Uncertainty and the Welfare Economics of Medical Care

By Arrow, Kenneth J. | Bulletin of the World Health Organization, February 2004 | Go to article overview

Uncertainty and the Welfare Economics of Medical Care


Arrow, Kenneth J., Bulletin of the World Health Organization


I. Introduction: Scope and Method

This paper is an exploratory and tentative study of the specific differentia of medical care as the object of normative economics. It is contended here, on the basis of comparison of obvious characteristics of the medical-care industry with the norms of welfare economics, that the special economic problems of medical care can be explained as adaptations to the existence of uncertainty in the incidence of disease and in the efficacy of treatment.

It should be noted that the subject is the medical-care industry, not health. 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. It is the complex of services that center about the physician, private and group practice, hospitals, and public health, which I propose to discuss.

The focus of discussion will be on the way the operation of the medical-care industry and the efficacy with which it satisfies the needs of society differ from a norm, if at all. The "norm" that the economist usually uses for the purposes of such comparisons is the operation of a competitive model, that is, the flows of services that would be offered and purchased and the prices that would be paid for them if each individual in the market offered or purchased services at the going prices as if his decisions had no influence over them, and the going prices were such that the amounts of services which were available equalled the total amounts which other individuals were willing to purchase, with no imposed restrictions on supply or demand.

The interest in the competitive model stems partly from its presumed descriptive power and partly from its implications for economic efficiency....

If, ..., the actual market differs significantly from the competitive model, or if the assumptions of the two optimality theorems are not fulfilled, the separation of allocative and distributional procedures becomes, in most cases, impossible.

The first step then in the analysis of the medical-care market is the comparison between the actual market and the competitive model....

In this paper, the institutional organization and the observable mores of the medical profession are included among the data to be used in assessing the competitiveness of the medical-care market. I shall also examine the presence or absence of the preconditions for the equivalence of competitive equilibria and optimal states. The major competitive preconditions, in the sense used here, are three: the existence of competitive equilibrium, the marketability of an goods and services relevant to costs and utilities, and nonincreasing returns. The first two, as we have seen, insure that competitive equilibrium is necessarily optimal; the third insures that every optimal state is the competitive equilibrium corresponding to some distribution of income. (4) The first and third conditions are interrelated; indeed, nonincreasing returns plus some additional conditions not restrictive in a modern economy imply the existence of a competitive equilibrium, i.e., imply that there will be some set of prices which will clear all markets....

That risk and uncertainty are, in fact, significant elements in medical care hardly needs argument. I will hold that virtually all the special features of this industry, in fact, stem from the prevalence of uncertainty.

The nonexistence of markets for the bearing of some risks in the first instance reduces welfare for those who wish to transfer those risks to others for a certain price, as well as for those who would find it profitable to take on the risk at such prices. But it also reduces the desire to render or consume services which have risky consequences; in technical language, these commodities are complementary to risk-bearing. Conversely, the production and consumption of commodities and services with little risk attached act as substitutes for risk-bearing and are encouraged by market failure there with respect to risk-bearing. …

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