Posted: 29 Jun 2007
Date Written: July 2007
In 1958, Reuben Kessel published Price Discrimination in Medicine. It applied intermediate-level price theory to physician behaviour, providing an explanation, in pre-insurance days, of charging fees geared to patients' incomes. Such fee-setting behaviour is consistent with a sophisticated form of income maximization, and offered an alternative to the standard view of sliding fees as a form of charity. It could thus be fitted into the more conventional economic framework of behaviour based on self-interest rather than altruism, leading to Kessel's analysis of the medical profession's interest in limiting entry to practice as a way to consolidate market power. Overall, the paper was a nice example of observed behaviour interpreted through economic theory but rooted in an explicit institutional context. Five years later, Kenneth Arrow published Uncertainty and the Welfare Economics of Medical Care. This extraordinarily influential paper re-directed economists' attention from the supply side to the demand side of the medical market. This shift in focus led directly to the Welfare Burden school of analysis that has so deeply influenced health economics since then. Optimal-insurance coverage could be analysed in terms of a putative trade-off between the benefits of reduced uncertainty and the costs of excess use, where excess is defined relative not to impact on health but to willingness to pay. Arrow recognized the significance of informational imperfections and asymmetries, but his followers largely ignored those qualifications. They have spent a generation playing happily with supposedly exogenous demand curves and the well-defined horizontal supply curves that are generated only by profit-maximizing firms in perfectly competitive industries without specialized factor inputs. Arrow himself adopted this framework unmodified in his 1976 paper on the Welfare Analysis of Changes in Health Coinsurance Rates, where he also makes explicit the assumption necessary to derive welfare conclusions from this framework the population must be made up of identical clones. In that paper, Arrow states: The basic function of health insurance is the reduction of uncertainty. As an empirical statement, this is incorrect. In practice, health care payment systems perform three functions. They do reduce uncertainty, but they also transfer significant amounts of wealth, not just ex post but ex ante, both from individuals at low risk of illness to those at high risk, and from higher to lower income individuals. Insurance systems also serve as a sort of (highly imperfect) consumers' cooperative that creates countervailing power to balance that of suppliers of care. Private insurance is incapable of performing these additional and critical functions and, absent public subsidy or regulatory promotion, is non-existent outside the academic literature. In this presentation we shall show that Kessel's understanding of the dynamics of markets for health care is consistent with this reality, while Arrow's is not. Kessel's framework provides economists with a perspective for recognizing and analyzing issues such as the public-private debate. Arrow's seminal paper leads us away from reality, into a world of theoretical abstractions and distractions. It is unfortunate that iHEA has chosen to offer a prestigious Arrow prize rather than a Kessel prize.
Keywords: health insurance; health care markets; economic theory
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