Uwe E. Reinhardt is an economics professor at Princeton. He has some financial interests in the health care field.



In last week’s post I discussed Kenneth Arrow’s exploration of whether special characteristics set health care apart from other commodities — whether it had a “moral dimension.” The post generated a lively set of commentaries.

Professor Arrow, a Nobel laureate, explored in the early 1960s what the characteristics would be of a perfectly competitive market for an ordinary commodity, how the medical care industry deviated from those characteristics and what aspects of health care might explain these deviations.

He concluded that virtually all the special features of the medical care industry — the role of nonprofit institutions; the expectation that physicians, although vendors of medical services, would always put the interests of their patients above their own self-interest; professional licensing and many other forms of government regulation — could “be explained as social adaptations to the existence of uncertainty in the incidence of disease and in the efficacy of treatment.”

This uncertainty has several aspects.

First, physicians may not agree on the medical condition causing the symptoms the patient presents.

Second, even if physicians agree in their diagnoses, they often do not agree on the efficacy of alternative responses — for example, surgery or medical management for lower-back pain.

Third, information on both the diagnosis of and the likely consequences of treatment are asymmetrically allocated between the sell-side (providers) and the buy-side (patients) of the health care market. The very reason that patients seek advice and treatment from physicians in the first place is that they expect physicians to have vastly superior knowledge about the proper diagnosis and efficacy of treatment. That makes the market for medical care deviate significantly from the benchmark of perfect competition, in which buyers and sellers would be equally well informed.

Uncertainty and asymmetry of information about the quality of goods or services being traded is not, of course, unique to the medical care market. It is ubiquitous in modern economies that trade in highly complex goods and services. We find these characteristics, for example, in financial transactions, including all types of insurance; in automobile repairs, in plumbing and even in the purchase of some consumer electronics.

Wherever asymmetry of information is present, there exists the potential for the better-informed market participants to exploit the ignorance of the less well informed. How society responds to this flaw in markets depends on the severity of its consequences.

In the market for electronic products, for example, the consequences appear to be regarded as trivial. A customer may be seduced into purchasing an excessively complex and expensive product, but society takes no action on this front. In finance, on the other hand, the consequences of asymmetric information can be severe, as we have been reminded once again in the recent financial crisis. That is why society responds by imposing on financial services numerous regulations on disclosure, behavior and industrial structure.

Professor Arrow explained many of the nonmarket social institutions and regulations characteristic of medical care that he had identified as “attempts to overcome the lack of optimality resulting from asymmetry of information and the inability of competitive markets to allocate efficiently all of the risks inherent in health care.”

Pointedly, he said, “It is the general social consensus, clearly, that the laissez-faire solution for medicine is intolerable.”

Professor Arrow touches on the moral aspects of health care only in passing (in the third section of his paper, “Nonmarketable Commodities”). That term refers to what economists call externalities, which occur when a decision-maker may not bear all of the costs or reap all the benefits brought on by his or her decisions.

In formal economics, the moral dimension of health care manifests itself in an externality modeled by economists as “interdependent utility functions.” That fancy jargon covers cases in which person A is happy (altruism) or unhappy (social envy) from knowing that person B consumes a certain commodity. Economists do not prescribe such interdependencies; they take them as givens in prevailing cultural norms.

With respect to health care, Professor Arrow observed that people typically have “concern for the health of others.” He commented:

The taste for improving the health of others appears to be stronger than for improving other aspects of their welfare. In the interdependencies generated by concern for the welfare of others there is always a theoretical case for collective action if each participant derives satisfaction from the contributions of all.

These tastes, Professor Arrow concluded, help explain some unique characteristics of the medical care market, for example, the redistribution of purchasing power built into private and public health insurance and the peculiar form of price discrimination practiced in the industry at the time of his writing, which struck him as not aimed mainly at profit maximization but instead as an attempt to make health care affordable to the poor. (In a still-famous article published in 1958, Reuben Kessel of the University of Chicago had argued that price discrimination in health care was motivated purely by profit maximization.)

Much has changed since the early 1960s. In particular, the unimaginable advances in information technology have revolutionized many sectors of the economy. In health care, this electronic revolution has made it possible for patients to be much better informed about the efficacy of alternative medical treatments. That, by itself, should have reduced the problem of information asymmetry.

On the other hand, as medical science and practice advance rapidly, the information gap between physicians and their patients increases. Many transactions in the market for health care therefore still proceed on the basis of trust in the expertise and integrity of physicians and other health workers, rather than on the countervailing power of equally well-informed buyers and sellers, each looking out only for their own self-interest.

Advances in electronic computation have also given rise to new markets for insurers to trade in the risks and management of health care. In principle, these advances should also have yielded greater transparency on prices in health care. Remarkably, though, prices in the health care sector remain basically opaque to this day.

In a recent interview with Conor Clarke in The Atlantic, Professor Arrow was asked how much of his 1963 paper “is still an accurate representation of the problems the health market faces.”

He responded:

I think the basic analysis hasn’t changed. There are wars over the details, but the basic analysis is accepted. Some specifics have changed. If you look closely at my argument there is a sociological structure. There is a kind of sociological thesis. The market won’t work — it doesn’t work well in the health context. But something else supplements the market, and the thing I put stress on in the paper are the elements that put a non-economic influence on the market: professional commitments to provide a service, to engage in services that aren’t self-serving. Standards of caring decided by non-economic actors. And one problem we have now is an erosion of professional standards. In a way there is more emphasis on markets and self-aggrandizement in the context of health care, and that has led to some of the problems we have today.

Coming from one of the most revered economists of our age, these are sobering thoughts.

Next week, I shall return to Professor Arrow’s comments on the concept of “efficiency,” as economists define and use the term. In my view, when economists wax mushy on the virtue of what they call “efficiency,” it is time to run for the hills, for they are selling a preferred moral doctrine in the guise of science.