Uncertainty and the welfare economics of medical care Kenneth Arrow HSPM J712 • Arrow laid out in mathematical terms the necessary prerequisites for a free market to have optimal outcomes why health care doesn't fit the free market ideal Number 1 reason: • The patient can't evaluate the quality of the doctor’s advice. • Arrow calls this "uncertainty." What economists mean by “optimal” The Pareto criterion: • an allocation of resources is "optimal" if there is no way to rearrange the resources and make somebody better off without making somebody else worse off • “Optimal” = “Efficient” in econ jargon The First Optimality Theorem If and only if we have: • Consumer sovereignty • Perfect competition • Everything is for sale Then • a free market will generate an optimal allocation of resources Consumer sovereignty • Consumers have the – Knowledge – Ability • To make buying decisions Consumer sovereignty • When you buy, you know what the product will do for you and what all possible alternative products will do for you • You know the price of what you are buying and you know the prices of all alternative products Perfect competition • Buyers and sellers freely choose whether to buy or sell. – They freely agree on what price is paid. – No government restrictions. – Each actor is a small part of the market. Each acts as if his or her decisions have no effect on anyone else. • No collusion among buyers or sellers, in other words • Why he assumes “no increasing returns in production” Why “no increasing returns in production” is needed Lower average cost at higher rates of production Lower prices by big firms Big firms take over. Only a few firms in the market. Monopolistic behavior – the firm restricts supply to raise the price Or oligopolistic behavior – firms make price and output decisions based on their rivals’ expected behavior Everything is for sale • “marketability of all goods and services relevant to costs and utilities” • No external costs or benefits • You can buy insurance against any risk (more on this later) The First Optimality Theorem If and only if we have: • Consumer sovereignty • Perfect competition Then • a free market will generate an optimal allocation of resources Second optimality theorem – Based on the same assumptions • If we as a society don’t like the allocation of resources, we can fix it by redistributing wealth The problem of buying information • Much of what we buy from physicians is advice. • To evaluate the advice – to decide how much it would be worth to us and how much to offer to pay – we would need to know what the advice were. • If we knew what the advice were, we would not have to buy it. Buying information is a problem for consumer sovereignty But this problem is especially bad for medicine, because it’s hard to evaluate the advice even after you get it: • You (the patient) don’t have medical training • You may be emotionally upset • You may be unconscious Yet you have additional buying decisions to make.