Health Care Markets Fail So Government Must Intervene? Kenneth Arrow Said No Such Thing

We’ve all been subjected to the familiar mantra, the sort of incantation that echoes through the halls of policy debates: Kenneth Arrow demonstrated that markets fail in health care, necessitating government intervention. This phrase has become something of a talisman for advocates on all sides of the health care reform debate.

What follows this incantation varies wildly. Perhaps you’ll hear a case for regulating nurse practitioners, or a defense of physicians dispensing medications, or even an outright call for price controls on pharmaceuticals. Some will advocate for the complete abolition of profit, private health insurance, and, while we’re at it, human nature itself, all in pursuit of a utopian vision of Medicare for All. To many, it seems that health care is a realm where market failures are omnipresent, and government solutions are the holy grail.

However, one must pause to consider: Kenneth Arrow never actually claimed that government intervention is the panacea for all health care woes.

In 1972, Arrow was awarded the Nobel Prize in Economics for his groundbreaking contributions to economic equilibrium theory and welfare economics, which also included the rather unflattering observation that democracy has its shortcomings.

Nine years prior, the American Economic Review published Arrow’s pivotal paper, “Uncertainty and the Welfare Economics of Medical Care.” Although the Nobel committee chose not to highlight this article, Berkeley health economist James C. Robinson noted that Arrow’s 1963 essay is “a good article by a great economist,” and a significant application of risk theory in health economics, which could pave the way for future advancements.

Indeed, Arrow’s 1963 work remains foundational in health economics, primarily due to its assertion that various market failures impede health care markets from achieving efficiency. As Robinson aptly summarized, the crux of Arrow’s argument is the imperfect and asymmetrical distribution of health care information. Such discrepancies from the ideal of perfect competition often leave consumers and producers unable to make socially optimal choices—or even rationally choose against making them. Arrow observed that both government and market actors frequently attempt to address these issues through various means, including ethical standards.

This is precisely why Arrow’s insights have been appropriated more broadly than perhaps warranted. The health sector is rife with interest groups eager to extract special privileges from the government. What better way to bolster one’s argument than to invoke a Nobel laureate who theorized that health care markets cannot deliver optimal outcomes? Robinson explains that Arrow’s work has been used to justify a plethora of inefficiencies and claims within the health care industry:

[Arrow’s] article…has been seized upon to justify every inefficiency, idiosyncrasy, and interest-serving institution in the health care industry…It has served to lend the author’s unparalleled reputation to subsequent claims that advertising, optometry, and midwifery are threats to consumer well-being, that nonprofit ownership is natural for hospitals though not for physician practices, that price competition undermines product quality, that antitrust exemptions reduce costs, that consumers cannot compare insurance plans and must yield this function to politicians, that price regulation is effective for pharmaceutical products despite having failed in other applications, that cost-conscious choice is unethical while cost-unconscious choice is a basic human right, that what consumers want is not what they need, and, more generally, that the real is reasonable, the facts are functional, and the health care sector is constrained Pareto-efficient.

It would probably astonish the average health economist to learn that Arrow also suggested that government intervention can exacerbate issues; that numerous problems existing in 1963 stemmed from nonmarket interventions; that the government should not restrict medical school admissions or subsidize medical education; that government actions can make health care less accessible by inflating prices; that insurance encourages price inflation; that maximizing health insurance benefits requires “maximum possible discrimination of risks”; and that preexisting conditions are uninsurable, rendering attempts to cover them “probably pointless.” Ideologues and rent-seeking factions tend to quote Arrow more than they engage with his work, read it more than they comprehend it, and distort it more than they genuinely appreciate it.

Furthermore, it might surprise them to know that Arrow wasn’t particularly engrossed in the sector his research so profoundly influenced. By 1999, the health sector had eclipsed all other sectors in terms of congressional lobbying expenditures, a position it has maintained ever since. Such financial clout allows the industry to shape the regulations, tax policies, and subsidies that Arrow’s work helped to stimulate. In 2016, while advocating for a Canadian-style health system in the U.S., Arrow shrugged, stating, “Of course, [Nobel Prize-winning economist] George Stigler would say that there could be regulatory capture, but so far it doesn’t seem to have happened really.”

When the theoretical and the practical collide, what is a social scientist to do?

Click here to read Arrow in his own words. For a deeper dive into how Arrow’s 1963 work diverges from the interpretations of ideologues and special interest groups, check out Kenneth Arrow’s 1963 Article on Health Care Doesn’t Say What You Think.

Michael F. Cannon (MA, JM) is the director of health policy studies at the Cato Institute.