Risk, Uncertainty, and the Institutions of Health Care
Arrow, 1963
Michael Ash
Department of Economics
Perspectives – p.1/20
Course Details
• Open spot in presentation on April 29, topic is Unsystematic,
Chapter 8: From HMOs to Managed Care
Perspectives – p.2/20
Basic Argument
• Special economic institutions and problems in medical are
explained as adaptations or problems of uncertainty in
◦ Incidence of disease
◦ Efficacy of treatment
• Arrow analyzes medical-care industry in relation to the
competitive market model.
Perspectives – p.3/20
Notes on “optimality” (recalls Reinhardt)
• Normative loading of the term “optimal”
• Minimal guidance about the best distribution (among optimal
states)
• Reminder of the Second Optimality Theorem (a.k.a. Second
Welfare Theorem)
Perspectives – p.4/20
Positive benchmarks
• Milton Friedman on prediction
• Preconditions for competitive equilibria
◦ Is there competitive equilibrium?
◦ Are the relevant goods and services marketable? (e.g., no
externalities)
◦ Are returns to scale non-increasing?
Perspectives – p.5/20
Non-Marketability
• Technological, e.g., communicable diseases and other
externalities
• Social or historical controls, e.g., market in organs
• Risk-bearing: why are there so many “missing” classes of
insurance?
◦ Moral hazard (avoidable and unavoidable risks, diluted
incentives to avoid losses)
◦ Pricing of information/knowledge
Perspectives – p.6/20
Compensatory Institutions
• Functionalist perspective: “The doctrine that society will seek to
achieve optimality by non-market means if it cannot achieve them
in the market is not novel. Certainly, the government, at least in
its economic activities, is usually implicitly or explicitly held to
function as the agency which substitutes for the market’s failure.”
• Preference for redistribution understood in terms of desire for
insurance. Unpredictable (“deserving”) categories.
Perspectives – p.7/20
Features of the Medical-Care Market
• Demand
◦ Risk. Low probability but high loss (both care and lost
earnings)
• Expected Behavior of the Physician
◦ Why? Cannot test the product before consuming it. Real
danger in self-interested behavior.
◦ “Collectivity-Oriented Behavior”
◦ Very little advertising or overt price competition
◦ Ideology that physician’s advice is completely divorced from
self-interest
◦ Ideology that treatment is dictated by objective needs and
not ability to pay
◦ Social and legal role of the physician as arbiter of health.
◦ Important role of non-profits, suspicion of profit-making
Perspectives – p.8/20
Features of the Medical-Care Market
• Product Uncertainty.
1. Limited trials or second chances.
2. Informational inequality between provider and patient
• Supply Conditions
◦ Licensing (minimum quality standard)
◦ Public subsidy of supply (medical education); and
◦ Rationed entry to medical school; and
◦ Non-profit provision of the education
◦ Non-availability of cheaper, low-cost alternatives
Perspectives – p.9/20
Features of the Medical-Care Market
• Pricing Practices
◦ Price discrimination by income (less than there was in 1963)
◦ Preference for Fee-for-Service. Physician opposition to
prepayment and to closed-panel practice. (Less effective
than it was in 1963).
◦ Limited overt price competition (but likely covert price
competition in response to demand conditions)
Perspectives – p.10/20
Comparison with the Competitive Model
• Non-marketable Commodities. Externalities as already
discussed. Also, widespread sentiment that the health of others
matters for welfare.
• Increasing Returns. Problem of rural provision. Specialists in
cities. (Mitigated by transportation infrastructure.)
• Entry. Generally restricted which boosts physician earnings, but
◦ Marginal entrants would be of lower quality
◦ Subsidy is partly responsible for perception of restricted entry
◦ Failures in the education market (esp. credit for education)
• Exclusion of imperfect substitutes, e.g., immunization centers
• Pricing. Price discrimination as evidence of monopoly.
Prepayment and monopoly pricing. Limits of the monopoly model
to explain actual charity price discrimination. Observation that
ε < 1.
Perspectives – p.11/20
Adding Uncertainty
The risks in medical care:
• becoming ill
• incomplete or delayed recovery
Why don’t suitable insurance policies exist?
For example, only have to pay the doctor when you recover.
Risk and Insurance.
Perspectives – p.12/20
Theory of Ideal Insurance
Risk Aversion. If an individual is given a choice between a probability
distribution of income, with a given mean m, and the certainty of
the income m, he (she) would prefer the latter.
Advantages of Risk Pooling With roughly independent risks, there
can be substantial gains from risk pooling.
An Insurer offers to indemnify the insured. Structure of an insurance
policy: risk, premium, deductible, copayment.
Perspectives – p.13/20
Problems of Insurance
• Moral hazard. Effect of insurance on incentives. Copayment and
deductible.
• Alternative methods of insurance payment: (1) prepayment; (2)
indemnities according to a fixed schedule; and (3) insurance
against costs.
• Third-party control over payments. Prepayment plans (insurance
and medical service are supplied by the same group) strong
incentive to keep down medical costs. Limited incentive to shop
for better prices. Note: direct institutional control rather than
market forces.
Perspectives – p.14/20
Problems of Insurance, continued
• Administrative costs (“loading” fees). Enormous difference
between individual and group policies. Makes case for
widespread, compulsory plans.
• Predictability and insurance. Prefer insurance for risky,
unpredictable events (hospitalization and surgery). (Aside: people
over-insure in many cases, e.g., AAA or wire repair.) Lifetime
insurance against chronic illness desirable but hard to come by.
Perspectives – p.15/20
Pooling of unequal risks
Pooling versus discrimination of risks.
Redistribution of income from those with low propensity to illness to
those with high propensity.
How would a competitive market work? Would separate the two. But
insurance with a longer time perspective.
Preview of Akerlof critique.
Perspectives – p.16/20
Gaps and coverage: 1963
• No coverage of unemployed, institutionalized, aged.
• Between one-fifth and one-fourth of all medical-care expenditures
insured, but
• half of all hospital expenses and 35 percent of care bills of $1,000
per year or more.
Perspectives – p.17/20
Uncertainty of Effects of Treatment
• Uncertainty about the effects of treatment
• Asymmetric uncertainty between patient and provider
• Ideal insurance: pay only in the event of recovery. Advantage:
Care is provided efficiently. Problem: physician would bear the
risk. (Possible solution via pooling.)
• Trust and delegation. Social obligation for best practice by
physician as part of commodity. Delegate choices to the
physician.
• Basic principle: barriers to information flow and incompleteness
of risk markets argue for coordination.
Perspectives – p.18/20
Uncertainty of Effects of Treatment
• Licensing and educational standards
• Arrow has functionalist perspective: licensing is for quality control
under “public pressure”; if it were for monopoly power, “public
pressure” would intervene.
• Types of licensing
◦ Fully licensed occupation; nonqualified are excluded.
◦ Graded licensing for some tasks but not others. (Note:
growth of specialization since 1963, not licensing but
credentialling)
◦ Certification or labelling without licensing.
◦ Consumer choice.
• Question is whether patient or physician bears the risk of gaps in
medical knowledge.
Perspectives – p.19/20
Conclusions
• “The failure of the market to insure against uncertainties has
created [ed.: emph. added] many social institutions in which the
usual assumptions of the market are to some extent contradicted.”
Perspectives – p.20/20