Arrow on health care

Notes for September 19

Main points

Your PPE correspondent has a nasty cold, so this will be brief.

I laid out where the Arrow article fits in our course. Welfare economics is a part of the utilitarian tradition of linking freedom, markets, and, wait for it, well-being. But instead of maximizing overall utility, the aim is efficiency, in a very specific sense of the word. Arrow describes the theorems of welfare economics and then explains why the market in health care does not fit them very well.

Then Professor Brown led the class through the specific reasons why it is hard to achieve ideal markets in health care.

Prof. Green opines

This is Arrow’s thesis. (I added the numbers.)

“I propose here the view that, (3) when the market fails to achieve an optimal state, society will, to some extent at least, recognize the gap, and nonmarket social institutions will arise attempting to bridge it. … It has always been a favorite activity of economists to point out that actions which on their face achieve a desirable goal may have less obvious consequences particularly over time, which more than offset the original gains.

But it is contended here that the special structural characteristics of the medical-care market are largely attempts to overcome the lack of optimality due to (1) the nonmarketability of the bearing of suitable risks and (2) the imperfect marketability of information. (4) These compensatory institutional changes, with some reinforcement from usual profit motives, largely explain the observed noncompetitive behavior of the medical-care market, behavior which, in itself, interferes with optimality. The social adjustment towards optimality thus puts obstacles in its own path.” (p. 947)

Here is how I understand what that says. There are two reasons why efficient markets in health care and health insurance are difficult to establish: (1) and (2). When society encounters problems like that, (3) it develops ways to compensate for the problems. Those compensating institutions move the society closer to an efficient outcome. However (4) the compensating institutions also make it more difficulty to have efficient markets in health care and health insurance.

This is very complicated and I can’t say that I always followed the thread through his various examples.

I think I understand how licensing, education requirements and the professional ethics of doctors are ways of responding to the problem posed by the consumer’s lack of knowledge. All your advice about what to buy comes from the doctor who is selling it to you, so you want the doctor to be motivated by concern for your health rather than personal profit. To put it another way, you wouldn’t be willing to pay the doctor so much if you didn’t have some assurance that you were getting good advice: licensing, educational requirements, and professional ethical codes are supposed to provide that assurance. So the institutions of licensing, educational requirements, and professional codes all compensate for a problem. But they also make it more difficult to have efficient markets because they reduce the supply of doctors and discourage doctors from competing on price and so on.

So far, so good. However, I find it difficult to draw a line from the information asymmetries that make health insurance partly “unmarketable” to a social response. I can see at least two. First, individuals who want to buy health insurance know more about their risk of ill health than those who are selling health insurance do. So the latter pass up on opportunities to sell insurance at a price the former are willing to pay out of fear that the risks of doing so are greater than they, in fact, are. Second, insurers depend on doctors to certify that treatments are called for under the insurance policy. Since doctors are the ones who get paid for the treatments they recommend, insurance companies demand a higher premium than they otherwise would to cover the losses they anticipate from doctors’ recommending unnecessary treatments. What are the social institutions that compensate for these problems? Maybe the professional ethical code is supposed to take care of the second. But while I see how that might work for individuals, I have a hunch that it doesn’t persuade a firm like an insurance company to ignore the economic incentives behind a doctor’s recommendations.

It’s quite possible that there is no social institution that compensates for the problems with insurance. If so, that’s a big deal: Arrow is right that health care has to be paid for with insurance as the costs are unpredictable and well beyond what most people could cover through savings. Maybe that’s why there has to be government intervention in the insurance market. For instance, Obamacare requires insurance companies to take all comers, regardless of medical risk (this is called “community rating”). It makes up for this by requiring that everyone buy insurance, healthy and sick alike; this ensures that insurance companies can pay for the costs of the sick people that they are required to cover. They use the premiums they get from the healthy people. That does not solve all of the problems with the insurance market, of course, but it is one of the basic parts of Obamacare.

In addition, it seems to me that there is one thing that Arrow’s analysis leaves out. Arrow was concerned to explain why markets for health care and health insurance are inefficient. That means that there are possible mutually beneficial exchanges that do not happen. For example, I want to buy insurance from you at the rate that you are willing to accept but you won’t sell it to me because you are worried that there is something you don’t know that will make it a bad deal for you. That is an inefficient result because we would both be better off if you accepted the price I am willing to pay for insurance and no one would be made worse off by our transaction.

However there is an important class of cases that would be left out even in a functioning market that reaches an efficient outcome. These involve people with chronic health problems who cannot afford to pay the full cost of their care. This class includes people who are born with health problems. It also includes the elderly, who are quite likely to have health problems. There is no insurance market for these people because there is no risk: we know they need care. An insurance company would have to charge a premium that exceeds the cost of the care but buying such a policy makes no sense. That means there is no mutually beneficial exchange left on the table here and so no inefficiency. Other people in the market will have to take a loss if the person with the chronic condition is to get care.

This wouldn’t be a problem if we did not care about whether such people got care. But we do. So it is.

Finally, I found the suggestion that there is a kind of automatic social response to the problems with markets interesting. Posner will say something similar about the way the law works, for what it’s worth. It’s a fascinating suggestion. But don’t they owe some sort of story about the mechanisms in play? If these compensating social institutions are not the result of deliberate decisions, what brings them into existence and sustains them?


Here’s an interview with Arrow from 2009, when Obamacare was being debated. Paul Krugman weighed in, claiming Arrow’s paper showed the need for Obamacare in 2009 and again in 2013. Conversely, opponents of Obamacare take aim at it by disputing Arrow’s arguments.

Atul Gawande’s famous article in the New Yorker also drew on one of Arrow’s themes, professional ethics. Gawande compared the prices for health care in two Texas cities: McAllen and El Paso. While the story is complex, a major part of it is that doctors in McAllen see themselves as businessmen. Gawande thought that explained a lot about how they ran their medical practices. Because they sought to maximize their profits, they ordered more services and charged higher prices than doctors who stick more closely to the older professional standards.

I said that Ronald Reagan was hired by the AMA to proselytize against Medicare. You can listen to it yourself.

Ruiwen asked why the US is an outlier: unlike its wealthy peers, it has no serious attempt at universal health insurance. I said it was the doctors: they profit the most from this system, they blocked universal health insurance during the New Deal and kept at it until recently. But we shouldn’t leave employers out of it either: they run the system the US has and have obstinately insisted on keeping it. Here are a trio of short articles that are relevant to this question. They are by Uwe Reinhart, an economist who specializes in health care. First, the prices for medical services are a lot higher in the US than they are in other countries. If you track down who is keeping the surplus, you’ll probably find a major source of opposition to a national health care system. Second, Reinhart considers whether doctors are overpaid or not. Finally, he blames employers for high health costs: they insisted on keeping a system where buyers can’t exert leverage over sellers, unlike a more unified system.

Since I mentioned Reinhart, allow me to suggest a very interesting and accessible paper he wrote on Arrow’s article: “Can Efficiency in Health Care Be Left to the Market?”, Journal of Health Politics, Policy and Law (2001) (link).

Finally, here are two articles on the history of the US health care system that I think are pretty good.

This page was written by Michael Green for Freedom, Markets, & Well-being, PPE 160, Fall 2013. It was posted September 19, 2013.
Freedom, Markets, & Well-being