Kenneth Arrow on healthcare economics: a 21st century appreciation

Nobel laureate Kenneth Arrow passed away on February 21, 2017. In a classic, fifty-year-old paper entitled Uncertainty and the Welfare Economics of Medical Care, Arrow discussed how:

“the operation of the medical-care industry and the efficacy with which it satisfies the needs of society differs from… a competitive model… If a competitive equilibrium exists at all, and if all commodities relevant to costs or utilities are in fact priced in the market, then the equilibrium is necessarily [Pareto] optimal” (emphasis added)

Note the implicit assumption that price reflects value, to which I’ll return. As Arrow elegantly explained, there are vast differences between the actual healthcare market and the competitive model, and, moreover, these differences arise from important features of the actual healthcare market.

Identifying the lack of realism of the competitive model in health care may lead to deeper understanding of the actual system. In essence this is what Arrow does. Although both medical care and our expectations have changed greatly, Arrow ’63 is still valid and worth reading today.

Here is Arrow’s summary of the differences between the healthcare market and typical competitive markets.

The nature of demand

Demand for medical services is irregular and unpredictable:

“Medical services, apart from preventive services, afford satisfaction only in the event of illness, a departure from the normal state of affairs… Illness is, thus, not only risky but a costly risk in itself, apart from the cost of medical care.”

Expected behavior of the physician

“It is at least claimed that treatment is dictated by objective needs of the case and not limited by financial considerations… Charity treatment in one form or another does exist because of this tradition about human rights to adequate medical care.”

Product uncertainty

“Recovery from disease is as unpredictable as its incidence…  Because medical knowledge is so complicated, the information possessed by the physician as to the consequences and possibilities of treatment is necessarily very much greater than that of the patient, or at least so it is believed by both parties.”

Supply conditions

Barriers to entry include licensing and other controls on quality (accreditation) and costs.

“One striking consequence of the control of quality is the restriction on the range offered… The declining ratio of physicians to total employees in the medical-care industry shows that substitution of less trained personnel, technicians and the like, is not prevented completely, but the central role of the highly trained physician is not affected at all.”

Pricing practices

There are no fixed prices:

“extensive price discrimination by income (with an extreme of zero prices for sufficiently indigent patients)… the apparent rigidity of so-called administered prices considerably understates the actual flexibility.”

Avik Roy observes in a critical National Review article that “Because patients don’t see the bill until after the non-refundable service has been consumed, and because patients are given little information about price and cost, patients and payors are rarely able to shop around for a medical service based on price and value.”

Medicine has seen major changes since Arrow’s 1963 paper. For example, the treatment of blocked coronary arteries has evolved from coronary bypass to angioplasty to early stents and finally drug-eluting stents. We have seen the advent of minimally invasive surgery, robotic surgery and catheter-based cardiac valve repair and replacement. We have seen drugs to treat hepatitis C and biologicals to treat arthritis and cancer. Many conditions have been transformed from acute to chronic but (at least temporarily) manageable. There are also divergent trends, such as increases in both natural childbirth and Caesarean sections.

In the last 50 years, medicine has become more powerful, but also significantly more complex and overall, more expensive. Intensive care units are a good example, both valuable therapeutically, but expensive to provide. At the same time, many treatments are both better (more valuable to the patient) and less expensive to provide; these range from root canal (frequently two visits to the dentist instead of four) to the significantly less invasive treatments for many cardiac rhythm abnormalities (radio-frequency ablation) and stents for coronary artery disease. The advent of epinephrine auto-injectors has been a lifesaver, but the cost of the Epi-Pen has increased significantly.

Can a competitive economic system appropriately and reasonably price such treatments and devices? Arrow argues that, if not, non-market social institutions will arise and address these challenges. Here is a deeper look.

Arrow’s first two points are still virtually axiomatic today: demand for medical services has become even more unpredictable with the continued growth of advanced, effective interventions and corresponding, appropriately increasing (in my opinion), patient expectations. Similarly, as medical care advances, we increasingly see medical care as a human right and in many cases, a societal obligation. We have come to expect treatment dictated by objective needs and not limited by financial considerations, not only from physicians but from a growing number of key players including pharmaceutical companies. To their credit, in many cases (AIDS comes to mind) pharmaceutical companies have responded by sharply reducing prices in the developing world.

Powerful chemotherapeutic and biologic drugs may have increased the uncertainty and asymmetry of information observed by Arrow, both in their effectiveness and in their side effects. In many cases one needs the language and mathematics of probability and statistics to evaluate, assess and describe their efficacy and utility. One needs an understanding of probability to determine when and how to use common preventive techniques, such as mammograms and PSA screening. Here is an example, paraphrased from Gigerenzer and Edwards (see also Strogatz). Women 40 to 50 years old, with no family history of breast cancer, are a low-risk population; the overall probability of breast cancer in this population is 0.8%. Assume that mammography has a sensitivity of 90% and a false positive rate of 7%.  A woman has a positive mammogram. What is the probability that she has breast cancer? Among 25 German doctors surveyed, 36% said 90% or more, 32% said 50-80%, and 32% said 10% or less. Most (95%) of United States doctors thought the probability was approximately 75%.  (See the links above for the answer, or see my next blog on the challenge of communicating probability).

Arrow’s information asymmetry remains, despite the growing availability of accessible medical information on the web, perhaps for good reasons such as the ability to effectively address the needs of sicker patients.

I would amend Arrow’s discussion of supply conditions to include a wide variety of cost barriers ranging from large fixed costs of ICUs to the costs of medical research. The high cost of basic medical services relative to per capita GDP in the the developing world represents a barrier as high as any faced in the developed world.  As Arrow notes, society has addressed this challenge through a variety of pricing mechanisms outside traditional competitive models. This may not, and in general will not achieve a Pareto optimum, but their wide endorsement by society does indeed suggest that these approaches achieve a more general optimum.

“I propose here the view 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… But it is contended here that the special structural characteristics of the medical-care market are largely attempts to overcome the lack of optimality due to the nonmarketability of the bearing of suitable risks and the imperfect marketability of information. 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.”

It is this view which I find too limiting. I would suggest that society has at least implicitly concluded that price alone does not define value, and thus formed a broader definition of optimality, not simply Pareto optimality in a competitive market. Society is finding and supporting ways to overcome obstacles toward this broader sense of optimality.

The Bill & Melinda Gates Foundation vaccination project aims to reduce the number of children that die each year from preventable disease (currently around 1.5 million). The lifebox project, founded by Dr Atul Gawande, provides affordable, high quality pulse oximeters to the developing world and now seeks to address basic surgical safety in the developing world. Important advances also arise in the developing world; most recently, an easy to deliver, more effective oral cholera vaccine developed in Vietnam.

Arrow himself recognizes the limits of a traditional economic description of the medical care market in his concluding Postscript, arguing that “The logic and limitations of ideal competitive behavior under uncertainty force us to recognize the incomplete description of reality supplied by the impersonal price system.” I conclude more generally that prices not only do not necessarily represent value in medical care (as Arrow observed), but that the combination of uncertainty, externalities, high costs, divergent economies, and technological advance means that price alone cannot describe value in medical care. A broader more general theory of healthcare economics with a foundation standing on the shoulders of giants such as Kenneth Arrow, with perhaps a more general multi-dimensional Pareto optimum, might help us all better understand where we are and where we might go.



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