University of South Carolina, Arnold School of Public Health, HSPM J712

What makes health care special?

© Samuel L. Baker, 2002 Revised Sept. 19, 2011.

What do I mean by "special"?

"Special" means aspects of health care that would make a free market less than optimal.

Jargon note: When I say that a free market is optimal or efficient, that is about the outcome, not the process. When I say that a free market is sub-optimal or inefficient, that is about outcome, not necessarily about process. Outcome means what the people get. It's the allocation and the distribution: what gets made, how it gets made, and who gets what. Process is about how buying and selling is done. The stock market's process has surely gotten much more efficient with computerization and the internet. Are we getting better results in terms of the allocation of capital in the economy? I'm less sure about that.

Economic systems can be evaluated according to their allocative efficiency or their distributional equity.

Equity -- fairness -- involves value judgments. Economists shy away from this.

Economists therefore usually write about efficiency, as an apparently value-neutral criterion for evaulating a market or a policy.

To ignore distribution, however, is itself to make a value judgement. Can an outcome, free market or otherwise, be labelled "optimal" if people with less ability to pay lack access to needed health care? More on this in class, and below.

Inefficiencies in health care markets

Even leaving aside unequal access by family budget, there are allocative inefficiencies in health care markets.

Free markets are presumed to be efficient (again, by that I mean that they produce efficient outcome). Here is why:

How can a market be inefficient (again, by that I meant that it produces an inefficient outcome, in which it would be possible to make some people better off without making anyone worse off)?

Many people misconstrue what Arrow meant to say with his first and second optimality theorems. If you just look at the first optimality theorem's result, which is that free markets produce optimality, you miss the point. Arrow did not prove that real world free markets produce optimality. What he did was show what assumptions you have to make to conclude that free markets produce optimality.

Here's an analogy: Euclid of Alexandria, the Father of Geometry, did not prove that the three angles of a triangle add up to 180°. What he proved was that you need make a certain assumption about how parallel lines behave if you want to logically conclude that the three angles of a triangle add up to 180°.

Arrow's first optimality theorem is similarly based on certain assumptions. Arrow's real contribution to knowledge was laying out, with mathematical precision, what those assumptions are. Based on that, we can say that a market can be inefficient if:

Arrow, writing in 1963, saw that there were problems for health care in all three of these areas. He was particularly concerned about the third area, information.

I'd like to write about the second area first:

External costs and benefits

External costs or benefits are costs and benefits that fall outside market transactions.

When property rights are unclear or not easily enforced, particularly regarding collective property or public goods.

A public good is a good such that providing it to one person means providing it to everybody.

External benefits make health care special

  1. immunizations and other measures to control the spread of illness
  2. External benefits from consumption of health care services

It may seem like I've snuck my values in, and I do believe that health care is a human right.

The difference is that I am asserting that nearly all of us also believe this, so that we, as a society, are missing a chance to raise the well-being most people, not just those whose health is neglected, by limiting access to services to what the market provides.

How do we deal with this inefficiency of the market, caused by external benefits to health care?

Arrow argues that where you have an inefficiency, societies evolve ways to reduce the inefficiency, by restricting or augmenting the market.

So we have a patchwork of formal programs and social arrangements that provide health care for those who cannot afford it:

A major reason that we don't have a textbook in this class is that I have not found that takes seriously the external benefits of health care.

Private health insurance is shrinking away from its social role (more on both of these later)

Now, let's look at Arrow's main issue in health care:

Information problems

The consumer often cannot make an informed cost-benefit judgment when care is purchased.

This causes potential inefficiency, because the consumer may make a trade that makes him or her worse off.

Arrow: Society's solution is trust. The agency relationship.

Health insurance also involves serious information problems.

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