Arrow demonstrated that health care markets are prone to failure, a notion that echoes from his 1963 seminal paper “Uncertainty and the Welfare Economics of Medical Care.” This leads to the conclusion that the government should implement X.
In practice, it seems many quote Arrow’s work more than they engage with it, and they engage with it more than they truly comprehend it, often twisting his insights to fit their narratives.
Arrow was not a champion of libertarianism; rather, he endorsed a Canadian-style health system for the U.S. and various government-run health systems internationally.
Yet, in a curious twist of fate, many of Arrow’s observations could actually push health care towards a more libertarian model. Ironically, the very champions of government intervention who invoke Arrow’s name might find that a rigorous application of his insights today would advocate for less governmental involvement.
Arrow (1963) pointed out, as others had, that health care markets do not fit the idealized model of perfect competition. Market participants often operate without complete information; we frequently lack knowledge about when health care will be needed, what specific care is required, or whether a treatment will be effective. Concurrently, providers have a significant information advantage over consumers, leading to a scenario where health outcomes and financial security fall short of potential.
Moreover, Arrow noted that “when the market fails to achieve an optimal state, society will, to some extent at least, recognize the gap, and nonmarket social institutions will arise attempting to bridge it.” He identified the U.S. health sector of 1963 as a prime example of this phenomenon, citing government regulations (like clinician licensing) and “other social institutions” such as professional ethical codes.
Importantly, Arrow did not argue that market failure automatically necessitates government intervention. He also did not claim that current interventions effectively close the gap between actual and potential output; indeed, he suggested that in some cases, nonmarket interventions could exacerbate the issue. Thus, he approached the question of government intervention with a critical lens, equally highlighting its potential pitfalls.
To begin with, Arrow downplayed the role of health care itself, asserting that it contributes less to overall health and welfare—especially for impoverished populations—than public health initiatives or basic commodities. He wrote (1963):
- The causal factors in health are many, and the provision of medical care is only one. Particularly at low levels of income, other commodities such as nutrition, shelter, clothing, and sanitation may be much more significant…. There is every reason to suppose that [the contribution of public health to welfare] is considerably more important than all other aspects of medical care.
Arrow also recognized that government actions introduce their own set of complications—so many, in fact, that intervention can worsen the original problem:
- It is virtually impossible to find a set of taxes and subsidies that will not have an adverse effect on the achievement of an optimal state.
He noted that self-interest could distort nonmarket interventions, leading to a decrease in social welfare and admitted that many of the issues plaguing U.S. health care markets in 1963 stemmed not from market forces but from these very interventions. Nonmarket solutions are imperfect, often undermined by industry self-interest:
- These compensatory institutional changes, influenced by typical profit motives, largely explain the observed noncompetitive behavior of the medical-care market, which, in itself, impedes optimality. The social adjustment towards achieving optimality thus creates obstacles in its path.
Arrow further asserted that nonmarket approaches could worsen existing problems:
- Certainly this process is not… uniformly successful in approaching more closely to optimality when the entire range of consequences is considered. It has always been a favorite activity of economists to point out that actions which on their face achieve a desirable goal may have less obvious consequences, particularly over time, that may more than offset the original gains.
Many of the challenges identified in 1963 were, according to Arrow, the result of nonmarket interventions:
- The failure of the existing market to provide a means whereby the services can be both offered and demanded upon payment of a price… may be due to social or historical controls…. Both the quality and the quantity of the supply of medical care are being strongly influenced by social nonmarket forces.
Take licensing, for instance. Arrow contended that clinician licensing inflates medical costs, limits access to care, curtails employment opportunities for non-physician clinicians, underutilizes physicians, and stifles innovation in medical facilities and care delivery. Licensing also hampers productivity among non-physician clinicians and physicians alike:
- The licensing laws… exclude all others from engaging in any one of the activities known as medical practice. As a result, costly physician time may be employed at specific tasks for which only a small fraction of their training is needed, and which could be performed by others less well trained and therefore less expensive. One might expect immunization centers, privately operated, but not necessarily requiring the services of doctors.
Arrow was open to maintaining licensing, replacing it with voluntary certification, or even eliminating it altogether. Regarding the debate between licensing, certification, and laissez-faire practices, he noted:
- It is beyond the scope of this paper to discuss these proposals in detail. I wish simply to point out that they should be judged in terms of the ability to relieve the uncertainty of the patient in regard to the quality of the commodity he is purchasing.
Arrow observed that licensing drives up the cost of medical education, prompting further government involvement through subsidies for medical education:
- The high cost of medical education in the United States is itself a reflection of the quality standards imposed by the American Medical Association [i.e., licensing]… and it is, I believe, only since then that the subsidy element in medical education has become significant. Previously, many medical schools paid their way or even yielded a profit.
He opposed limits on the number of medical school slots and firmly rejected subsidies for medical education, arguing that physicians should bear the full cost of their training:
- The earnings of physicians rank highest among professional groups, so there would not at first blush seem to be any necessity for special inducements to enter the profession…. One might expect that the tuition of medical students would be higher than that of other students…. To achieve genuinely competitive conditions, it would be necessary not only to remove numerical restrictions on entry but also to remove the subsidy in medical education. Like any other producer, the physician should bear all the costs of production, including, in this case, education.
In relation to licensing, Arrow acknowledged that government has obstructed health plans aimed at minimizing decision-making frictions surrounding coverage—integrated, prepaid group plans like Kaiser Permanente.
In such prepayment plans, where insurance and medical services are provided by the same organization, the incentive to keep costs low is strongest. Conversely, in plans such as those offered by Blue Cross, a conflict of interest emerges between the insurer and the provider, particularly the hospital.
Government has also hindered integrated, prepaid health plans:
- In the past, the opposition to prepayment plans has taken distinctly coercive forms, certainly transcending market pressures, to say the least.
One might infer from Arrow’s analysis that frustrations with prior authorization stem not from market failures but rather from government failures.
“Were today’s health policy wonks to actually read Arrow’s views on health insurance, it would cause a scandal.”
Indeed, if contemporary health policy experts were to truly digest Arrow’s insights on health insurance, it could spark quite a controversy. Arrow posited that health insurance contributes to inflated medical costs, that charging higher premiums for the sick is essential to optimize health insurance benefits, that preexisting conditions are largely uninsurable, and that insuring those with such conditions is “pointless.”
- Insurance removes the incentive on the part of individuals, patients, and physicians to shop around for better prices for hospitalization and surgical care.
- Hypothetically, insurance requires for its full social benefit a maximum possible discrimination of risks. Those in groups with higher incidences of illness should pay higher premiums.
- Among people who already have chronic illness, or symptoms which reliably indicate it, insurance in the strict sense is probably pointless.
On a more technical note, Arrow argued that consumer risk aversion naturally mitigates adverse selection in health insurance markets:
- From the point of view of the individual, since he has a strict preference for the actuarially fair policy over assuming the risks himself, he will still have a preference for an actuarially unfair policy, provided, of course, that it is not too unfair.
Arrow also alluded to government failures in a more indirect manner. He identified three demographic groups that the market was failing to insure in 1963. These were the unemployed, the institutionalized, and the elderly—groups penalized by government policy in their health insurance pursuits:
- Insurances against the cost of medical care are far from universal. Certain groups—the unemployed, the institutionalized, and the aged—are almost completely uncovered…. The insurance mechanism is still very far from achieving the full coverage of which it is capable.
A casual observer might interpret Arrow’s observations as a critique of market failures. However, it’s noteworthy that these groups also coincidentally represent those whose health insurance purchases the federal tax code has penalized for four decades.
Unlike his adherents, Arrow characterized his conclusions as tentative, hesitating to draw sweeping policy recommendations:
- This paper is an exploratory and tentative study. I have been chary about drawing policy inferences.
By 1999, the health sector had eclipsed all other economic sectors in terms of congressional lobbying expenditures, a title it has maintained ever since, as illustrated in Figure 1:
Fast forward to 2016. By then, the bootleggers and Baptists of the health care sector had spent five decades misappropriating Arrow’s insights to safeguard the world’s costliest government health care programs and exorbitant medical prices, alongside a fair share of subpar care.
In 2016, Arrow himself remarked on his belief that the U.S. should adopt a Canadian-style single-payer system:
- 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.
Whatever Arrow was preoccupied with in the half-century following his article, it appears he wasn’t keeping a close eye on U.S. health care.
So, invoke with caution.
