“It is the general social consensus, clearly, that the laissez-faire solution for medicine is intolerable.” – Kenneth Arrow, 1963.

As Republicans struggle to find an acceptable replacement for Obamacare, a task that does not yet appear to be complete given the growing opposition to their recent proposal, they would do well to remember the words of the person who invented healthcare economics, Kenneth Arrow.

Professor Arrow, a Nobel Prize-winning economist who recently passed away at the age of 95, argued that the market for healthcare is not like other markets for several reasons.

Healthcare often involves large, unexpected expenses. To be able to pay these large expenses if and when they occur, people must have adequate savings or the ability to borrow when needed to cover the costs. But even that may not be enough, an individual may not have saved enough or be able to borrow enough to cover necessary healthcare costs. In the face of such uncertainty – not even knowing who will need healthcare and when – pooling money into an insurance fund and then sharing the risk of a major expenditure across individuals is a natural way to handle this uncertainty.

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But health insurance markets have the well-known problems that are difficult to overcome. First, there is what economists call moral hazard –- people tend to take more risks when they are insured or seek healthcare for trivial ailments. The insurance company is paying, so why not? Deductibles, which make it costly to take risks or get help for minor problems, are one way to overcome the moral hazard problem.

The bigger problem is called “adverse selection.” When people are pooled together in an insurance fund some will have very high expected medical costs (due, for example, to pre-existing conditions), others will have low expected costs, and the premium they are charged will reflect average healthcare use. For the healthy, that’s a bad deal – the premiums are more than their expected health spending. So many of them won’t purchase insurance (and the emergency room is available for serious problems, and if the bill is big enough someone else will end up paying). That leaves more people with high expected health costs in the insurance pool, leading to higher premiums and more dropouts, a process that continues until only the highest cost patients are left and the premiums are unaffordable.

One way to stop this spiral to market collapse is a mandate that keeps healthy people in the insurance pool. The mandate in Obamacare wasn’t strong enough, and too many relatively healthy (and often young) people went without insurance. The mandate in the Republican proposal is even weaker and actually creates an incentive to go without insurance. The penalty for going without insurance does not occur until you sign up for insurance after a lapse, so the rational thing to do is to wait as long as possible before getting insurance. It’s hard to see how this will work.

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The presence of insurance companies in the health services market creates another problem. It means people are going to have their choices – what will be paid for, the type of care, etc. – determined by insurance companies and the policies they offer. Unlike most other goods, you can’t choose whatever health care treatment you want. The insurance company must approve it, and insurance companies will deny payment whenever possible. They have whole staffs devoted to finding reasons to deny payment, so some type of regulatory oversight is needed to ensure consumers get the care they were promised.

But the most problematic aspect of delivering healthcare in the private marketplace is that consumers do not have the information they need to make informed healthcare choices. What type of implantable heart monitor is best? If they are on sale down the road, can I trust the quality? Do I even need this procedure – are there other treatments that are equally or more effective? Doctors often disagree, if they don’t know the answers, how can I make informed choices?

We often don’t care about information problems; for example, the market for wine certainly involves a great deal of uncertainty on behalf of consumers. In many cases, people likely pay far too much for wine due to their lack of knowledge. But unlike health care, the consequences of making a bad wine choice won’t end up harming your health permanently, or maybe even causing death. When market failures have potentially severe consequences, such as in healthcare or the financial sector, regulation is needed to insulate against very costly outcomes for individuals or the economy as a whole.

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How can the information problem be solved? One way is through professional standards, certification, and self-policing within the medical profession. We expect more from doctors than we expect from, say, car salespeople. We expect doctors to guide us in making the best possible healthcare choices, but I have no such expectation when I buy a car. Doctors could sell all sorts of unnecessary tests, follow-ups, etc. to unwitting consumers – think of all the unnecessary add-ons you are pressured to purchase after agreeing to buy a car – but we expect more from medical professionals.

In this regard, Professor Arrow made an interesting comment in an interview in 2009 when asked if anything had changed since he wrote his path-breaking paper on health economics decades ago:

“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 healthcare, and that has led to some of the problems we have today.”

Another way to overcome the information problem is to let an informed agent make decisions on your behalf. This is the role that institutions such as HMO’s are supposed to play. But HMOs make less money when consumers receive more care, and consumers do not trust HMO-type institutions to make important decisions about their health. Thus, regulatory oversight is needed to make sure that insurance companies are delivering policies that provide adequate coverage, and that consumers can get the care the pay for.

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That does not end the long, long list of problems in healthcare markets. For example, if everyone around me is healthier, I am less likely to get sick, so there are what economists call “externalities” in these markets. When externalities are present, the private sector will not produce the socially desirable quantity of a good. Government mandates that, for example, require people to be vaccinated against some diseases can overcome this problem.

When you put all of these problems together, especially the information problem, professor Arrow’s assertion seems clearly true. The market for healthcare does not operate like most markets. Government involvement is needed to ensure consumers get the care they need, and to ensure that care providers are not taking advantage of consumer’s lack of knowledge.

Once the need for government involvement to overcome market failures is accepted, and to me, it seems impossible to deny, the question is how well a particular healthcare proposal addresses these problems. Obamacare is not perfect, and some tweaks were needed. But it did a pretty good job of tackling these varied and difficult problems in healthcare markets.

However, the Republican plan does not even seem to recognize the full extent of the problems in healthcare markets, and when it does, the remedies are far from adequate. Anyone who is serious about a delivering broad-based, affordable healthcare insurance should give it two bigly thumbs down.