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INTERVIEW //

Kenneth Arrow: Re-examining the Health Care Market, 50 Years On

Nobel Prize-winning economist Kenneth Arrow discusses the current state of the health care industry.

By Adam Marcus // Spring 2013
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Denise Bosco for Proto

In 1963, Kenneth Arrow, a Stanford economist well on his way to winning a Nobel Prize in Economics, published a paper in The American Economic Review on what had been an unexplored area of research: the market for health care. In perhaps no other industry, he wrote, are consumers as uncertain about the quality of the services they are receiving. Comparison shopping is all but impossible: Buying health care is not like getting a haircut or making a stock trade, transactions in which both buyer and seller should in theory have access to the same information about price and value. As a result, Arrow says, all consumers can do is trust physicians—a distinctly nonmarket relationship. American medicine has undergone significant changes in the five decades since the publication of Arrow’s paper. But health care continues to exhibit the nonmarket interactions he described, suggesting that his thoughts about the system still apply.

Q:When your paper appeared in 1963, the vast majority of physicians worked in private practices, Medicare and Medicaid had yet to be created, and, not surprisingly, only about half of all Americans over age 65 had medical insurance. The U.S. health care system, then, is in many ways unlike the one you were writing about. How has your analysis changed to accommodate these developments?

A: There has been a certain chipping away of the trust relations among the health care industry, the insurers and the public. Overt commercialization is much more prevalent now than it was then. The idea of hospitals advertising in newspapers, for example, is a relatively new phenomenon. The interpretation in my original paper was that this failure to act commercially was in a way a signal to the public: “We’re not out to get you; we have obligations to you; we won’t over treat to fill up our idle time.” But even now, I think we are relying on the obligations of doctors not to do too much. The social contract—that doctors will to some extent go against their self-interest by not taking advantage of their superior knowledge—shows up in many ways. For example, medical associations will recommend healthy living habits, an action that will reduce their income.

Q: You wrote that uncertainty about the quality of health care is “perhaps more intense here than in any other important commodity.” Why does that matter for patients?

A: Uncertainty about the cost of medical care can be transferred through the market by means of an insurance policy. But uncertainty about the quality of care cannot be insured against in any simple way. The fact of low quality would have to be established, which would be difficult. In extreme cases, there is a remedy in the form of medical malpractice litigation, but the difficulties and costs of this procedure are obvious. We can try to transfer the financial risks, but there’s no good way to transfer the risks in the quality of performance. If you have a repetitious operation‐manufacturing integrated circuits, say—you can correct errors. You can communicate, supervise, test. The trouble with medicine is that every event is unique, and patients are not in a position to enforce good quality. They’re not in a position to know there’s an error, and if they do, what are they going to do about it? That’s why I’m hesitant about reducing malpractice litigation. There’s no question that litigation encourages defensive medicine. But it is a way, albeit crude, of calling people to account.

Q: You note that physician groups use extensive training and licensing as means of establishing barriers to entry into the field. Why is this so important?

A: Milton Friedman, another Nobel laureate in economics, argued that we shouldn’t even license doctors. People would simply learn the good products and the bad products—although it’s not clear how this learning would be spread. With a brand of car that performs badly, a lot of people talk about it and the market moves away from it. The reason is that one car is like another, and if yours is bad, mine is likely to be bad too. But doctors are unique. We rely on the doctors themselves to do the policing—but they tend to stick together. Licensing and the requirement of training provide some limitations on the risks of low quality in addition to the imperfect information contained in word of mouth and the recommendations of other physicians. It remains true, however, that these necessary regulations can be used to restrict entry and so raise fees. There is no full solution.

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