Uncertainty and the welfare
economics of medical care
Kenneth Arrow
HSPM J712
• Arrow laid out in mathematical terms the
necessary prerequisites for a free market to
have optimal outcomes
why health care doesn't fit the free
market ideal
Number 1 reason:
• The patient can't evaluate the quality of the
doctor’s advice.
• Arrow calls this "uncertainty."
What economists mean by “optimal”
The Pareto criterion:
• an allocation of resources is "optimal" if there
is no way to rearrange the resources and make
somebody better off without making
somebody else worse off
• “Optimal” = “Efficient” in econ jargon
The First Optimality Theorem
If and only if we have:
• Consumer sovereignty
• Perfect competition
• Everything is for sale
Then
• a free market will generate an optimal
allocation of resources
Consumer sovereignty
• Consumers have the
– Knowledge
– Ability
• To make buying decisions
Consumer sovereignty
• When you buy, you know what the product
will do for you and what all possible
alternative products will do for you
• You know the price of what you are buying
and you know the prices of all alternative
products
Perfect competition
• Buyers and sellers freely choose whether to
buy or sell.
– They freely agree on what price is paid.
– No government restrictions.
– Each actor is a small part of the market. Each acts
as if his or her decisions have no effect on anyone
else.
• No collusion among buyers or sellers, in other words
• Why he assumes “no increasing returns in production”
Why “no increasing returns in production” is needed
Lower average cost at higher rates of
production
Lower prices by big firms
Big firms take over. Only a few firms in
the market.
Monopolistic behavior – the firm
restricts supply to raise the price
Or oligopolistic behavior – firms make
price and output decisions based on
their rivals’ expected behavior
Everything is for sale
• “marketability of all goods and services
relevant to costs and utilities”
• No external costs or benefits
• You can buy insurance against any risk (more
on this later)
The First Optimality Theorem
If and only if we have:
• Consumer sovereignty
• Perfect competition
Then
• a free market will generate an optimal
allocation of resources
Second optimality theorem
– Based on the same assumptions
• If we as a society don’t like the allocation of
resources, we can fix it by redistributing
wealth
The problem of buying information
• Much of what we buy from physicians is
advice.
• To evaluate the advice – to decide how much
it would be worth to us and how much to
offer to pay – we would need to know what
the advice were.
• If we knew what the advice were, we would
not have to buy it.
Buying information is a problem for
consumer sovereignty
But this problem is especially bad for medicine,
because it’s hard to evaluate the advice even
after you get it:
• You (the patient) don’t have medical training
• You may be emotionally upset
• You may be unconscious
Yet you have additional buying decisions to
make.