher when thetechnology is better
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Technological change that has
benefited the economyThe steam engine
Electricity
Internal Combustion EngineWide Body Jet
Fax Machine
Photocopy Machine
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Technological change that has
benefited the economyThe Telephone
The Radio
The TelevisionThe DVD player
The Computer
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Labor Quality (Human Capital)
Increased Workforce Quality can also increase
output
Which group of people would be better able to
produce computers:
A. 50 laborers with a middle school education
B. 50 laborers with masters degrees in Computer science
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A Review Human Capital
Labor input(hours)
RealGDP
L1
Y0
Y1
PF0
PF1
Here you can see a shiftupwards of the productionfunction, due to an increaseof education and training of
the workforce
An improvement ineducation and training willpush the productionfunction up, thus increasing
outputFor given inputs oftechnology and capital,labor productivity will behigher when the the
workforce has moreeducation and training.2/12/2012 Prof. Rushen Chahal
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The Three Pillars of Productivity
GrowthWhen discussing productivity growth, it is not thecurrent levels of capital (physical), technology and
workforce quality (human capital) that matter, but theirrates of increase.
Wealthy nations have more capital, technology, and
skilled workers than poorer countries
But the growth rates of these inputs are notnecessarily lower in poorer countries
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Country GDP per hourof work 1973(as percentageof U.S. GDP)
GDP per hour ofwork 1998 (aspercentage ofU.S. GDP
GrowthRate
United States 100 100 1.5
France 76 98 2.5
UnitedKingdom
67 79 2.2
Germany 62 77 2.4
Argentina 45 39 0.9
Ireland 41 78 4.1
Mexico 38 29 0.5
Peru 26 15 -0.7
Brazil 24 23 1.2
The U.S. clearly
has a higherGDP per hourof work thanthese othercountries
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Country GDP per hourof work 1973(as percentageof U.S. GDP)
GDP per hour ofwork 1998 (aspercentage ofU.S. GDP
GrowthRate
United States 100 100 1.5
France 76 98 2.5
UnitedKingdom
67 79 2.2
Germany 62 77 2.4
Argentina 45 39 0.9
Ireland 41 78 4.1
Mexico 38 29 0.5
Peru 26 15 -0.7
Brazil 24 23 1.2
But the growth
rate of GDP perhour of workwas higherthan the U.S.for some of
these countriesWhy is this?
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Country GDP per hourof work 1973(as percentageof U.S. GDP)
GDP per hour ofwork 1998 (aspercentage ofU.S. GDP
GrowthRate
United States 100 100 1.5
France 76 98 2.5
UnitedKingdom
67 79 2.2
Germany 62 77 2.4
Argentina 45 39 0.9
Ireland 41 78 4.1
Mexico 38 29 0.5
Peru 26 15 -0.7
Brazil 24 23 1.2
The levels of capitalstock, technology,and education wereprobably lower inthese countries
But the capitalstock, level oftechnology, andaverageeducationalattainment
probably allincreased fasterin thesecountries than inthe United states
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The Three Pillars of Productivity
GrowthThe levelof productivity in a nation dependson its supplies of human and physical capital
and the state of its technology.
But the growth rate of productivity depends on
the rates of increase of these three factors
(Baumol, 2001)
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The Convergence Hypotheses
This hypothesis states that the productivity
growth rates of poorer countries tend to be
higher than those of richer countries, so in the long run the growth
rates will converge (they will become equal).
Time
RealGDP
perCapita
$2,000
$10,000
Richer Country
Poorer Country
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The Convergence Hypotheses
Why might this happen?
In poor countries, the capital stock might be growing fasterthan in rich countries.
The education level might be growing faster as more peoplereceive basic and higher education.
The main reason for this long run convergence is that poorcountries can copy (learn from) rich countries. They donot have to grow through new research and innovation,which is slower and more costly than learning fromsomeone else.
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The Convergence Hypotheses
Innovation: The creation of new technology
and ideas.
The most technologically advanced (rich)
nations depend on research and innovation to
increase technology. This is costly and time
consuming (takes a long time).
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The Convergence Hypotheses
Imitation: Using technologies and ideas
already developed by other nations
to use in your own nation.
Less advanced (poor) countries can use imitation
to adopt technologies already in use by more
advanced (rich) countries
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The Convergence Hypotheses
Does this always happen?
Country GDP per Capita,1999 (In U.S. $)
GDP Growth rate1990-1999
Belarus $2,630 -4.3%
Russia 2,270 -6.1
Ukraine 750 -10.8
Ecuador 1,310 2.2
Haiti 460 -1.7
Cameroon 580 1.3
Rwanda 250 -1.5
Sierra Leone 130 -4.8
Clearly not allpoor countriesexperience this
convergenceprocess
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Growth Policy: Encouraging Productivity
Growth
In order to encourage growth, the government
can take measures to encourage the growth
of:A. Capital (Physical)
B. Technology
C. Workforce Quality (Human Capital)
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Growth Policy: Encouraging Productivity
Growth
We say:
Capital formation (building new physical capital)
Technology development (Technological Progress)
Workforce Quality (Human Capital) Improvement
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Growth Policy: A: Encouraging Capital
Formation
Investment: The purchase of capital by businesses,which will increase the capital stock
Capital Formation: The process through whichbusinesses invest in capital,and thus form new capital
In order to increase the capital stock, governments can dowhat?
They can encourage businesses to invest.
How can they do this?
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Growth Policy: A: Encouraging Capital
Formation
Encouraging Investment:
1. Interest rates
2. Tax laws3. Technical change
4. Growth of demand
5. Political stability and Property Rights
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Growth Policy: A: Encouraging Capital
Formation
1. Interest Rates
Where do businesses get money for investment?
Mainly by borrowing it.
So, when interest rates fall, investment normally
rises. Why?
Because business often borrow to finance their
investments, and the real interest rates is the cost of
borrowing money. When interest rates fall, borrowing
money is less expensive, so investment is less
expensive.
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Growth Policy: A: Encouraging Capital
Formation
1. Interest Rates
Conclusion:
Lower interest rates = less expensive to borrow = more
investment
Higher interest rates = more expensive to borrow = lessinvestment
The government can encourage more investment bylowering interest rates. It can discourage investment by
raising interest rates.
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Growth Policy: A: Encouraging Capital
Formation2. Taxes
Capital gains the profit earned by selling anasset for more than you paid for it.
Taxes on capitalgains - tax on businesses
profits from selling capital.
By decreasing these taxes, government can
encourage businesses to invest more. Taxes oncorporate profits can also be decreased in order to
encourage investment. The government can
encourage investment rates by lowering taxes
on investment.2/12/2012 Prof. Rushen Chahal
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Growth Policy: A: Encouraging Capital
Formation
3. Technology
Technology and capital are closely related. It is often
the case that the only way to use new technology is
to buy new capital.
Therefore when there is new technology available, it
will encourage businesses to investment in new
capital.
Policies that encourage improvement of technology
(to be discussed later) will also encourage investment
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Growth Policy: A: Encouraging Capital
Formation
4. The Growth of Demand
When demand is very high, businesses feel that
increased investment will be profitable.
High levels of sales relative to current capacity
and expectations of rapid economic growth
create an atmosphere conducive to investment
(Baumol, 2001)
Increased government spending or lower taxes (or lowerinterest rates) will increase aggregate demand
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Growth Policy: A: Encouraging Capital
Formation
5. Political Stability and Property Rights
Businesses (and all people) want to be sure that
their property or profits will not be taken fromthem. If they think this will happen, then they
will not invest. This is one reason that
investment in Africa has been so low, but is
now increasing. Property rights are possiblythe most important factor for the creation of
capital.
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The Importance of Investment
Copyright2003 Southwestern/Thomson Learning
(a) Growth Rate 19601991 (b) Investment 19601991
South Korea
Singapore
Japan
Israel
Canada
Brazil
West Germany
Mexico
United Kingdom
Nigeria
United States
IndiaBangladesh
Chile
Rwanda
South Korea
Singapore
Japan
Israel
Canada
Brazil
West Germany
Mexico
United Kingdom
Nigeria
United States
IndiaBangladesh
Chile
Rwanda
Investment (percent of GDP)Growth Rate (percent)0 1 2 3 4 5 6 7 0 10 20 30 40
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Growth Policy: B: Encouraging Technology
Development (Technological Progress)
1. Education
2. Capital Formation
3. Research and Development
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Growth Policy: B: Encouraging Technology
Development (Technological Progress)
1. Education
Who are the leaders in innovation and
technological progress?a. Scientists
b. Engineers
c. Skilled business managers
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Growth Policy: B: Encouraging Technology
Development (Technological Progress)
1. Education
High levels of education, especially
scientific, engineering, and managerialeducation, contribute to the advancement
of technology (Baumol, 2001)
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Growth Policy: B: Encouraging Technology
Development (Technological Progress)
One problem facing some poor countries is
the brain drain the emigration of many of the
most highly educated workers to rich countries.
People from poor countries with a valued
education can often earn far greater incomes
by moving to rich countries.
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Growth Policy: B: Encouraging Technology
Development (Technological Progress)
2. Capital Formation
It is easier to do research and development with new
capital than with old capital. Also, more capital means there are
more resources available for consumption and investment, so there
will be a lower opportunity cost of doing research.
High rates of investment contribute to rapid
technological progress
Thus, the techniques for encouraging capital
formation can also encourage technology
development
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Growth Policy: B: Encouraging Technology
Development (Technological Progress)
3. Research and Development
By directing more of an economys resources
towards research and development, thegovernment can directly influence the rate of
technological development
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Growth Policy: B: Encouraging Technology
Development (Technological Progress)
Government Support for Research and
Development:
1. Subsidies for private R&D spendingthrough tax laws
2. Working together with private companies
involved in research3. Direct government spending on R&D
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Growth Policy: C: Encouraging Workforce
Quality Improvement (Human Capital)
More educated people earn higher wages
People with higher wages are generally more
productive.Thus, there is a direct link between education
and productivity. More education = higher
productivity (generally)
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Growth Policy: C: Encouraging Workforce
Quality Improvement (Human Capital)
In rich countries, primary education is a requirement
by law. It is also paid for through taxes, so everyone
can go to school.
Policies that raise high school rates of attendance
and completion can improve workforce quality.
Policies that improve the qualityof high schooleducation can improve workforce quality.
Unfortunately such policies are difficult to implement
effectively.2/12/2012 Prof. Rushen Chahal
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Growth Policy: C: Encouraging Workforce
Quality Improvement (Human Capital)
Sending more young people to college or trade
schools can improve workforce quality
On the job training can also prove valuable in
improving the quality of the workforce (Human
Capital)
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Growth Policy: C: Encouraging Workforce
Quality Improvement (Human Capital)
China has set the goal of giving every child an
education of at least 9 years by 2007
This is a big taskUnclear whether they will be required to pay
tuition
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The productivity speed-up and
slowdown in America
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Productivity Slowdown, 1973-1995
What caused it?
Growth slowed to about 1.4 percent during this
period
Possible reasons for this include:
1. Low investment
2. High energy prices
3. Low workforce skills (low Human Capital)
4. A technological slowdown
5. Increased environmental regulations
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Productivity Slowdown, 1973-1995
What caused it? Low Investment?
U.S. businesses were not investing a lot (far less
than Germany and Japan)
BUT
Investment did not decline as a percentage of GDP
during this period, so low investment might not have
caused the productivity slowdown (previously, the
same level of investment and higher labor productivity
growth had occurred at the same time)
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Productivity Slowdown, 1973-1995
What caused it? Low Investment?
1948-1973 1973-1995 1995-2002
Growth rate
of laborproductivity
2.8% 1.4% 2.4%
Contribution ofcapital
formation
0.9 1.0 1.6
Contribution oftechnology
1.9 0.4 0.8
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Productivity Slowdown, 1973-1995
What caused it? High Energy Prices?
OPEC raised oil prices sharply in 1973
Higher oil prices should reduce use of energy by
businesses, decreasing labor productivity.
Productivity fell worldwide, not just in the U.S.
BUT
Oil prices dropped in the 80s, but there was no
corresponding productivity increase at that time
So, high oil prices might not have caused the productivity
slowdown
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Productivity Slowdown, 1973-1995 What caused
it? Inadequate Workforce Skills (low Human Capital)?
A general belief that educational quality is declining
in the U.S.
Was it just a case of Americans getting stupider and
worse at their jobs?
Reflected by decreasing rates of standardized tests
and increased labor force share of low-skilled
uneducated immigrants.
Maybe . . . But
Attendance rates, graduation rates and educational
levels have all been steadily increasing over the
slowdown period
So, low workforce skills (low Human Capital) might not have caused
the productivity slowdown2/12/2012 Prof. Rushen Chahal
P d ti it Sl d 1973 1995
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Productivity Slowdown, 1973-1995
What caused it? Technological
Slowdown?Possibly civilian innovation was still higher
earlier, in the 50s and 60s.
Possibly because the U.S. spends most of itsR&D on military developments
Time lag before new technology is adapted by
businesses
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P d ti it Sl d 1973 1995
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Productivity Slowdown, 1973-1995
What caused it? Technological
Slowdown?1948-1973 1973-1995 1995-2002
Growth rate
of laborproductivity
2.8% 1.4% 2.4%
Contribution ofcapital
formation
0.9 1.0 1.6
Contribution oftechnology
1.9 0.4 0.8
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Productivity Slowdown, 1973-1995
What caused it?
A definite answer is still not known.
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Productivity Speedup
Starting in 1995, the U.S. economy
experienced a speedup in productivity growth
This has been attributed to:1. High Investment
2. Falling Energy Prices
3. Advances in Information Technology
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High Investment
An explosion in the IT industry lead to high
investment in the 90s
Investment as a percentage of real GDP rosefrom 9.1 percent in 1991 to 14.6 percent in
2000
A rise in the capital stock led to a rise inproductivity
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Surging Investment
Investment as
percentage of Real GDP,
1991
9%
91%
Investment
EverythingElse
Investment as
percentage of Real GDP,
2000
15%
85%
Investment
EverythingElse
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Surging Investment
1948-1973 1973-1995 1995-2002
Growth rate
of laborproductivity
2.8% 1.4% 2.4%
Contribution ofcapital
formation
0.9 1.0 1.6
Contribution oftechnology
1.9 0.4 0.8
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Falling Energy Prices
1996-1998 Energy Prices were falling.
This should signify a higher consumption of
energy by businesses, and thus higher
productivity
BUT
Oil prices fell in the 80s too, and there was no
corresponding rise in productivity
Maybe it is a combination of factors
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Advances in Information
TechnologyInnovation exploded in the 90s:
Computers => faster and cheaper
Telecommunications systems improved
Development of the internet
Probably also a reflection of the lag time it
took for businesses to fully take advantage of
these new technological advances. These
technologies were first developed before the
90s.2/12/2012 Prof. Rushen Chahal
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Advances in Information
Technology
1948-1973 1973-1995 1995-2002
Growth rate
of laborproductivity
2.8% 1.4% 2.4%
Contribution ofcapital
formation
0.9 1.0 1.6
Contribution oftechnology
1.9 0.4 0.8
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The Productivity Speedup
It seems that both capital formation and
technological change provide logical
explanations for the productivity speedupwitnessed in America recently
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A return to our initial question
Why does the relative price of college tuition
keep rising?
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A return to our initial question
1. As labor productivity increases, real wages
tend to rise at the same rate
When labor is able to produce more per hour,
it is generally paid more per hour
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A return to our initial question
2. In an economy, there are some services
where labor productivity cannot grow, or
growth is limited:
-Teaching
-Simple medical treatments
-Live performances
-Police officers-Chefs
In general, advances in technology do not affect the productivity
of these things.2/12/2012 Prof. Rushen Chahal
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A return to our initial question
3. Real wages in different occupations must
rise at similar rates
This might not hold true for the short run, but
eventually wages must rise at the same rates. This is
because ofopportunity cost. If wages for computer
scientists rise and wages for doctors do not, then
many people who would have become doctors would
become computer scientists instead. So, to haveenough doctors, doctors wages will have to rise with
the wages of everyone else.
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A return to our initial question
The labor productivity of teachers has not
increased as it has in other professions.
But wages for teachers must rise at the same
rates as professions where labor productivity
has increased.
So wages of teachers will rise faster than rises
in their productivity
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A return to our initial question
Because teachers wages rise faster than their productivity, their services
must become more expensive relative to other goods and services
This holds true for all industries where labor productivity growth is limited.
We call this problem the cost disease of the personal services
This is not the only explanation for increased cost. Others include higher
demand (more people go to college now than before) and increased
government subsidies for college (which leads to higher demand).