That invisible hand's not holding a bandage

    Sunday’s Times editorial page for the zillionth time puzzles over  why the US health care system is exceptional: exceptionally expensive without caring for us exceptionally well.

    In 1963 the economist Kenneth Arrow said why. He published a paper on the medical care industry in the December issue of The American Economic Review. My google search didn’t turn up much in the way of a refutation. In 2009 an Atlantic interviewer seemed to feel the same way—neither he nor Arrow discussed any particularly trenchant critics. Perhaps because fairly soon after writing it, Arrow became at 51 the youngest winner of the Nobel Prize for economics.

    In a couple of minutes you could read the couple of sentences in which he summarized for the Atlantic what he’d written 46 years earlier. I recommend that:

    Or with a lot of work—which I don’t recommend—you could take on that original paper. Courtesy of OldenGoldenDecoy who supplied the link:

    The third alternative is Now Read On. On a couple of occasions I’d said I would read it. Done that. I can’t say that reading it caused a veil to drop from my eyes. Also said I would post my summary here. FWIW here it is.

    Clearly it would have been presumptuous for me to pretend I’m qualified to critique Arrow. What I’ve done instead is just turn his pages and quote enough of what seems to be the significant statements so that you get what he’s driving at.

    I start with his conclusion then go through the paper quoting various fragments. Maybe not the most important ones, but ones that struck me. If some don’t seem to make sense go to the source and you’ll probably find my fragments are too fragmentary. Feel free to comment pointing out where I’ve got it wrong. You’ll be doing Dagblog and me a service. Arrow, too.

    His words are in italics. When I insert my own words to replace an overly technical term—that’s in a parenthesis. If I make my own comment, it is in bold face.

    I used to give my papers to my much smarter roommate, who’d ostentatiously skip the first 3 pages saying,  “I never read introductions,” meaning mine. Unlike Charlie you’ve just finished one. So we start with Arrow’s conclusions:

    Page 945

    …illness is……an unpredictable phenomenon The ability to shift the risks of illness to other (i.e. buy insurance) …is worth a price which many are willing to pay. Because of pooling or superior willingness and ability others are willing to bear the risks .Nevertheless a great many risks are not covered……indeed the markets for….risk coverage are poorly developed… (because) it is impossible to draw up …policies which will….distinguish among risks, particularly since observation of the results will be incapable of distinguishing between avoidable and unavoidable risks, so that incentives to avoid losses are diluted....


    Now, backing up, let’s begin at the beginning,


    Arrow says in essence that normally under the Grand Old Market Economy (hereafter GOME) them that has gets. And theoretically society (this was before Margaret Thatcher disposed of the idea there is one) doesn’t have to get into the gritty details of how the medical care industry should be set up, just see that money goes to the right people. But If …the actual market differs significantly from the competitive model the separation of the allocative and distributional procedures       becomes impossible.


    I.e. the GOME doesn’t work.

    The first step … the comparison between the actual market and the (GOME).  …



    Recently, M. Friedman….argued that …any. model should be tested solely by its ability to predict. …This point of view is valuable in stressing that a certain amount of lack of realism in the assumptions of a model is no argument against its value


    (so much for you M. Friedman!)



    When there is uncertainty, information or knowledge becomes a commodity, but the demand for information is difficult to discuss in …rational terms….The frequently not known …to the buyer; if he knew enough to measure the value…he would know the information itself…..But information ,in the form of skilled care, is precisely what is being bought from most physicians…..The elusive character of information….suggests that it departs from the usual   (run of things that can be handled by the GOME)


    That risk and uncertainty are ……significant elements in medical care hardly needs argument……virtually all the special features of this industry …stem from ….uncertainty.


    Footnote One form of information is research. Not only does… (it) have unconventional aspects…new ideas can be used over and over (and there are) difficulties of market control …Hence ….a free enterprise economy will…under invest in research.



    The special …characteristics of ….medical care…are largely attempts to overcome the lack of optimality due to the (fact that it’s hard to insure and) the imperfect marketability of information. These compensatory institutional changes, with some reinforcement from usual profit motives …explain the…noncompetitive behavior of the medical care market.

    ……society (sorry about that, Maggie) will seek to achieve optimality by non market means if it cannot achieve them in the market….the government ….. usually substitutes for the market’s failure.

    ….a good part of the preference for redistribution …..can be reinterpreted as a desire for insurance…..virtually nowhere..has its aim simply equalization of income. The help (goes) to those who are disadvantaged …by events which (are) unpredictable: the blind, dependent children, the medically indigent.


    The most obvious characteristic…of…demand for medical services is that it is not steady …as for food …but irregular and unpredictable…….It is hard …to think of (something else) of which this is true.


    ….the demand for medical services is associated with….an assault on personal integrity. There is risk of death…the .risks are not unique……food is also a necessity but …can be guaranteed with sufficient income where the same cannot be said of avoidance of illness.

    ….the customer cannot test the product before consuming it (so the doc’s) behavior is supposed to be governed by a concern for the customer’s welfare which would not be expected of a salesman.

    [Flavius. On my first visit to a new internist. I heard him saying into the phone “Listen, we’re going to beat this thing”.  I thought, - I like this doc. .]


    Departure from the profit motive is strikingly manifested by the overwhelming predominance of non profit…hospitals


    … is commonplace that the physician-patient relation affects the quality of the medical care product….if nothing else, the patient expects the same physician will …treat him

    Uncertainty as to the quality of the product is…more intense here than in any other…commodity. In most commodities, the possibility of learning from one’s own experience or.others is strong because there is an adequate number of trials….Further, the…uncertainty ….is greater for medical care in severe cases than for, say, houses or automobiles even though .these are also expenditures sufficiently infrequent

    …..the difference in information relevant here is …as to the consequence of a purchase of medical care. There is always.inequality of information …between the producer and the purchaser….but in most cases the customer may well have as good an understanding of the utility of the product as the producer.


    In competitive theory …… governed by the …return compared with the return …from the use of the same resources elsewhere. There is significant departures .in the case of medical care.   Most obviously entry … restricted by licensing. (which) restricts supply and...increases the cost.

    A second feature is more remarkable. The cost of medical education …is high and….borne only to a minor extent by the student (The various subsidies) should …cause a fall in …price….which is offset by rationing through skilled limited entry to schools. ..It is striking and insufficiently remarked…that such an important  part of (the US health care system) should be performed by nonprofit-oriented agencies.

    But whether support is public or private …..both the quality and the quantity of …medical care are being strongly influenced by  ...nonmarket forces


    The problems of….price fixing should be mentioned. Price competition is frowned on….if physicians find themselves with unoccupied time, rates are likely to go down


    The most striking departure from competitive behavior is restrictions on entry to the field. discussed.above…


    … for (medical education) are difficult to obtain

    There is a second aspect in which the contrast with competitive behavior is…even sharper. It is the exclusion of….imperfect substitutes. The licensing laws ….do exclude all others form engaging in……….medical practice

    The pricing practices of the medical industry depart sharply from the competitive norm


    Kessel has argued that price discrimination….is designed to maximize profits along the classic lines of discriminating monopoly ……………….. I do not believe that discrimination is profit maximizing. That price discrimination by income is not completely profit-maximizing is obvious in the extreme case of charity.

    …But it remains true that this price discrimination is a source of nonoptimality  i.e. that there is at least some other system under which no one would be worse off and at least someone would be better.

    Hypothetically……everyone would be better off if prices were made equal for all, and the rich compensated the poor for losing the better prices they enjoyed when the docs discriminated in their favor.


    Footnote A striking illustration of the desire for security in medical care is provided by émigrés from the Soviet Union…..Those in Germany preferred the German system to the Soviet, but those in the United States preferred ( by 3 to 1) the Soviet system. The reasons boil down to certainty of care


    B The Theory of Ideal Insurance

    …individuals are normally risk-averters….if given a choice between a  probability of income with a given mean M and the certainty of  M…he would prefer the latter…Suppose (someone)offer(s) an actuarially fair insurance against medical costs…..the individual will certainly prefer to take out a policy and will have a welfare gain.


    Will this be a social gain? Obviously yes, if the insurance agent is suffering no social loss……


    ….A suitable insurance policy would….mean he paid nothing if he doesn’t benefit

    C Problems of Insurance

     The moral hazard The welfare case for insurance policies…… overwhelming. It follows that the government should undertake insurance in hose cases where this market ….has failed to emerge. Nevertheless, there are….practical limitations.  …One of the limits is the  effect on incentives. What is desired is that the event…is taken out of the control of the individuals…… medical policies the cost…is not completely determined by the illness but depends on the choice of doctor and (the individual’s) willingness to use medical services. To some extent the professional relationship between physician and patient limits the…..hazard


    The need for third party control is reinforced (by the fact that) insurance removes the incentive to shop around for better prices

    963 Administrative costs…… of the most important (costs) is selling costs………... (the) enormous economies of scale …..provides a very strong argument for widespread plans including …….compulsory ones.

    Hypothetically, insurance requires maximum discrimination of risks,


     those in groups of higher incidences of illness should pay higher premiums…In fact there’s a tendency to equalize………This constitutes …a redistribution of income …..some of this may be thought of as insurance with a longer time perspective

    D Uncertainty of Effects of Treatment

    …an ill uncertain about the effectiveness of medical treatment…and his uncertainty may be...different from …his physician

      Ideal insurance will. involve insurance against a failure to benefit


    under ideal insurance medical care will always be undertaken in which the (benefit) exceeds the cost.

    In the absence of ideal insurance…the patient…wants to have some guarantee hat at least the physician is using his knowledge to the best advantage.

    To put it another way the social obligation for best practice is part of (what) the physician sells    As a signal to the buyer. …the physician avoids …obvious…..profit maximizing. Purely arms length bargaining would be incompatible…psychologically with the trust relations.

    Price discrimination and … treatment for the indigent …..follow.

    As a…consequence of informational inequality the patient must delegate….much of his freedom of choice


    To justify this….is to give the “best” treatment… Compromise in quality even to save the patient money is …failure to live up to the social bond.

    Flavius Now this automatic choice of the best practice is explained by fear of being sued.

    Notice the general principle. Because there are barriers to information and…..there is no market (where)…the risks can be insured coordination of purchase and sales must take place through convergent expectations….greatly  assisted by …prominent signals and these in turn force patterns of behavior which are not…………optimal

    (As stated)….the general uncertainty about …medical treatment is handled…by rigid entry requirements…….to reduce uncertainty …of the consumer…this explanation which is perhaps naïve is more tenable than any idea of a monopoly to increase income.

    The social demand for guaranteed quality can be met in more than one way however. (1)The occupation can be licensed


    (2) The state can certify or label without …exclusion…. (3) Nothing at all can be done; consumers can make their own choices.


    …..the failure of the market to insure against uncertainties has (resulted) in the usual assumptions of the market (not applying) The logic and limitations of ideal competitive behavior under uncertainty force us to recognize the incomplete description of reality supplied by the impersonal price system.



    Thanks for wading through this, Flavius. If I had to pick the one bit that resonated the most with me, it'd be this part:

    When there is uncertainty, information or knowledge becomes a commodity, but the demand for information is difficult to discuss in …rational terms….The frequently not known …to the buyer; if he knew enough to measure the value…he would know the information itself…..But information, in the form of skilled care, is precisely what is being bought from most physicians…..The elusive character of information….suggests that it departs from the usual

    Yes I was struck by that too.

    I had hoped  I'd come on statements that caused me to nod my head and say "ah, now it all becomes clear". That didn't happen.. Which caused me to think : what's the big deal about Arrow's paper anyway?. Maybe it's the accumulation of such insights.

    One that interested me was the one where Arrow  says

    o Since the patient can't know what the doc knows, he has to trust him

    o But that means he has to feel like the doc isn't screwing him economically

    o so the doc has to avoid looking like he is profit maximizing, he can't just charge whatever the market will bear.

    Anyway if I had it to do over, I wouldn't.But at least now I don't think that maybe there's some great source of wisdom somewhere on health care.. 


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