Arrow ‘63

I. Introduction, Scope and Method

First, it should be noted that we’re focusing on medical care specifically here, rather than health in general. Many things affect health beyond just medical care. We’ll be comparing it to the norm in economics of a product sold under perfect competition, where firms don’t have the individual power to set prices, there are no restrictions on supply or demand or transaction costs, and markets are complete (meaning you can buy and sell anything that exists in the market, and can make bets on all possible future states of the world). Under these conditions, the so-called welfare theorems apply. The first welfare theorem shows that such a market will be Pareto stable, meaning no one could be made better off without making someone else worse off (this is also misleadingly called Pareto efficient or Pareto optimal). But this isn’t all that useful, because lots of things can be Pareto stable, even highly unequal societies. So we will prefer some Pareto stable allocations to others. This is where the second theorem comes in: it says that every Pareto stable state corresponds to some initial distribution of wealth with this model.

II. A Survey of the Special Characteristics of the Medical Care Market

As noted before, illness can be very costly. But not just in terms of direct medical costs: serious illness can also reduce future income, either by dropping you out of the labor force for a while or disabling you in some way (not to mention dying, of course). Combined this fact with the unpredictable demand for healthcare, and a customer cannot really test medical care to see if they like it. You can’t simply test out chemotherapy, or try different treatment centers for different prices. To be clear, the problem isn’t that you don’t know how a certain procedure or treatment works: That’s normal for commodities, you generally don’t know how stuff is made. The problem is there is inequality in the information about the consequences of a purchase. It’s a simple fact that the medical practitioner will know much more than you, and this simply can’t be overcome. So while you may expect your landlord or utility company to act in their self-interest, that’s not seen as acceptable for medical workers. After all, acting in their self interest could make your life hell for years, or even kill you, and you wouldn’t know. This means you have to trust them, which normal markets don’t require. Several things result from this. First, it’s common for hospitals to label themselves as non-profits. Second, there’s medical licensing, which in a literal sense delineates which practitioners you should and shouldn’t trust, as getting a license requires years and years of education. Lastly, you’ll expect to stick with the same doctor you trust, instead of always looking for better options like you do with other goods.

III. Comparison with the Competitive Model under Certainty

Usually, people don’t go out of their way to support the consumption of others. It’s not like you’d be particularly moved by someone not getting a computer they wanted, for example. But individuals seem to want to help the health of others. Additionally, there are increasing returns to medical care. Think of how many more things a large hospital can have than a small one, including many things that aren’t divisible, like specialists or medical equipment. This is especially an issue in low-density areas with few, smaller hospitals.

IV. Comparison with the Ideal Competitive Market under Uncertainty

Even if they were insurance policies for all conceivable risks, medical care would still face issues. Since people are risk averse, they will prefer a guaranteed income of X over a non-guaranteed income with an average payout of X. This is, at its core, where insurance companies can make their money: by charging more than X for premiums. It should be noted that there are significant economies of scale here. Administrative costs as a percent of total spending will decrease as the insurer gets bigger. Plus, when the risk pool of customers is larger, there are more people to spread risk around to, so they can offer a lower price.

Postscript

Lastly, a note: Society will naturally create institutions to correct severe market failures. This applies to everything from physician licencing to unions. So we should be careful to decry things for interfering with the free market: they may exist to fix certain problems in the market. But of course, whatever ad hoc way society has of dealing with such problems is not necessarily the best way.

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