Arrow on markets for medical care Notes for September 14

Main points

The uncertainties involved in medical care explain two things, according to Arrow. They explain why there is no market solution to the inefficient distribution of financial risk. And they explain why doctors act in ways that seem to prevent markets from forming.

Why inefficiency?

Let me unpack that a bit.

The distribution of financial risk is inefficient because there are people who are willing to assume the risk of covering the costs of health care for what others are willing to pay them. But the former do not, in fact, sell insurance to the latter. Thus, we have a Pareto inefficient distribution of risk. There is a possible improvement of everyone’s welfare without reducing anyone’s.

People usually eliminate inefficient distributions such as these when they are free to make exchanges with one another. After all, if you want to sell and I want to buy, the mutually satisfactory solution is pretty obvious. Why does inefficiency persist with health care? Because the uncertainties involved in health insurance are too great. If information were perfect, the relevant exchanges of premiums for insurance would occur. But it isn’t, so they don’t.

Of course, information is never perfect. But it’s far worse in the case of medical care than with other goods.

Since the really big payments for health care are infrequent and unpredictable, consumers pay them through insurance. That adds another layer of complexity to pricing. Insurance companies, rather than the recipients of health care, pay the bills. Their interests are in conflict with those of the recipients and providers of health care, each of whom can hide crucial information from the insurer. Doctors can claim more treatments are needed than, in fact, are. Consumers demand services on the grounds of feeling ill without verification. And consumers know more than the insurers do about how likely they are to need really expensive health care, creating the problem of adverse selection.

Why do doctors act that way?

The providers of medical care, or “doctors,” for short, frustrate market solutions. They restrict entry into their field, reducing the supply of doctors below what the available demand would support. They do not compete on the basis of price. Indeed, they seem to go out of their way to hide as much information about prices as they can. Doctors play dual roles. They both tell consumers what they need and sell their services to meet the need. With other goods, consumers know what they want and look for the best deal among suppliers. With health care, they don’t even know what it is they’re shopping for until a doctor tells them. They need to be told both what condition they have and also how to treat it.

Why do doctors do these things? One explanation is that they use professional standards and the like to extract monopoly rents, prices higher than they could get in a functioning market.

Arrow’s explanation is that they are responding to a demand that consumers make. The problem we face is that doctors know much more about what we need than we do. Our solution, according to Arrow, is to insist that doctors adhere to professional standards that depart from the norms of market behavior. We want doctors to think of themselves as professionals who give objective advice independent of prices. As part of that, we want them to show that this is how they think of themselves. Publishing prices would contradict that image. So they don’t do it.

One result is to make it more difficult to establish markets for health care. But there’s little loss, according to Arrow, since we couldn’t do that even if doctors did not adhere to special professional codes.

Do we buy insurance when we buy insurance?

Arrow is certainly right to note that it doesn’t make sense to pay for routine, predictable care through insurance. It’s predictable, after all. No one is going to sell you insurance to cover the predictable care except by charging more than the care costs.

And yet, that’s pretty much the way it works. I take the boy to Kaiser every three or four months for check-ups. We pay a modest co-payment and the insurance company covers the rest. What gives? Are they dumb to sell me insurance to cover those visits or am I dumb to have bought it?

Here is what I think is going on. My “insurance” policy includes more than insurance, as Arrow analyzes it. It’s partly a savings plan and partly an insurance plan. I pay a set amount every month. This covers my family’s routine care and the risk that we’ll need some expensive, unpredictable care. The part that covers routine care is like a special savings plan and the other part is an insurance policy proper.

Are there good reasons why savings and insurance should go together like that? Why not have my savings plan in a bank and my insurance plan with an insurance company? As you’ll see when you hit the working world, there are high deductible insurance policies coupled with tax deferred health savings plans that do just this. They funnel savings to the financial services companies and insurance to the insurance companies. Some people think that this is the way all health insurance should work. We’ll discuss some of their ideas on November 30. Financial services companies are certainly very keen on the idea.

Does that make more sense than paying one “insurance plus savings” bill to a health company like Kaiser? Are there sensible reasons why the organization that runs my health savings plan also runs my insurance plan? That would be an interesting question to pursue.

This page was written by Michael Green for PPE Senior Seminar, PPE 190, Fall 2009. It was posted September 18, 2009.
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