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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Sharing the burden of healthcare: providing care to our sickest patients

One of the major challenges to affordable, universal health insurance is the high cost of providing care to the sickest patients. According to Roy Vaughn, senior vice president at BlueCross BlueShield of Tennessee, “just 5 percent of the company’s marketplace customers had accounted for nearly 75 percent of its claims costs.” What is the cost of healthcare for the typical person in the United States?Distribution of per capita US health expenditures 2012

Data from 2012, the last year for which a full analysis is available, presents a complex and confusing picture. The graph above shows per capita expenditures by percentile starting with the highest per capita expenditure. 10% face expenditures of at least $10,250. The median per capita expenditure was $854. The mean average per capita expenditure was $4309 – five times the median – and “the top 1 percent ranked by their healthcare expenses accounted for 22.7 percent of total healthcare expenditures with an annual mean expenditure of $97,956″. In brief, there is no typical person: since the bottom 50% accounted for 2.7% of total expenditures, the average per capita expenditure of the top 1% was 420 times that of the bottom 50%. There really is no typical person in terms of healthcare expenditures.

Pareto/ power law distribution of healthcare costs

This extreme distribution of healthcare costs (approximately an “80/20”, Pareto/ power law distribution) poses a major challenge to providing universal healthcare through traditional insurance models based upon risk pooling. Prior to the Affordable Care Act (ACA), the US health insurance industry addressed these challenges with risk selection – adjusting premiums or denying insurance to patients with high predicted risks, such as those with pre-existing conditions, and imposing caps on annual and/or lifetime benefits, much like the way the auto insurance industry sets premiums and limits benefits to address extreme differences in projected driver risks. Come back tomorrow for another blog post with more technical details about the Pareto distribution and healthcare costs.

Risk selection is illegal but prevalent

The ACA makes both caps on benefits and risk selection based upon pre-existing conditions illegal. In particular, US insurance carriers are required to provide coverage to all, at rates independent of pre-existing conditions, a requirement which President-Elect Donald Trump would like to keep.

However, the extreme distribution of healthcare costs means that “Targeting the highest spenders represents the greatest opportunity to have a significant impact on overall spending”; an opportunity for insurance carriers as well as for public policy. Moreover, there are good predictors for high spending: age and end of life, chronic conditions, and high spending in a previous year. For example 44.8% of the top decile in 2008 healthcare expenditures “retained this top decile ranking with respect to their 2009 healthcare expenditures”; a fact cited in an extensive Forbes report. Swiss and Dutch experience found risk selection prevalent and persistent. However, with every adult paying the same premium – within a given fund for the same type of contract – but expected healthcare expenditure (HCE) varying widely, strong incentives for risk selection are created in the absence of an adequate risk adjustment scheme. Although risk selection is illegal, it is prevalent. Swiss conglomerates of insurance carriers have been reported to achieve risk selection by assigning applicants to “specific carriers based on their risk profiles.”

Removing the economic incentives for risk selection

There is one clear way to avoid built-in economic incentives for risk selection (incentives which seem to drive insurance company behavior); that is, a single payer system, universally or as excess coverage for significant, predictable expenses. The United States now has several parallel single payer systems, namely Medicare for the elderly, Medicaid for the very poor and CHIP for children; thus, in effect, a public/private partnership in healthcare. These pre-existing single-payer systems might serve as models for a more inclusive US single payer system. Alternatively, the United States might act as an insurer of last resort, providing umbrella insurance covering individual expenses above some relatively high limit, or for costly but treatable conditions using the End Stage Renal Disease (ESRD) Program, passed in 1972 as a model. This approach would also remove extreme costs from the health insurance risk pool, as both Medicare and the ESRD Program do now, by providing near-universal coverage for our sickest patients outside the private insurance system (elderly US citizens and those with severe chronic kidney disease, respectively).

Tomorrow I will return to the Pareto-like distribution of healthcare expenditures and its consequences for any competitive insurance program. But for now, a few conclusions. Medicare and the ESRD program provide models for a smooth transition from health insurance pre-ACA with its caps and limitations to a more universal system. Medicare can be expanded to a broader public alternative. Universal coverage for additional treatable but high-risk conditions can be modeled on the ESRD program. These steps should provide the basis for further evolution of the present public/private partnership into a more universal, more cost-effective system.

In my opinion, the extreme distribution of healthcare expenditures and the ability to perform risk selection, even though illegal, present a strong, essentially irrefutable argument for a single payer system; either overall, or for chronic conditions and expenditures predictable through risk selection. In the US, Medicare and the ESRD program provide illustrative, successful and useful models.

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Access to medicines and medical technologies for the global poor

The UN Secretary General’s High Level Panel on Access to Medicines recently published its long awaited report Promoting innovation and access to health technologies. The report explores and proposes some solutions to the well recognised problem of under-investment in research and development for new treatments for diseases that afflict the global poor. In the pharmaceutical market, innovation is directed to the areas that generate the highest returns. These market incentives explain why no new anti-tuberculosis drug has been developed since the 1960s. As a result, some of the WHO’s sustainable development goals (SDGs), such as to eradicate TB and malaria by 2030, look fanciful. To increase investment in research and development new incentive structures would need to be put in place.

Interventions already take place in the market to encourage R&D. Patents granting temporary monopolies are already widely used to allow companies to recoup the high costs of drug development. However, reported R&D costs, as we have previously discussed, are likely to be inflated to justify longer patent lengths. The UN report identifies other methods of ‘evergreening’ such as filing multiple patents for small variations of various drugs or patents for multiple indications of the same drug. The World Trade Organisation enforces strict US-style patent rights around the world, but it permits significant flexibility for granting patents. The report recommends punitive action against companies that pressure countries to use these flexibilities in their favour.

Relying on market incentives also leads to other adverse outcomes. The academic medical literature has become distorted. Industry funded research is more likely to find favourable outcomes. In some cases significant harms are not reported as the Vioxx scandal demonstrated. We have also previously reported on how policy uncertainty reduces pharmaceutical R&D. Thus, state involvement in the industry seems to be warranted.

Joseph Stiglitz proposed an international multi-billion dollar fund to reward drug innovations that did the most to improve public health. Other solutions proposed in the UN report are to prohibit patents on innovations resulting from publicly funded research, forcing private companies in the medical sector to disclose the true costs of R&D, and the public financing of biomedical R&D through transaction taxes and other mechanisms.

Some may worry that such restrictions and market distortions may significantly reduce private spending on medical R&D. But it should be noted that only around 14% of the industry’s budget goes towards R&D; a greater share is spent on marketing. However, as an editorial in the Lancet notes, these recommendations would require endorsement and adoption quickly as new legislation such as the trans-Pacific partnership (TPP) is gaining momentum, which will exacerbate the situation further.

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