Economics of Medical Care Research Paper Starter

Economics of Medical Care

(Research Starters)

This essay examines the application of economic norms and theories to the study of medical care and medical care costs. Using a landmark article published in 1963 by Nobel Prize winning economist Kenneth J. Arrow as a launching point, the analysis of medical economics is presented from the perspective of medical care in a competitive market. A series of retrospective articles presented in the "Journal of Health Politics, Policy and Law" provides further perspectives on Arrow's article. The essay concludes with a brief look at work in the area of market forces in the medical care market and a consideration of the role of the Internet in providing information on quality and price to medical providers and consumers.

Keywords Adverse Selection; Asymmetrical Information; Health Insurance; Managed Care; Managed Competition; Medical Economics; Medical Insurance; Moral Hazard; Pareto Optimality; Price Elasticity of Demand

Health Care Management: The Economics of Medical Care


Is the medical care market a "competitive" market as defined by the discipline of economics? Can the general norms and theories of economics be applied to medical care? These are the questions that are discussed in this article. First, it is important to note that the language used here is "medical" economics and not "health" economics. Medical economics refers to the study of the medical industry as represented by goods and services produced and provided by physicians, ancillary providers, clinics, and hospitals. Health economics implies a state of being that includes factors such as diet, exercise, and individual risk behaviors such as smoking, drinking, non-seat belt use, etc. The exploration of health economics is not considered in the scope of this article and best left for a separate discussion.

The Birth of Medical Care Economics

In December 1963, the "American Economic Review" published an article by noted economist Kenneth J. Arrow, "Uncertainty and the Welfare Economics of Medical Care." This article marks the beginning of the study of medical economics (Hammer, Haas-Wilson & Sage, 2001). The importance of Arrow's article was observed some forty years later as the October 2001 issue of the "Journal of Health Politics, Policy and Law" provided a series of retrospective articles examining the thesis set forth in Arrow's article in light of the tremendous changes in medical care delivery and finance in subsequent decades.

First, to put his article in context, Arrow was writing before the era of health maintenance organizations (HMOs), managed care, and many of the major technological advances in medicine that are commonplace today. These would include advanced imaging such as magnetic resonance imaging (MRI), and major new classes of drugs used in infection control, cancer treatment, mental health, and other conditions. Thus, the retrospective analysis published in October 2001 sheds additional information on Arrow's original thesis in the context of our current understanding of medical economics.

Arrow's thesis in his 1963 article was that "the role of moral hazard in medical insurance arises from inequalities of information between the insurer on the one hand and the physician and patient on the other" (as restated in Arrow, 2001). The concept of moral hazard is defined as the effect of insurance on the behavior of the insured (Nicholson, 1990). In general, the availability of insurance creates the potential for increased demand. This is clearly seen in the medical care market where the spread of insurance, in particular Medicaid and Medicare, has created an increased demand for medical services (Millenson, 2001; Arrow, 1963). Arrow and others argue that medical care markets fail to address increased demand through increased prices because medical care is a non-competitive market. Arrow's contention that medical care is a special market distinct "from the norms of welfare economics" is explored in the following sections (Reinhardt, 2001).

Pareto Optimality

The concept of Pareto optimality, as first described by Vilfredo Pareto in 1897, states that competitive equilibrium exists in a market when an allocation of resources is such that giving one additional allocation to one person results in making another person worse off. Stated another way, a condition of Pareto optimality resource allocation is such that all participants in a market are in equilibrium and a change to make one better off makes another one worse off. Pareto optimality can be further understood by examining the First and Second Theorems of Optimality.

First Theorem of Optimality

The First Theorem of Optimality states: "If a competitive equilibrium exists at all, and if all commodities relevant to costs and utilities are in fact priced in the market, then equilibrium is necessarily optimal: There is no other allocation of resources to services which will make all participants in the market better off" (Arrow, 1963, p. 942). Reinhardt (2001) further states that the assumptions underlying the First Theorem are:

  • Both buyers and sellers understand fully the good and services available in the market
  • Both buyers and sellers are price takers because neither has influence over prices in the market
  • All relevant prices are known to all participants before a purchase transaction takes place.

Second Theorem of Optimality

The Second Theorem of Optimality states: "If there are no increasing returns in production, and if certain other minor conditions are satisfied, then every optimal state is a competitive equilibrium corresponding to some initial distribution of purchasing power" (Arrow, 1963, p. 943). To apply this theorem to the reality of the medical care market one assumes that an equal distribution of purchasing power exists to insure a state of equilibrium. In its most practical sense, an equal distribution of purchasing powers is achieved through taxes and subsidies. Thus, the question of how the purchasing power gets re-distributed becomes a question of politics and social justice and not necessarily economics.

If you argue that the medical market operates in such a manner as to efficiently meet the needs of both patients and providers, e.g. buyers and sellers, you must also argue that the medical market meets the criteria of a market in a state of competitive equilibrium, e.g. fulfills the assumptions of the First and Second Theorems of Optimality.

The significance of the Arrow article is that he was the first to systematically apply the standard norms and assumptions of economics to the medical market especially with respect to competitive equilibrium and Pareto optimality. His work opened the door for subsequent important research and theoretical discourse that continues in the literature to this day.

Asymmetrical Information

Arrow and subsequent researchers theorize that it is the asymmetry of information between patients and providers, mainly physicians that cause the medical market to be characterized as a noncompetitive equilibrium. Researchers, economic and non-economic alike, contend that medical economics are "different" because of the role of information (Robinson, 2001). Asymmetrical information means that the distribution of information between buyers or sellers is skewed, i.e. not equal. In the case of the medical market, the distribution of information is not equal. Buyers, e.g. patients, do not have access to all or the same information as sellers, e.g. physicians. The health care delivery system is built on the assumption that doctors are more knowledgeable about medical diagnosis and treatments than their patients. Because of that knowledge, as a society we give doctors the medical, legal, and political authority to not only provide medical care but also to set policy and determine the pricing structure of medical care.

Uncertainty in Medical Care

This imbalance, or asymmetry, of information is manifest along several dimensions. First is the role of uncertainty in medical care. According to Arrow, uncertainty occurs in two ways. When a patient sees a doctor he is uncertain about the consequences of his decision to purchase treatment in the first place and uncertain about the effectiveness of that treatment in the second place. At the time that Arrow was writing, there was almost no way for a patient to obtain information about his own condition prior to seeing the doctor, no way to determine which doctor was best suited to treating the condition, and no way to evaluate treatment options or outcomes of the treatment (Haas-Wilson, 2001). The internet has provided an avenue for patients to gain a great deal more information about diagnosis and treatment options but by and large, physicians still hold a monopoly on medical information.

This information monopoly on the part of physicians is an outcome of the growth and development of medicine as a profession. As scientific treatments evolved and medical education became more sophisticated, physicians sought to withhold this specialized knowledge from anyone other than a trained physician. This was accomplished by strict licensure requirements and by increasing levels of...

(The entire section is 4070 words.)