Kenneth Arrow on Health Care: It's Not What You Think

Arrow showed that health care markets fail, goes the ritual invocation of the Nobel Prize-winning economist’s 1963 article “Uncertainty and the Welfare Economics of Medical Care.”1 Therefore, government should do X.

As a rule, people cite Arrow’s 1963 article more than they read it, read it more than they understand it, and distort it more than they embrace it.

Arrow was no libertarian. He advocated a Canadian-style health system for the United States and other types of government-run health systems elsewhere.

Nevertheless, many insights from Arrow’s article would move health care in a libertarian direction. Ironically, the fact that wonks and others have so successfully invoked Arrow to achieve greater government intervention in health care means that fully applying his insights today would result in less government intervention.

Arrow (1963) observes, as others had, that health care markets do not conform to the theoretical construct of a perfectly competitive market. Market actors lack perfect information, for example. We often do not know when we will need medical care, what we will need, whether a treatment will work, or even whether it has worked. At the same time, producers know vastly more, at least about the latter three, than consumers do. Those departures result in output (health, financial security) falling short of what is theoretically possible.

Arrow (1963) then observes 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.” Arrow wrote that the U.S. health sector of 1963 “exemplifies this tendency.” Examples included both government regulation (e.g., clinician licensing) and “other social institutions” (e.g., codes of professional ethics).

Arrow did not argue that market failure ipso facto justifies government intervention. He didn’t even argue that existing interventions had succeeded in bridging the gap between actual and potential output. Sometimes, he wrote, nonmarket interventions cause that gap to widen. Ultimately, he argued against government intervention in health care markets as much as he argued for it.

For starters, Arrow downplayed the importance of health care. He wrote that medical care contributes less to health and welfare, particularly for the poor, than public health or other 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.

Next, Arrow acknowledged that government intervention always introduces new problems—so many, that intervening can make the underlying problem worse:

• 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 argued that greed affects nonmarket interventions in ways that undermine social welfare and admitted that many of the problems present in US health care markets in 1963 were the result not of market forces but of nonmarket interventions. Nonmarket mechanisms aren’t perfect, partly because industry self-interest directs and undermines them:

• These compensatory institutional changes, with some reinforcement from usual profit motives, largely explain the observed noncompetitive behavior of the medical-care market, behavior which, in itself, interferes with optimality. The social adjustment towards optimality thus puts obstacles in its own path.

He argued further that nonmarket efforts to solve a problem can make the problem worse.

• 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, which more than offset the original gains.

Many problems that existed in 1963 were due to 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.

One example is licensing. Arrow argued that clinician licensing increases medical prices, reduces access to care, reduces employment opportunities for non-physician clinicians, under-employs physicians, and reduces innovations in facilities and medical care delivery. Licensing also reduces non-physician clinician productivity, physician productivity, and innovation

• 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 preserving licensing, replacing it with voluntary certification, or replacing it with nothing. On licensing vs. certification vs. laissez-faire, he wrote:

• 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 increases the price of medical education, which led government to intervene further by subsidizing 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 argued against limits on medical school slots and firmly opposed subsidies for medical education, arguing that physicians should pay the full cost of their education themselves.

• 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.

Related to licensing, Arrow acknowledged that government has blocked health plans that reduce frictions surrounding coverage decisions—integrated, prepaid group plans like Kaiser Permanente.

In prepayment plans, where the insurance and medical service are supplied by the same group, the incentive to keep medical costs to a minimum is strongest. In plans of the Blue Cross group, there has developed a conflict of interest between the insurance carrier and the medical-service supplier, in this case particularly the hospital.

Government has also blocked 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.

Reading Arrow, one might conclude that dissatisfaction over prior authorization is the result not of market failure but government failure.

Were today’s health policy wonks to actually read Arrow’s views on health insurance, it would cause a scandal. Arrow argued that health insurance encourages higher medical prices, that charging higher premiums to the sick is necessary to maximize the benefits from health insurance, that preexisting conditions are uninsurable, and that insuring preexisting 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 of 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 tempers 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 referred to government failures indirectly. He identifies three groups to whom markets were failing to provide health insurance in 1963. Uninsured groups were those whose health insurance purchases the government penalized.

• 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 reader might think Arrow was identifying a market failure. Yet those just happen to be groups whose health insurance purchases the federal tax code had been penalizing for 40 years.2

Unlike his followers, Arrow described his conclusions as tentative and was reluctant to draw any policy recommendations from them. Arrow was more modest than his acolytes.

• This paper is an exploratory and tentative study. I have been chary about drawing policy inferences.

By 1999, the health sector had overtaken every other economic sector in terms of congressional lobbying expenditures, a distinction it has held ever since, as shown in Figure 1:

Two years later, U.C. Berkeley economics professor James C. Robinson hailed Arrow (1963) as “a good article by a great economist.”3 But Robinson rued the article’s ubiquitous abuse by health care’s bootleggers and Baptists:

• The central proposition of [Arrow’s] article, that health care information is imperfect and asymmetrically distributed, 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….

• For the noneconomist, Arrow’s primary message should be that most sectors of the economy work reasonably well (at least compared to medicine)… and hence that the price mechanism should be accorded greater respect and its potential applicability to the health sector be pushed higher on the list of research priorities.

Fast forward to 2016. By then, bootleggers and Baptists had spent half a century misappropriating Arrow to protect the world’s most expensive government health care programs and highest medical prices, as well as lots of low-quality care.

Even so, in that same year, Arrow said the following4 about his belief that the United States 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 doing in the 50 years since he published his article, he wasn’t paying close attention to U.S. health care.

Invoke with caution.

Footnotes

[1] Kenneth Arrow, “Uncertainty and the Welfare Economics of Medical Care,” The American Economic Review. December 1963.

[2] Michael F. Cannon, “End the Tax Exclusion for Employer-Sponsored Health Insurance.” Cato Institute, May 24, 2022.

[3] James C. Robinson, “The End of Asymmetric Information.” Project Muse, October 2001.

[4] See Asher Schechter’s interview of Arrow, “There Is Regulatory Capture, But It Is By No Means Complete”. ProMarket, March 15, 2016