Fermat's Library | Uncertainty and the Welfare Economics of Medical Care annotated/explained version.

TH1E

AMERICAN

ECONOMIC

REVIEW

VOLUME

LIII

DECEMBER

1963

NUMBER

5

UNCERTAINTY AND THE

WELFARE

ECONOMICS OF

MEDICAL CARE

By

KENNETH J.

ARROW*

I.

Introduction:

Scope

and Method

This

paper

is an

exploratory and

tentative study of

the specific

differentia

of

medical care

as the

object of normative

economics.

It

is contended

here, on the

basis of

comparison of

obvious

characteris-

tics of the

medical-care

industry with

the norms

of

welfare

economics,

that

the

special

economic

problems of

medical care

can be

explained

as

adaptations

to

the

existence of

uncertainty in the

incidence

of dis-

ease and in

the

efficacy of

treatment.

It

should

be noted that

the subject is

the medical-care

industry,

not

health.

The

causal factors

in

health are

many,

and

the provision

of

medical

care is

only one.

Particularly at low levels

of

income,

other

commodities such as

nutrition, shelter,

clothing,

and

sanitation

may

be

much

more

significant.

It

is the

complex

of services that

center

about the

physician, private

and

group

practice,

hospitals,

and

public

health,

which I

propose

to

discuss.

The focus of

discussion will be

on

the way the

operation of

the

medical-care

industry

and

the efficacy with

which it

satisfies the needs

of

society

differ from a

norm,

if

at all. The "norm"

that

the econo-

mist usually

uses for the

purposes

of

such

comparisons

is

the

operation

of a

competitive

model,

that

is,

the

flows

of

services

that would

be

*

The

author

is

professor

of economics

at

Stanford

University. He

wishes to express

his

thanks for useful comments

to

F.

Bator,

R.

Dorfman,

V.

Fuchs,

Dr.

S.

Gilson,

R.

Kessel,

S.

Mushkin,

and

C. R.

Rorem. This

paper

was

prepared

under

the

sponsorship

of the Ford

Foundation

as

part

of

a

series of

papers

on the economics of

health,

education,

and

welfare.

942

THE

AMERICAN

ECONOMIC

REVIEW

offered and

purchased and the

prices that would

be paid for them

if

each

individual in

the market

offered or purchased

services at the

going

prices as if his

decisions had no

influence over

them, and the

going

prices were such

that the amounts

of services

which were

available

equalled the total

amounts which

other

individuals were willing

to

purchase, with no

imposed

restrictions on supply

or demand.

The interest in

the competitive

model stems

partly from

its

pre-

sumed descriptive

power and partly

from its

implications

for

economic

efficiency. In

particular, we can

state the following

well-known

prop-

osition

(First

Optimality

Theorem). 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 optimal

in

the following

precise sense (due

to V. Pareto):

There is no other

allocation of

resources to services

which will

make

all participants in

the

market better

off.

Both the

conditions of this

optimality theorem

and the definition of

optimality call for

comment. A

definition is

just

a

definition, but

when

the definiendum is

a word already

in common use

with

hWighly favor-

able

connotations,

it is clear that

we are really

trying to be

persuasive;

we are

implicitly

recommending

the achievement of

optimal states.' It

is

reasonable

enough to assert that

a change in

allocation which

makes

all

participants

better off is one

that certainly

should be made; this

is

a value

judgment, not a

descriptive proposition,

but it is a very

weak

one. From this it

follows that it is

not desirable to

put up with a

non-

optimal allocation.

But it does not

follow that if

we are at an

alloca-

tion

which is

optimal in the Pareto

sense, we should

not change to

any

other. We cannot

indeed make a

change that does

not hurt

someone;

but

we can still

desire to change

to another

allocation if the

change

makes

enough

participants better

off and by so much

that we feel that

the

injury

to

others is not enough

to offset the

benefits. Such

inter-

personal

comparisons are, of

course, value

judgments. The

change,

however, by the

an optimal state;

of

course there are

many possible

states, each of which

is

optimal

in the

sense here used.

However,

a

value judgment on

the desirability of

each possible new

distribution

of

benefits and

costs

corresponding

to each possible

re-

allocation

of

resources is not, in

general,

necessary. Judgments

about

the distribution

can

be made

separately,

in

one

sense, from those about

allocation

if

certain conditions

are fulfilled.

Before

stating the relevant

proposition,

it is

necessary

to

remark that the

competitive equilibrium

achieved

depends

in

good measure on the

initial

distribution of pur-

chasing power, which

consists

of

ownership

of

assets

and

skills

that

'This

point has

been

stressed by I.

M. D.

Little [19, pp.

71-74].

For the

concept of a

"persuasive

definition," see C.

L.

Stevenson [27,

pp. 210-17].

ARROW:

UNCERTAINTY AND

MEDICAL CARE

943

command a

price

on

the market.

A

transfer of

assets

among individ-

uals

will,

in

general,

change the

final

supplies

of

goods

and

services

and the

prices

paid

for

them.

Thus,

a

transfer of

purchasing power

from

the well to

the

ill

will

increase the

demand for medical

services.

This

will

manifest

itself in

the

short run in

an increase

in

the

price

of

medical

services

and

in

the long

run

in an

increase

in

the

amount

sup-

plied.

With

this in

mind,

the

following statement

can be made

(Second

Optimality

Theorem): 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 dis-

tribution of

purchasing

power.

Operationally, the

significance

of this

proposition is

that

if the

conditions of

the

two

optimality

theorems are

satisfied,

and if

the

allocation

mechanism

in

the

real

world

satisfies the

conditions for

a

competitive

model,

then

social

policy can

confine

itself

to

steps

taken

to

alter

the

distribution of

purchasing

power.

For

any

given

distribution

of

purchasing

power,

the

market

will,

under the

assumptions

made,

achieve a

competitive

equilibrium

which

is

neces-

sarily

optimal; and

any

optimal

state

is a

competitive

equilibrium cor-

responding to some

distribution

of

purchasing

power,

so

that

any

desired

optimal

state

can

be

achieved.

The

redistribution

of

purchasing

power

among

individuals

most

simply

takes

the form

of

money:

taxes

and

subsidies.

The

implications

of

such

a

transfer

for

individual

satisfactions

are,

in

general,

not

known in

advance.

But

we can

assume that

society can

ex post

judge

the

distribution of

satisfactions

and,

if

deemed

unsatisfactory,

take

steps

to

correct

it

by

subsequent

transfers.

Thus,

by

successive

ap-

proximations,

a

most

preferred

social

state

can

be

achieved,

with

re-

source allocation

being

handled

by

the

market

and

public

policy

con-

fined to

the

redistribution

of

money

income.2

If,

on

the

contrary, the

actual

market

differs

significantly

from

the

competitive

model,

or if

the

assumptions

of the

two

optimality

the-

orems

are not

fulfilled, the

separation

of

allocative and

distributional

procedures

becomes,

in

most

cases,

impossible.3

The

first

step

then

in the

analysis

of the

medical-care

market is the

2The

separation

between

allocation

and

distribution

even

under

the

above

assumptions

has

4osSed

over

problems

in

the execution

of

any

desired

redistribution

policy;

in

practice,

it

is

virtually

impossible

to

find a set of

taxes

and

subsidies

that

will

not

have an ad-

verse

effect on

the

achievement of

an

optimal

state.

But

this

discussion

would

take

us

even

further

afield

than

we have

already

gone.

'The

basic

theorems of

welfare

economics

alluded to

so

briefly

above

have

been

the

subject

of

voluminous

literature,

but

no

thoroughly

satisfactory

statement

covering

both

the

theorems themselves

and

the

significance of

exceptions

to them

exists. The

positive

assertions of

welfare

economics

and

their relation

to the

theory

of

competitive

equilibrium

are

admirably

covered

in

Koopmans

[181.

The

best

summary

of the

various

ways

in

which

the

theorems

can

fail

to

hold

is

probably

Bator's

[6].

944

THE

AMERICAN

ECONOMIC

REVIEW

comparison between the

actual

market

and the

competitive

model.

The

methodology

of

this

comparison

has

been

a

recurrent

subject

of

con-

troversy

in

economics

for

over a

century.

Recently, M. Friedman

[15]

has

vigorously

argued that

the

competitive

or

any

other model

should

be

tested

solely

by

its

ability to

predict.

In

the

context

of

competition,

he

comes

close to

arguing

that

prices

and

quantities are the

only

rele-

vant

data. This

point of

view

is

valuable

in

stressing

that

a

certain

amount of

lack of

realism

in

the

assumptions

of a model is

no

argu-

ment

against

its

value.

But

the

price-quantity

implications of

the com-

petitive

model

for

pricing are

not

easy to

derive without

major--and,

in

many

cases,

impossible-econometric

efforts.

In

this

paper,

the

institutional

organization

and

the

observable

mores

of

the

medical

profession are

included

among

the

data to

be

used

in

assessing the

competitiveness

of the

medical-care

market.

I shall

also

examine

the

presence

or

absence

of

the

preconditions

for

the

equiva-

lence

of

competitive

equilibria

and

optimal

states.

The

major

competi-

tive

preconditions,

in

the sense

used

here,

are

three: the

existence

of

competitive

equilibrium,

the

marketability

of

all

goods

and

services

relevant to

costs

and

utilities,

and

nonincreasing

retiurns.

The

first

two,

as

we

have

seen,

insure

that

competitive

equilibrium is

necessarily

op-

timal;

the

third insures

that every

optimal state

is the

competitive

equilibrium

corresponding

to

some

distribution

of

income.4

The

first

and

third

conditions

are

interrelated;

indeed,

nonincreasing

returns

plus

some

additional

conditions

not

restrictive

in

a

modern

economy

imply

the

existence

of a

competitive

equilibrium,

i.e.,

imply

that

there

will be

some

set

of

prices

which

will

clear all

markets.5

The

concept of

marketability

is

somewhat

broader

than

the

tradi-

tional

divergence between

private

and social

costs

and

benefits. The

latter

concept

refers

to

cases in

which

the

organization

of

the

market

does

not

require an

individual

to

pay

for

costs

that

he

imposes

on

others

as

the

result of

his

actions or

does

not

permit

him

to

receive

compensation

for

benefits he

confers. In

the

medical

field,

the

obvious

example

is

the

spread

of

communicable

diseases.

An

individual

who

fails to

be

immunized

not

only risks

his

own

health, a

disutility

which

presumably

he

has

weighed

against

the

utility

of

avoiding

the

proce-

dure,

but also

that of

others.

In

an

ideal

price

system, there

would

be a

price

which

he

would

have

to

pay

to

anyone

whose

health is

endan-

gered,

a

price

sufficiently

high

so

that the

others

would

feel

compen-

sated;

or,

alternatively,

there

would

be

a

price

which

would be

paid to

him

by others

to

induce him

to

undergo

the

immunization

procedure.

'There

are

further

minor

conditions,

for

which

see

Koopmans

[18,

pp.

50-551.

5

For

a

more

precise

statement

of

the

existence

conditions,

see

Koopmans

[18,

pp.

56-60]

or

Debreu

[12, Ch.

5] .

ARROW:

UNCERTAINTY

AND

MEDICAL CARE

945

Eilther

system

would

lead

to an

optimal

state,

though

the

distributional

implications

would

be

different. It

is, of

course,

not hard to see that

such price

systems could

not,

in

fact,

be

practical;

to

approximate

an

optimal state it

would

be

necessary

to

have

collective

intervention

in

the

form

of

subsidy

or

tax or

compulsion.

By

tlle

absence

of

marketability

for

an

action

which

is

identifiable,

technologically

possible,

and

capable of

influencing

some

individual's

welfare,

for

better

or

for

worse,

is

meant here

the

failure

of the

exist-

ing

market

to

provide a

means

whereby the

services

can

be both

of-

fered

and

demanded

upon

payment of

a

price.

Nonmarketability

may

be due

to

intrinsic

technological

characteristics

of

the

product which

prevent a

suitable

price

from

being

enforced,

as in

the

case

of com-

municable

diseases,

or it

may

be

due

to

social

or

historical

controls,

such

as

those

prohibiting

an

individual

from

selling

himself into slav-

ery.

This

distinction

is,

in

fact,

difficult to

make

precise,

though it

is

obviously

of

importance for

policy;

for

the

present

purposes,

it

will be

sufficient to

identify

nonmarketability

with

the

observed

absence

of

markets.

The

instance

of

nonmarketability

with

which

we

shall

be

most

con-

cerned is

that

of

risk-bearing.

The

relevance

of

risk-bearing to

medical

care

seems

obvious;

illness is

to a

considerable

extent

an

unpredictable

phenomenon.

The

ability

to

shift

the

risks

of

illness

to

others

is

worth

a

price

which

many

are

willing to

pay.

Because

of

pooling

and

of

supe-

rior

willingness

and

ability,

others

are

willing to

bear

the

risks.

Never-

theless,

as we

shall

see

in

greater

detail, a

great

many

risks

are

not

covered,

and

indeed

the

markets

for

the

services of

risk-coverage

are

poorly

developed

or

nonexistent.

Why

this

should be

so is

explained

in

more

detail

in

Section

IV.C

below;

briefly,

it is

impossible to

draw

up

insurance

policies

which

will

sufficiently

distinguish

among

risks,

par-

ticularly

since

observation

of

the

results

will

be

incapable of

distin-

guishing

between

avoidable

and

unavoidable

risks, so

that

incentives

to avoid losses

are

diluted.

The

optimality

theorems

discussed

above are

usually

presented

in

the literature as

referring

only

to

conditions

of

certainty,

but

there

is

no

difficulty

in

extending

them

to

the

case

of

risks,

provided

the

addi-

tional

services

of

risk-bearing

are

included

with

other

commodities.6

However,

the

variety

of

possible

risks in

the

world

is

really

stagger-

ing.

The

relevant

commodities

include,

in

effect,

bets on

all

possible

occurrences

in

the world

which

impinge

upon

utilities. In

fact,

many

of

these

"commodities,"

i.e.,

desired

protection

against

many

risks,

are

'The

theory,

in variant

forms,

seems to

have

been

first

worked

out

by

Allais

[2],

Arrow

[5],

and Baudier

[7].

For

further

generalization,

see Debreu

[11]

and

[12,

Ch.

71.

946

THE

AMERICAN ECONOMIC

REVIEW

simply not

available.

Thus,

a

wide class of commodities

is

nonmarket-

able,

and a

basic

competitive

precondition

is not

satisfied.7

There is

a

still

more

subtle

consequence

of

the

introduction of

risk-

bearing

considerations.

When

there

is

uncertainty,

information

or

knowledge

becomes

a

commodity.

Like

other

commodities,

it has

a

cost

of

production

and

a

cost

of

transmission,

and so

it

is

naturally

not

spread out over

the

entire

population

but

concentrated

among

those

who can

profit

most from

it.

(These

costs

may

be measured in time

or

disutility

as well

as

money.)

But the

demand for information is

diffi-

cult to

discuss in

the

rational terms

usually

employed.

The

value

of

information

is

frequently

not

known

in

any

meaningful

sense to

the

buyer; if,

indeed,

he

knew

enough

to

measure

the

value

of

informa-

tion, he

would

know

the

information

itself.

But

information,

in

the

form

of

skilled

care, is

precisely

what

is

being

bouight

from

most

physi-

cians,

and,

indeed, from

most

professionals.

The

elusive

character of

information

as

a

commodity

suggests

that

it

departs

considerably

from

the usual

marketability

assumptions

about

commodities.8

That risk

and

uncertainty

are,

in

fact,

significant

elements in

medi-

cal care

hardly

needs

argument.

I

will hold

that

virtually

all

the

special

features

of this

industry,

in

fact, stem

from

the

prevalence

of

uncer-

tainty.

The

nonexistence of

markets

for the

bearing

of

some

risks

in

the

first

instance

reduces

welfare

for

those

who

wish

to

transfer

those

risks

to

others

for a

certain

price, as

well

as

for

those

who

would

find it

profit-

able to

take

on

the risk

at such

prices. But it

also

reduces

the

desire to

render

or

consume

services

which

have

risky

consequences;

in

techni-

cal

language,

these

commodities are

complementary

to

risk-bearing.

Conversely,

the

production

and

consumption

of

commodities

and

serv-

ices

with

little

risk

attached

act

as

substitutes

for

risk-bearing

and

are

encouraged

by market

failure

there

with

respect to

risk-bearing.

Thus

the

observed

commodity

pattern

will

be

affected by

the

nonexistence

of

other

markets.

'

It

should

also

be

remarked

that

in

the

presence

of

uncertainty,

indivisibilities

that

are

sufficiently

small to

create

little

difficulty

for

the

existence and

viability

of

competitive

equilibrium

may

nevertheless

give

rise

to

a

considerable

range

of

increasing

returns be-

cause

of

the

operation of

the law of

large numbers.

Since most

objects of

insurance

(lives,

fire

hazards,

etc.)

have

some

element

of

indivisibility,

insurance

companies

have

to

be

above

a

certain

size. But

it is

not clear

that

this

effect is

sufficiently

great to

create

serious

obstacles

to the

existence and

viability

of

competitive

equilibrium

in

practice.

8

One form of

production

of

information

is

research.

Not

only

does

the

product

have

unconventional

aspects

as

a

commodity,

but it

is also

subject

to

increasing

returns

in

use,

since

new

ideas, once

developed,

can

be

used

over

and over

without

being

consumed, and

to

difficulties

of

market

control,

since

the cost

of

reproduction is

usually much less

than

that

of

production.

Hence,

it

is not

surprising that a

free

enterprise

economy will

tend

to

underinvest

in

research;

see Nelson

[211

and

Arrow

[4].

ARROW: UNCERTAINTY AND

MEDICAL

CARE

947

The

failure

of

one or more

of the

competitive

preconditions

has

as

its most

immediate and

obvious

consequence a

reduction in

welfare

below

that

obtainable

from

existing resources and

technology,

in

the

sense of

a failure to

reach an

optimal

state

in

the

sense of Pareto.

But

more can

be said. I

propose

here the

view that,

when the

market fails

to achieve an

optimal

state,

society will,

to

some extent at

least,

recog-

nize

the gap, and

nonmarket

social

institutions will

arise

attempting to

bridge

it.9

Certainly

this

process

is

not

necessarily

conscious;

nor is it

uniformly

successful

in

approaching

more

closely to

optimality

when

the entire

range

of

consequences

is

considered. It

has always been

a

favorite

activity

of

economists

to

point

out that

actions which

on

their

face achieve a desirable

goal

may

have

less obvious

consequences

particularly

over

time, which

more

than

offset the

original

gains.

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

mo-

tives,

largely explain

the observed

noncompetitive

behavior

of

the

medical-care

market, behavior

which, in

itself,

interferes with

opti-

mality.

The

social

adjustment

towards

optimality

thus

puts obstacles

in

its own

path.

The

doctrine

that

society

will

seek

to

achieve

optimality

by

non-

market means if it

cannot achieve them in

the market is

not

novel.

Certainly,

the

government,

at least

in

its

economic

activities,

is

usually

implicitly

or

explicitly

held to

function as

the agency

which

substitutes

for the market's failure.'0

I

am

arguing

here

that in

some circum-

stances other social

institutions

will

step

into

the

optimality

gap, and

that the

medical-care

industry,

with its

variety

of

special

institutions,

some

ancient,

some

modern,

exemplifies

this

tendency.

It

may

be useful to

remark here

that a

good part

of the

preference

for

redistribution

expressed

in

government

taxation

and

expenditure

policies

and

private

charity

can

be

reinterpreted

as

desire for

insur-

ance.

It is

noteworthy

that

virtually

nowhere is

there a

system

of sub-

sidies

that has as

its

aim

simply

an

equalization

of

income.

The sub-

sidies

or other

governmental

help go

to

those

who are

disadvantaged in

life

by

events

the

incidence of

which is

popularly

regarded as

unpre-

'An

important

current

situation

in

which

normal

market

relations

have

had

to

be

greatly

modified

in the

presence of

great

risks is

the

production

and

procurement

of

modern

weapons; see

Peck

and

Scherer

[23,

pp.

581-82]

(I am

indebted

for this

refer-

ence to

V.

Fuchs)

and

[1,

pp.

71-75].

0For

an

explicit

statement

of

this

view,

see

Baumol

[8].

But I

believe

this

position

is

implicit

in

most

discussions of

the

functions of

government.

948

THE

AMERICAN

ECONOMIC

REVIEW

dictable: the

blind,

dependent

children,

the

medically

indigent.

Thus,

optimality,

in

a

context

which

includes

risk-bearing, includes

much

that

appears

to

be

motivated

by

distributional

value

judgments

when

looked

at

in

a

narrower

context."

This

methodological

background

gives

rise

to

the

following plan

for

this

paper.

Section

II

is a

catalogue

of

stylized

generalizations about

the

medical-care

market

which differentiate

it

from

the usual commod-

ity

markets.

In

Section

III

the

behavior

of

the

market

is

compared

with

that of

the

competitive

model

which

disregards the

fact of uncer-

tainty.

In

Section

IV,

the

medical-care

market is

compared,

both

as

to

behavior

and as to

preconditions,

with

the ideal

competitive

market

that

takes

account of

uncertainty;

an

attempt

will be made to

demon-

strate

that the

characteristics

outlined

in

Section

II

can be

explained

either

as the

result

of

deviations

from

the

competitive

preconditions

or

as

attempts

to

compensate

by

other

institutions

for

these

failures.

The

discussion

is

not

designed

to

be

definitive, but

provocative.

In

particu-

lar,

I

have been

chary about

drawing

policy

inferences;

to

a consider-

able

extent,

they

depend

on

further

research,

for

which

the

present

paper

is

intended to

provide

a

framework.

II. A

Survey

of

the

Special

Characteristics

of

the

Medical-Care

Market'2

This

section

will

list

selectively

some

characteristics

of

medical

care

which

distinguish

it from

the

usual

commodity of

economics

textbooks.

The list

is not

exhaustive,

and

it is

not

claimed

that

the

characteristics

listed are

individually

unique to

this

market.

But,

taken

together,

they

do

establish

a

special

place

for

medical

care

in

economic

analysis.

A.

The

Nature

of Demand

The

most

obvious

distinguishing

characteristics

of

an

individual's

demand for

medical

services

is

that

it

is

not

steady in

origin

as,

for

example,

for

food

or

clothing,

but

irregular

and

unpredictable.

Medi-

cal

services, apart

from

preventive

services,

afford

satisfaction

only

in

the

event

of

illness,

a

departure

from

the

normal

state

of

affairs. It

is

hard,

indeed,

to

think

of

another

commodity

of

significance

in

the

average

budget

of

which this

is

true.

A

portion of

legal

services,

de-

voted to

defense in

criminal

trials

or

to

lawsuits,

might

fall in

this

cate-

gory

but

the

incidence

is

surely

very

much

lower

(and,

of

course,

there

'Since

writing the

above,

I

find

that

Buchanan

and

Tullock

[10,

Ch.

13]

have

argued

that

all

redistribution can be

interpreted as

"income

insurance."

12For

an

illuminating

survey

to

which

I am

much

indebted,

see

S.

Mushkin

[20].

ARROW:

UNCERTAINTY

AND

MEDICAL CARE

949

are,

in

fact,

strong

institutional

similarities

between the

legal

and

medical-care

markets.)'3

In

addition,

the

demand

for

medical

services

is

associated,

with

a

considerable

probability,

with

an

assault

on

personal

integrity.

There

is

some risk

of

death and

a

more

considerable risk of

impairment

of

full

functioning. In

particular,

there is

a

major

potential for loss

or

reduc-

tion of

earning

ability.

The

risks

are not

by

themselves

unique;

food

is

also

a

necessity,

but

avoidance

of

deprivation

of

food can be

guaranteed

with

sufficient

income,

where

the

same

cannot be

said

of avoidance

of

illness.

Illness

is,

thus,

not

only

risky

but a

costly

risk in

itself,

apart

from

the

cost of

medical

care.

B.

Expected

Behavior

of

the

Physician

It is

clear

from

everyday

observation

that

the

behavior

expected

of

sellers

of

medical

care is

different

from

that

of

business

men in

gen-

eral.

These

expectations

are

relevant

because

medical

care

belongs to

the

category

of

commodities for

which

the

product

and the

activity

of

production

are

identical.

In all

such

cases,

the

customer

cannot

test

the

product

before

consuming it,

and

there

is

an

element

of

trust

in

the

relation.'

But

the

ethically

understood

restrictions on

the

activities

of

a

physician

are

much

more

severe

than

on

those

of,

say, a

barber. His

behavior is

supposed

to

be

governed

by

a

concern

for

the

customer's

welfare

which

would

not

be

expected

of a

salesman. In

Talcott Par-

sons's

terms,

there

is

a

"collectivity-orientation,"

which

distinguishes

medicine and

other

professions from

business,

where

self-interest

on

the

part

of

participants

is

the

accepted

norm.'5

A

few

illustrations

will

indicate

the

degree of

difference

between

the

behavior

expected of

physicians

and

that

expected of

the

typical

busi-

nessman.18

(1)

Advertising

and

overt

price

competition

are

virtually

eliminated

among

physicians.

(2) Advice

given

by

physicians

as

to

further treatment

by

himself

or

others is

supposed to

be

completely

"In

governmental

demand,

military

power

is

an

example

of

a

service

used

only

irregularly

and

unpredictably.

Here

too,

special

institutional

and

professional

relations

have

emerged,

though

the

precise

social

structure is

different for

reasons

that

are

not

hard

to

analyze.

"

Even

with

material

commodities,

testing

is

never

so

adequate

that

all

elements

of

implicit

trust can

be eliminated.

Of

course,

over

the

long

run,

experience

with the

quality

of

product

of

a

given

seller

provides

a

check on

the

possibility

of

trust.

15See

[22,

p. 463].

The whole of

[22,

Ch. 101

is a

most

illuminating

analysis

of

the

social

role of

medical

practice;

though

Parsons'

interest

lies in

different

areas

from

mine,

I

must

acknowledge

here

my

indebtedness

to

his

work.

16

I

am indebted to

Herbert Klarman

of

Johns

Hopkins

University for

some

of the

points discussed

in this

and the

following

paragraph.

950 THE AMERICAN ECONOMIC REVIEW

divorced

from

self-interest. (3) It is at least claimed that

treatment

is

dictated

by

the

objective

needs of

the case

and not

limited

by

financial

considerations."7

While the ethical compulsion is surely not

as absolute

in

fact as it

is in

theory, we can hardly suppose that it has

no influence

over

resource allocation in this area. Charity treatment in

one form

or

another does

exist because

of

this tradition about human

rights to ade-

quate medical care.'8 (4) The physician is relied on as

an expert

in

certifying

to

the existence of illnesses and injuries for various

legal

and

other

purposes. It

is

socially expected that his concern for the correct

conveying

of

information will, when appropriate, outweigh his desire

to

please

his

customers."g

Departure from the profit motive is strikingly

manifested by the

overwhelming predominance

of

nonprofit

over

proprietary

hospitals.20

The

hospital per

se offers services

not too different from

those of

a

hotel,

and it is

certainly

not obvious

that the profit motive

will not lead

to a

more efficient

supply.

The

explanation may

lie

either on the

supply

side or on

that

of

demand.

The

simplest explanation

is

that

public

and

private subsidies decrease the cost to the patient in

nonprofit hospitals.

A

second

possibility

is

that

the association of

profit-making

with the

supply

of

medical services

arouses

suspicion

and

antagonism

on

the

part

of

patients

and

referring physicians,

so

they

do

prefer

nonprofit

institutions.

Either

explanation implies

a

preference

on

the

part

of

some

group, whether

donors or

patients, against

the

profit

motive in the

supply

of

hospital

services.2'

1T The

belief that the ethics of

medicine demands treatment

independent of the patient's

ability to

pay is strongly ingrained.

Such a perceptive observer as

Rene Dubos has made

the

remark that

the

high

cost

of

anticoagulants restricts their use

and may contradict

classical

medical ethics,

as

though this

were an unprecedented

phenomenon.

See

[13,

p.

4191.

"A

time

may

come when medical

ethics will have to be

considered in the harsh

light of

economics" (emphasis added).

Of course, this expectation

amounts to ignoring

the

scarcity

of medical

resources;

one

has

only

to

have

been

poor

to

realize the error.

We

may

confidently

assume

that

price

and

income do

have some

consequences for

medical

expenditures.

18A

needed

piece

of

research

is a

study

of the

exact nature of

the

variations of medical

care

received

and medical

care

paid

for as

income

rises.

(The

relevant

income

concept

also

needs

study.)

For this

purpose,

some

disaggregation

is

needed;

differences in

hospital

care which

are essentially

matters

of

comfort

should,

in

the above

view, be much

more

responsive to

income

than, e.g., drugs.

"9 This role is

enhanced in a socialist

society,

where the

state itself is

actively concerned

with illness

in relation to

work;

see

Field

[14,

Ch.

91.

'

About

3 per

cent

of beds were

in

proprietary hospitals

in

1958, against

30 per

cent

in

voluntary

nonprofit,

and the remainder in

federal, state,

and

local

hospitals;

see

[26,

Chart

4-2,

p.

601.

"

C.

R.

Rorem

has

pointed

out

to me some

further factors

in

this

analysis. (1)

Given

the

social intention of

helping

all

patients

without

regard

to immediate

ability

to

pay,

economies

of scale would dictate a

predominance

of

community-sponsored

hospitals. (2)

ARROW:

UNCERTAINTY

AND

MEDICAL CARE

951

Conformity

to

collectivity-oriented behavior is

especially

important

since

it is a

commonplace

that

the

physician-patient relation affects

the

quality of

the

medical

care

product. A

pure cash nexus would be

in-

adequate;

if

nothing

else,

the

patient

expects

that

the same

physician

will

normally

treat

him on

successive

occasions. This

expectation

is

strong

enough

to

persist even in

the

Soviet

Union,

where

medical

care

is

nominally

removed

from

the

market

place

[14,

pp.

194-96].

That

purely

psychic

interactions

between

physician

and

patient

have

effects

which are

objectively

indistinguishable

in kind from the effects

of

medication is

evidenced

by

the

use of

the placebo as a

control in medi-

cal

experimentation;

see

Shapiro

[25].

C.

Product

Uncertainty

as to

the

quality of

the

product is

perhaps

more intense

here

than in

any

other

important

commodity.

Recovery from

disease

is

as

unpredictable

as is

its

incidence.

In

most

commodities, the

possi-

bility

of

learning

from

one's

own

experience

or

that

of

others is

strong

because

there is

an

adequate

number

of

trials.

In

the

case

of severe

ill-

ness,

that is,

in

general, not

true;

the

uncertainty

due to

inexperience

is

added

to the

intrinsic

difficulty

of

prediction.

Further,

the

amount

of

uncertainty,

measured

in

terms of

utility

variability, is

certainly

much

greater

for

medical care in

severe

cases than

for, say,

houses

or

auto-

mobiles,

even

though

these are

also

expenditures

sufficiently

infre-

quent

so

that there

may

be

considerable

residual

uncertainty.

Further,

there

is a

special

quality to the

uncertainty; it

is

very dif-

ferent on

the

two sides

of

the

transaction.

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.22

Further,

both

parties

are

aware of

this

informational

inequal-

ity, and

their

relation

is

colored

by this

knowledge.

To avoid

misunderstanding,

observe

that

the

difference

in

informa-

tion

relevant

here is a

difference

in

information

as to

the

consequence

of

a

purchase of

medical

care.

There

is

always

an

inequality of

infor-

mation

as to

production

methods

between

the

producer

and

the pur-

chaser of

any

commodity,

but

in

most

cases

the

customer

may

well

Some

proprietary

hospitals will tend

to control

total

costs

to the

patient

more

closely, in-

cluding

the

fees

of

physicians,

who will

therefore

tend

to

prefer

community-sponsored

hospitals.

2"Without

trying

to

assess

the

present

situation,

it is

clear in

retrospect

that

at

some

point

in

the

past

the

actual

differential

knowledge

possessed

by

physicians

may

not

have

been

much.

But

from

the

economic

point of

view,

it is

the

subjective

belief

of

both

parties,

as

manifested

in

their

market

behavior,

that is

relevant.

952

THE

AMERICAN

ECONOMIC

REVIEW

have as

good or nearly as

good an

understanding of the utility of

the

product

as

the producer.

D.

Supply Conditions

In

competitive theory,

the supply of a

commodity is governed by

the

net

return from its

production compared

with the return

derivable

from

the use of the same

resources elsewhere.

There are several

sig-

nificant

departures from

this theory in the

case of medical care.

Most

obviouisly,

entry

to the profession is

restricted by

licensing.

Licensing,

of course,

restricts supply and

therefore increases the cost of

medical

care. It is

defended as guaranteeing

a minimum of

quality.

Restriction

of

entry by

licensing occurs in most

professions,

including

barbering

and

undertaking.

A

second

feature is

perhaps even more

remarkable. The cost

of

medical education

today is

high and, according

to the usual

figures,

is

borne

only

to a minor

extent

by the student.

Thus,

the

private

benefits

to the

entering student

considerably exceed the costs.

(It is,

however,

possible that

research

costs, not properly

chargeable

to

education,

swell the

apparent

difference.)

This

subsidy

should,

in

principle,

cause

a fall

in

the

price

of

medical

services, which,

however,

is

offset by

ra-

tioning

through

limited

entry

to

schools

and

through

elimination of

students

during

the medical-school

career.

These

restrictions

basically

render

superfluous the

licensing, except

in

regard to graduates of for-

eign

schools.

The

special

role

of

educational institutions

in

simultaneously

sub-

sidizing

and

rationing

entry

is

common to all

professions

requiring

advanced

training.23

It is a

striking

and

insufficiently

remarked

phe-

nomenon that such

an

important

part

of

resource allocation should

be

performed

by nonprofit-oriented

agencies.

Since

this

last

phenomenon

goes

well

beyond

the

purely

medical

aspect,

we

will not

dwell

on

it

longer

here

except

to note

that

the

anomaly

is

most

striking

in

the medical

field.

Educational

costs tend to

be

far

higher

there

than

in

any

other branch

of

professional

training.

While

tuition

is the

same,

or

only slightly

higher,

so

that

the

subsidy

is

much

greater,

at the same time the

earnings

of

physicians

rank

high-

est

among professional

groups,

so

there

would not

at first blush

seem

to be

any necessity

for

special

inducements to

enter

the

profession.

Even if

we

grant that,

for

reasons

unexamined

here,

there is a

social

interest

in

subsidized

professional

education,

it

is not clear

why the

rate of

subsidization should differ

among professions. One

might

ex-

23The

degree

of

subsidy

in

different

branches

of

professional

education is

worthy

of a

major

research

effort.

ARROW:

UNCERTAINTY AND

MEDICAL

CARE

953

pect

that the tuition

of

medical

students

would

be

higher

than that

of

other

students.

The

high

cost

of

medical

education

in

the

United

States is

itself

a

reflection of

the

quality

standards

imposed by

the

American

Medical

Association since

the

Flexner

Report,

and it is,

I

believe,

only

since

then

that the

subsidy element in

medical

education has

become

signifi-

cant.

Previously,

many

medical

schools

paid their

way

or even

yielded

a

profit.

Another

interesting

feature of

limitation

on

entry

to

subsidized

edu-

cation

is the

extent of

individual

preferences

concerning

the

social

welfare,

as

manifested

by

contributions

to

private

universities.

But

whether

support is

public or

private, the

important

point is

that both

the

quality

and the

quantity of

the

supply

of

medical care are

being

strongly

influenced

by

social

nonmarket forces.24'25

One

striking

consequence

of

the control of

quality

is

the

restriction

on

the

range

offered. If

many

qualities of

a

commodity are

possible, it

would

usually

happen in

a

competitive

market

that

many

qualities

will

be

offered

on

the

market,

at

suitably

varying

prices,

to

appeal to

dif-

ierent

tastes

and

incomes.

Both the

licensing

laws and

the

standards of

medical-school

training

have

limited the

possibilities of

alternative

qualities of

medical

care.

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

com-

pletely,

but

the

central

role of

the

highly

trained

physician

is

not af-

fected

at

all.26

E.

Pricing

Practices

The

unusual

pricing

practices

and

attitudes

of the

medical

profes-

sion

are well

known:

extensive

price

discrimination by

income

(with an

extreme

of

zero

prices for

sufficiently

indigent

patients) and,

formerly,

a strong

insistence on

fee

for

services as

against

such

alternatives as

prepayment.

'Strictly

speaking,

there are four

variables

in

the

market for

physicians:

price,

quality

of

entering

students,

quality

of

education, and

quantity.

The

basic

market

forces,

demand

for

medical

services

and

supply

of

entering

students,

determine

two

relations

among

the

four

variables.

Hence, if the

nonmarket

forces

determine

the

last

two,

market

forces

will

determine

price

and

quality

of

entrants.

'The

suipply

of

Ph.D.'s is

similarly

governed,

but

there

are

other

conditions

in the

market

which

are

much

different,

especially

on

the

demand

side.

'Today

oinly

the

Soviet

Union

offers

an

alternative

lower level

of

medical

personnel,

the

feldshers,

who

practice

primarily in

the

rural

districts

(the

institution

dates

back

to the 18th

century).

According

to

Field

[14,

pp.

98-100,

132-33],

there is

clear

evidence

of strain

in

the

relations between

physicians and

feldshers,

but

it

is

not

certain

that

the

feldshers

will

gradually

disappear

as

physicians

grow in

numbers.

954

THE

AMERICAN

ECONOMIC

REVIEW

The

opposition to

prepayment is

closely

an even

stronger

opposition

to

closed-panel

practice

(contractual

arrangements

which

bind the

patient to a

particular

group

of

physicians). Again

these

atti-

tudes seem to

differentiate

professions

from

business.

Prepayment

and

closed-panel

plans

are

virtually

nonexistent

in

the

legal profession. In

ordinary

business, on

the other

hand, there exists

a wide

variety

of

exclusive

service contracts

involving sharing

of

risks;

it is

assumed

that

competition will select those which

satisfy

needs best.27

The

problems

of

implicit

and

explicit

price-fixing

should also

be

mentioned.

Price

competition

is

frowned

on.

Arrangements

of

this

type

are not

uncommon

in

service

industries,

and

they

have

not

been sub-

jected

to

antitrust

action.

How

important

this is is hard

to

assess.

It

has been

pointed

out

many times that the

apparent

rigidity of

so-called

admiriistered

prices

considerably

understates the actual

flexibility.

Here, too,

if

physicians

find

themselves with

unoccupied time,

rates are

likely to

go down,

openly

or

covertly;

if

there

is

insufficient

time for

the

demand, rates

will

surely rise.

The

"ethics" of

price

competition

may

decrease the

flexibility

of

price

responses,

but

probably

that is all.

III.

Comparisons

with

the

Competitive

Model under

Certainty

A.

Nonmarketable Commodities

As

already noted,

the diffusion

of

communicable diseases

provides

an obvious

example

of

nonmarket

interactions.

But from a

theoretical

viewpoint,

the

issues are well

understood, and

there is little

point in

expanding

on

this

theme. (This

should not be

interpreted as

minimiz-

ing

the

contribution of

public health

to welfare;

there is

every reason

to

suppose

that

it is

considerably

more important

than

all other

aspects

of medical

care.)

Beyond

this

special area

there

is a

more general

interdepeiidence,

the

concern of

individuals for the

health of

others.

The economic

manifes-

tations

of

this taste are to be

found

in

individual

donations to

hocpitals

and to

medical

education,

as

well

as

in

the

widely accepted

responsi-

bilities of

government

in this

area.

The taste for

improving the health

of others

appears

to

be

stronger

than for

improving

other

aspects

of

their

welfare.28

In

interdependencies

generated

by concern

for

the welfare

of others

there is

always

a theoretical

case

for

collective action if each

partici-

pant

derives satisfaction from

the contributions of

all.

'

The

law does

impose

some limits on

risk-shifting in

contracts, for

example, its gen-

eral

refusal to honor

exculpatory

clauses.

'

There

may be an

identification

problem in this

observation.

If the

failure of the

market

system

is, or

appears to be, greater

in medical care than

in, say,

food an

in-

dividual

otherwise equally

concerned

about

the two aspects

of others' welfare

may prefer

to

help

in

the

first.

ARROW: UNCERTAINTY

AND

MEDICAL

CARE

955

B.

Increasing

Returns

Problems

associated

with

increasing

returns

play

some role

in allo-

cation

of

resources

in the

medical field,

particularly

in areas

of low

density or

low

income.

Hospitals

show

increasing

returns

up to

a point;

specialists

and

some

medical

equipment

constitute significant indivisi-

bilities. In

many

parts of

the

world the

individual physician

may be

a

large

unit

relative

to

demand. In

such

cases it

can be

socially

desirable

to

subsidize

the

appropriate

medical-care

unit.

The

appropriate mode

of

analysis is

much

the

same as for

water-resource

projects.

Increasing

returns are

hardly

apt to

be a

significant

problem

in general

practice in

large

cities

in the

United

States,

and

improved

transportation

to

some

extent reduces

their

importance

elsewhere.

C.

Entry

The most

striking

departure from

competitive behavior is

restriction

on

entry to

the

field, as

discussed in

II.D

above. Friedman

and Kuz-

nets,

in a

detailed

examination

of the

pre-World War

II

data,

have

argued that

the higher income

of

physicians

could be

attributed

to

this

restriction.29

There is

some

evidence

that

the

demand for

admission to

medical

school has

dropped

(as

indicated by

the

number of

applicants

per

place

and the

quality of

those

admitted),

so

that the

number

of medi-

cal-school

places

is

not

as

significant a barrier

to entry as in

the

early

1950's

[28,

pp.

14-15].

But it

certainly

has

operated over

the

past and

it

is

still

operating

to a

considerable

extent

today. It

has, of

course,

constituted a

direct

and

unsubtle

restriction on

the

supply of

medical

care.

There are several

considerations

that must

be

added

to help

evaluate

the

importance

of

entry

restrictions: (1) Additional

entrants

would

be,

in

general, of

lower

quality;

hence, the

addition

to the

supply

of medi-

cal

care,

properly

adjusted

for

quality,

is

less

than

purely

quantitative

calculations

would show.30

(2)

To

achieve

genuinely

competitive con-

ditions,

it

would

be

necessary

not

only

to

remove

numerical

restrictions

on

entry

but

also

to

remove the

subsidy

in

medical

education.

Like

any

other

producer,

the

physician

should

bear

all

the costs

of

production,

"

See

[16,

pp.

118-37].

The

calculations

involve

many

assumptions

and

must

be re-

garded

as

tenuous;

see the

comments

by

C.

Reinold

Noyes

in

[16,

pp.

407-10].

'It

might

be

argued

that

the

existence

of

racial

discrimination

in

entrance has

meant

that

some of

the

rejected

applicants are

superior to

some

accepted.

However,

there is

no

necessary

connection

between an

increase in

the

number of

entrants and

a

reduction

in

racial

discrimination;

so

long

as

there is

excess

demand

for

entry,

discrimination

can

continue

unabated

and new

entrants

will

be

inferior

to

those

previously

accepted.

956

THE

AMERICAN

ECONOMIC

REVIEW

including,

in

this

case,

education.3'

It

is

not so

clear

that this

change

would

not

keep

even

unrestricted

entry down

below

the

present

level.

(3)

To

some

extent, the

effect of

making

tuition

carry

the full

cost

of

education

will

be to

create

too

few

entrants,

rather

than

too

many.

Given the

imperfections of

the

capital

market,

loans for

this

purpose

to

those who

do

not

have

the cash

are

difficult

to

obtain.

The

lender

really

has

no

security.

The

obvious

answer

is

some form

of

insured

loans,

as

has

frequently

been

argued;

not

too

much

ingenuity

would

be

needed

to

create

a

credit

system

for

medical

(and other

branches of

higher)

education.

Under

these

conditions the

cost

would still constitute

a

de-

terrent,

but

one

to be

compared

with the

high

future

incomes

to be

obtained.

If

entry

were

governed

by

ideal

competitive

conditions, it

may

be

that the

quantity

on

balance

would

be

increased,

though this conclu-

sion is

not

obvious.

The

average

quality

would

probably

fall,

even

under

an

ideal

credit

system,

since

subsidy

plus

selected

entry

draw

some

highly

qualified

individuals

who

would

otherwise

get

into

other

fields.

The

decline in

quality is

not

an

over-all

social

loss,

since

it is

accompanied

by

increase

in

quality in

other

fields of

endeavor;

indeed,

if

demands

accurately

reflected

utilities,

there

would be

a

net

social

gain

through a

switch

to

competitive

entry.32

There is a

second

aspect

of

entry

in

which

the

contrast with com-

petitive

behavior

is,

in

many

respects,

even

sharper.

It is

the

exclusion

of

many

imperfect

substitutes

for

physicians.

The

licensing

laws,

though

they

do

not

effectively

limit the

number

of

physicians, do ex-

clude

all

others

from

engaging

in

any one

of

the

activities

known

as

medical

practice. As

a

result,

costly

physician

time

may

be

employed

at

speCific

tasks for

which

only

a

small

fraction

of their

training

is

needed,

and

which

could be

performed by

others

less

well

trained

and

therefore

less

expensive.

One

might

expect

immunization

centers,

pri-

vately

operated,

but

not

necessarily

requiring

the

services of

doctors.

In

the

competitive

model

without

uncertainty,

consumers

are

pre-

siumed

to

be able

to

distinguish

qualities

of the

commodities

they

buy.

Under this

hypothesis,

licensing would

be, at

best,

superfluous

and

exclude

those

from

whom

consumers

would

not

buy

anyway;

but it

might exclude

too

many.

D.

Pricing

The

pricing practices

of

the

medical

industry

(see

II.E

above)

de-

'

One

problem here

is that

the

tax

laws do

not

permit

depreciation

of

professional

education,

so that

there

is

a

discrimination

against

this

form of

investment.

"2

To

anticipate later

discussion,

this

condition is

not

necessarily

fulfilled.

When it

comes to

quality

choices,

the

market

may be

inaccurate.

ARROW:

UNCERTAINTY

AND

MEDICAL CARE

957

part

sharply

from the

competitive

norm.

As

Kessel

[17]

has

pointed

out

with

great

vigor,

not

only is

price

discrimination

incompatible

with

the

competitive

model, but

its

preservation

in

the

face

of

the

large

number

of

physicians

is

equivalent to a

collective

monopoly.

In

the

past, the

opposition to

prepayment

plans

has taken

distinctly

coercive

forms,

certainly

transcending

market

pressures,

to say

the

least.

Kessel

has

argued

that

price

discrimination is

designed to

maximize

profits

along

the

classic

lines of

discriminating

monopoly

and that

organized

medical

opposition to

prepayment

was

motivated

by

the

desire

to

protect

these

profits.

In

principle,

prepayment

schemes

are

compatible with

discrimination,

but

in

practice they

do

not

usually

discriminate. I

do not

believe the

evidence that

the

actual scale of

dis-

crimination

is

profit-maximizing is

convincing. In

particular,

note that

for

any

monopoly,

discriminating

or

otherwise, the

elasticity

of

demand

in

each

market

at the

point

of

maximum

profits is

greater than

one.

But

it

is

almost

surely

true

for

medical

care

that the price

elasticity

of

demand for

all

income

levels is

less than

one.

That

price

discrimina-

tion

by

income

is

not

completely

profit-maximizing

is obvious

in the

extreme

case

of

charity; Kessel

argues that this

represents

an

appease-

ment of

public

opinion. But this

already

shows

the

incompleteness

of

the model

and

suggests

the

relevance

and

importance

of social and

ethical

factors.

Certainly

one

important

part

of

the

opposition

to

prepayment

was

its

close

relation

to

closed-panel

plans.

Prepayment is

a form

of

insur-

ance,

and

naturally

the

individual

physician

did

not wish to

assume the

risks.

Pooling

was

intrinsically

involved,

and this

strongly

motivates,

as

we shall discuiss

further

in

Section IV

below, control over

prices

and

benefits.

The

simplest

administrative

form is

the

closed

panel;

physi-

cians

involved

are,

in

effect,

the

insuring agent.

From this

point

of

view,

Blue Cross solved

the

prepayment

problem

by

universalizing

the

closed

panel.

The

case that

price

discrimination

by

income is

a form

of

profit

maximization

which

was

zealously

defended by

opposition

to fees

for

service seems

far

from

proven.

But

it

remains

true

that this

price

dis-

crimination,

for

whatever

cause,

is

a

source of

nonoptimality.

Hypo-

thetically,

it

means

everyone

would

be

better off

if

prices

were

made

equal

for

all,

and

the

rich

compensated

the

poor

for

the

changes in

the

relative

positions.

The

importance

of

this

welfare loss

depends on

the

actual

amount of discrimination

and on

the

elasticities of

demand

for

medical

services

by

the

different

income

groups.

If

the

discussion is

simplified

by

considering

only

two

income

levels,

rich

and

poor,

and if

the

elasticity

of

demand

by

either

one is

zero,

then

no

reallocation of

medical services

will

take

place

and

the initial

situation

is

optimal.

The

958

THE

AMERICAN ECONOMIC

REVIEW

only

effect of a change in

price will be the

redistribution of income

as

between

the

medical

profession and the group with

the

zero

elasticity

of

demand. With low

elasticities of demand, the

gain will be small.

To

illustrate, suppose the price

of medical care to the

rich is double that to

the

poor,

the

medical

expenditures by the

rich

are

20 per cent of those

by

the

poor,

and

the

elasticity

of demand for

both

classes is

.5; then

the

net

social

gain due to the

abolition of

discrimination is slightly over

1 per

cent of previous

medical expenditures.33

The

issues involved in the

opposition to

prepayment, the other major

anomaly

in

medical pricing,

are not meaningful

in the world of cer-

tainty

and will be discussed

below.

IV.

Comparison with the

Ideal Competitive

Model under Uncertainty

A.

Introduction

In

this section

we will

compare the operations

of the actual medical-

care market

with those

of

an

ideal system in

which not only the usual

commodities and services

but also insurance

policies against all con-

ceivable

risks

are

available.3

Departures consist

for the most part of

3It is assumed

that

there are

two classes,

rich and poor;

the price

of medical

services

to the

rich is twice

that to the

poor, medical

expenditures by

the rich are

20 per

cent

of

those

by the poor,

and the

elasticity of

demand for

medical services is

.5 for

both

classes.

Let

us

choose

our quantity

and

monetary units so

that the

quantity of

medical

services

consumed by

the poor

and

the price

they pay are

both 1. Then

the rich

pur-

chase .1

units

of

medical services

at a price

of 2. Given

the

assumption about

the

elasticities

of

demand,

the demand

function of the rich

is

DR(p)

-

.14

p--5

and

that

of

the poor is

Dp(p)

=

p`.

The

supply

of

miiedical services

is

assumed

fixed and

therefore

must

equal 1.1. If

price

discrimination were

abolished, the

equilibrium

price, p,

must

satisfy

the relation,

DR(P)

+

Dp(p)

1.1,

and therefore

p

=

1.07. The

quantities of medical

care

purchased by the rich

and

poor,

respectively, would

beDR(7p)

=

.135

and

Dp(75)

=

.965.

The

inverse demand

functions, the

priCe to be

paid

corresponding to any

given quantity

are

djv(q)

= .02/q2,

and

dp(q)

=

l/q'. Therefore, the

consumers' surplus

to the rich

generated by the

change is:

r

135

(1)

J

(.02/q2)dq

-

7(.135

-

.1),

and

similarly

the

loss

in consumers'

surplus by the

poor is:

(2)

f

(l/q2)dq

-

p(1

-

.965)

.965

If

(2)

is subtracted

from (1), the

second

terms cancel, and

the aggregate

increase in

consumers'

surplus is

.0156, or a

little over 1

per cent of

the initial

expenditures.

'A

striking

illustration of the

desire for

security in

medical care

is

provided

by the

expressed

preferences

of

etmigr&s

from the Soviet

Union as between

Soviet

medical

prac-

tice

and German

or

American

practice; see Field

[14, Ch.

12].

Those in

Germany pre-

ferred

the

German

system to the

Soviet, but

those in the

United States preferred

(in

a

ratio of

3 to 1) the

Soviet

system. The

reasons given boil

down to the

certainty

of

medical

care,

independent of

income or health

fluctuations.

ARROW:

UNCERTAINTY

AND

MEDICAL

CARE

959

insurance

policies

that

might

conceivably

be

written, but are

in

fact

not.

Whether

these

potential

commodities

are

nonmarketable,

or,

merely

because

of

some

imperfection

in the

market,

are

not

actually

marketed,

is a

somewhat

fine

point.

To recall

what has

already

been

said

in

Section

I,

there are

two

kinds

of

risks

involved in

medical

care: the risk

of

becoming

ill,

and

the

risk

of

total

or

incomplete

or

delayed

recovery.

The loss

due to

illness

is

only

partially

the

cost

of medical

care.

It

also consists

of

dis-

comfort

and

loss of

productive

time

during

illness,

and,

in

mole

serious

cases,

death

or

prolonged

deprivation

of normal function.

From

the

point

of

view

of

the

welfare economics of

uncertainty,

both

losses

are

risks

against

which

individuals

would

like

to

insure.

The nonexistence

of

suitable

insurance

policies for

either

risk

implies

a loss of

welfare.

B.

The

Theory

of

Ideal

Insuran cc

In

this

section,

the

basic

principles of

an

optimal

regime

for risk-

bearing

will

be

presented.

For

illustration,

reference will

usually

be

made to

the case

of

insurance

against

cost

in

medical

care. The

princi-

ples

are

equally

applicable

to

any

of

the

risks.

There is

no

single

source to

which

the

reader

can

be

easily

referred,

though

I

think the

principles are

at

least

reasonably

well

understood.

As a

basis

for

the

analysis, the

assumption

is

made

that

each

individ-

ual

acts

so

as

to

maximize

the

expected

value

of a

utility

function.

If

we

think of

utility

as

attached

to

income,

then the

costs of medical

care

act as a

random

deduction

from

this

income,

and it

is

the

expected

value

of

the

utility

of

income

after medical

costs

that

we

are

concerned

with. (Income after

mnedical

costs is

the

ability

to

spend

money

on

other

objects

which

give

satisfaction.

We

presuppose

that

illness

is

not

a

source of

satisfaction

in

itself;

to

the

extent

that it is

a

source

of

dissatisfaction,

the illness

should

enter

into

the

utility function

as

a

separate

variable.) The

expected-utility

hypothesis,

due

originally

to

Daniel

Bernoulli

(1738),

is

plausible

and is

the

most

analytically

man-

ageable

of all

hypotheses that

have

been

proposed

to

explain

behavior

under

uncertainty.

In

any

case,

the

results

to

follow

probably

would

not

be

significantly

affected

by

moving

to

another

mode

of

analysis.

It is

further

assumed

that

individuals are

normally

risk-averters.

In

utility

terms,

this

means

that

they

have

a

diminishing

marginal

utility

of

income. This

assumption

may

reasonably

be

taken to

hold for

most

of the

sKgnificant

affairs of

life for

a

majority

of

people,

but

the

pres-

ence

of

gamibling

provides some

difficulty in

the

full

application

of

this

view. It

follows

from

the

assumption

of

risk

aversion

that

if an

indi-

vidual

is

given a

choice

between

a

probability

distribution

of

income,

with

a

given

mean

n,

and the

certainty of the

income

m,

he

would

prefer

960

THE AMERICAN

ECONOMIC

REVIEW

the

latter.

Suppose, therefore,

an

agency,

a

large

insurance

company

plan, or

the

government, stands

ready to

offer insurance

against medical

costs on

an

actuarially

fair

basis;

that

is,

if

the costs

of medical

care

are a

random

variable with

mean

n, the

company will

charge

a

pre-

mium

n,

and

agree to

indemnify the individual for all medical costs.

Under these

circumstances,

the

individual

will

certainly prefer

to take

out

a

policy and

will

have a

welfare

gain

thereby.

Will

this be a social

gain?

Obviously

yes,

if

the

insurance

agent

is

suffering

no social

loss. Under

the

assuimption

that medical

risks

on

different individuals are

basically

independent, the

pooling

of them

reduces the risk

involved

to

the insurer

to

relatively

small proportions.

In

the

limit,

the welfare

loss, even

assuming risk

aversion on the

part

of the

insurer,

would

vanish

and

there

is a

net social gain

which

may

be

of

quite substantial

magnitude.

In

fact,

of

course, the

pooling of

risks

does not

go

to

the

limit;

there

is

only

a

finite number

of them

and

there

may

be

some

interdependence

among

the

risks due

to epidemics

and the

like.

But

then a

premium, perhaps

slightly

above the actuarial

level,

would

be sufficient to

offset

this welfare

loss.

From the

point

of

view

of

the

individual, since

he

has a

strict

preference for the

actuari-

ally

fair

policy

over

assuming the risks

himself, he

will still

have

a

preference

for an

actuarially

unfair

policy, provided,

of course, that

it is not too

unfair.

In addition to

a

residual

degree

of

risk

aversion

by insurers,

there

are other

reasons

for

the

loading of the

premium

(i.e., an

excess

of

premium

over

the

actuarial

value). Insurance

involves

administrative

costs. Also, because of the

irregularity

of

payments there

is likely

to

be

a cost

of

capital

tied

up.

Suppose,

to

take a

simple

case, the insurance

company

is not

willing

to sell

any insurance

policy

that a consumer

wants but

will

charge

a

fixed-percentage

loading

above the

actuarial

value for its

premium.

Then it

can

be

shown

that the most

preferred

policy

from the

point

of

view of

an

individual

is a

coverage

with a

deductible

amount;

that

is,

the

insurance

policy

provides 100 per

cent

coverage

for all

medical costs in

excess

of

some

fixed-dollar

limit. If,

however,

the

insurance

company

has

some

degree of

risk

aversion, its

loading may

also

depend

on

the

degree

of

uncertainty of the

risk. In

that

case,

the Pareto

optimal

policy

will

involve some

element

of co-

insurance, i.e.,

the

coverage

for

costs over

the

minimum limit

will be

some

fraction less than 100

per

cent

(for

proofs

of

these

statements,

see

Appendix).

These results

can

also be

applied

to the

hypothetical

concept

of in-

surance

against

failure to

recover from

illness.

For

simplicity,

let us

assume

that the

cost

of failure to recover

is

regarded

purely as a

money

cost,

either

simply productive

opportunities

foregone

or, more

gener-

ARROW:

UNCERTAINTY

AND

MEDICAL

CARE

961

ally,

the

money

equivalent of

all

dissatisfactions.

Suppose further

that,

given

that

a

person

is

ill, the

expected

value

of

medical

care

is

greater

than its

cost;

that

is,

the

expected

money

value

attributable

to

recovery

with

medical

help is

greater

than

resources

devoted

to

medi-

cal

help.

However,

the

recovery,

though

on

the

average

beneficial,

is

uncertain;

in

the

absence

of

insurance a

risk-averter

may well

prefer

not

to

take a

chance on

further

impoverishment

by

buying

medical

care.

A

suitable

insurance

policy

would,

however, mean that

he paid

nothing if

he

doesn't

benefit;

since

the

expected

value is

greater

than

the

cost, there

would be

a

net

social

gain.35

C. Problems

of

Insurance

1. The

moral

hazard.

The

welfare

case for

insurance

policies

of

all

sorts

is

overwhelming. It

follows

that

the

government should

under-

take

insurance

in

those

cases

where

this

market, for

whatever

reason,

has

failed

to

emerge.

Nevertheless,

there

are

a

number

of

significant

practical

limitations

on

the use

of

insurance.

It is

important to

under-

stand

them,

though

I do

not

believe

that

they

alter the

case

for the

creation

of

a

much

wider

class of

insurance

policies

than

now exists.

One

of

the

limits

which

has been much

stressed in

insurance litera-

ture is

the

effect of

insurance

on

incentives.

What is

desired in the

case

of

insurance is

that

the

event

against

which

insurance is

taken

be out

of

the control

of

the

individual.

Unfortunately,

in real life

this

separa-

tion can never

be

made

perfectly.

The outbreak

of

fire in

one's

house

or

business

may be

largely

uncontrollable by

the

individual,

but

the

probability

of

fire is

somewhat

influenced

by

carelessness,

and of course

arson is

a

possibility,

if

an

extreme

one.

Similarly, in

medical

policies

the

cost

of

medical

care

is

not

completely

determined

by

the illness

suffered

by the

individual

but

depends

on the

choice of

a

doctor

and

his

willingness

to

use

medical

services.

It is

frequently

observed

that

widespread medical

insurance

increases the

demand

for

medical

care.

Coinsurance

provisions

have

been

introduced

into

many

major

medical

policies

to

meet this

contingency

as

well as the

risk

aversion

of the

in-

surance

companies.

To

some extent

the

professional

relationship between

physician

and

patient limits the normal

hazard in

various

forms of

medical

insurance.

By

certifying

to

the

necessity

of

given

treatment

or the

lack

thereof,

the

physician

acts as

a

controlling

agent on

behalf of

the

insurance

companies. Needless

to

say,

it is

a

far

from

perfect

check;

the

phy-

sicians

themselves

are

not

under

any

control

and

it

may

be

convenient

for them

or

pleasing

to

their

patients

to

prescribe

more

expensive

medi-

"It

is a

popular

belief

that

the

Chinese,

at one

time,

paid

their

physicians

when

well

but not

when

sick.

962

THE

AMERICAN ECONOMIC

REVIEW

cation,

private

nurses,

more

frequent

treatments,

and

other

marginal

variations of

care. It

is

probably true that

hospitalization

and

surgery

are

more

under

the

casual

inspection of

others than is

general

practice

and

therefore less

subject to

moral

hazard;

this

may

be

one

reason

why

insurance

policies

in

those

fields

have

been more

widespread.

2. Alternative

methods

of

insurance

payment.

It is

interesting

that

no

less

than

three

different

methods of

coverage

of

the

costs

of

medical

care

have

arisen:

prepayment,

indemnities

according

to a fixed

schedule,

and

insurance

against

costs,

whatever

they

may

be.

In

prepayment

plans,

insurance

in

effect

is

paid

in

kind-that

is,

directly

in medical

services.

The

other

two

forms

both

involve

cash

payments

to the bene-

ficiary, but

in

the

one

case

the

amounts

to be

paid

involving

a

medical

contingency are

fixed

in

advance,

while in

the other the

insurance

car-

rier

pays all

the

costs,

whatever

they

may

be,

subject,

of

course,

to

provisions

like

deductibles

and

coinsurance.

In

hypothetically

perfect

markets

these

three forms of

insurance

would be

equivalent.

The

indemnities

stipulated

would,

in

fact, equal

the

market

price

of

the

services,

so

that

value

to the insured

would

be

the same if

he

were to be

paid

the fixed sum or

the market

price

or

were

given

the

services

free.

In

fact,

of

course,

insurance

against

full

costs and

prepayment

plans

both

offer

insurance

against

uncertainty

as

to the

price of

medical

services, in

addition

to

uncertainty

about their

needs.

Further,

by

their

mode of

compensation

to

the

physician,

pre-

payment

plans

are

inevitably

bound up

with

closed

panels so

that

the

freedom of

choice of

the

physician

by

the

patient is

less

than

it

would

be

under a

scheme

more

strictly confined

to the

provision of

insurance.

These

remarks

are

tentative,

and

the

question

of

coexistence of

the

different

schemes

should

be a

fruitful

subject

for

investigation.

3.

Third-party control over

payments.

The

moral

hazard

in

phy-

sicians' control

noted in

paragraph 1

above

shows

itself

in

those

in-

surance schemes where

the

physician

has the

greatest

control,

namely,

major

medical

insurance.

Here

there

has

been

a

marked

rise in

ex-

penditures

over

time.

In

prepayment

plans,

where

the

insurance

and

medical service

are

supplied

by

the

same

group,

the

incentive

to

keep

medical

costs to a

minimum is

strongest.

In

plans

of the

Blue

Cross

group,

there

has

developed a

conflict of

interest

between

the

insurance

carrier

and

the

medical-service

supplier,

in

this

case

particularly

the

hospital.

The

need for

third-party control

is

reinforced

by

another

aspect

of

the

moral

hazard. Insurance

removes

the

incentive

on

the

part of

in-

dividuals,

patients,

and

physicians

to

shop

around for

better

prices

for

hospitalization and

surgical

care.

The

market

forces,

therefore,

tend to

be

replaced

by

direct

institutional

control.

ARROW:

UNCERTAINTY

AND

MEDICAL CARE

963

4.

Administrative

costs. The

pure theory

of insurance

sketched

in

Section B

above omits

one very

important

consideration:

the costs

of

operating an

insurance company.

There are

several types

of

operating

costs, but

one of the

most

important

categories includes

commissions

and

acquisition costs,

selling costs

in usual

economic

terminology.

Not

only does

this mean

that

insurance policies

must be sold

for consid-

erably more

than

their actuarial

value, but

it also means

there

is

a

great

differential

among different

types of

insurance. It is

very striking

to

observe that among

health

insurance

policies of insurance

companies

in

1958,

expenses of

one sort or

another

constitute 51.6 per

cent of total

premium

income for

individual

policies, and

only 9.5 per

cent for group

policies

[26, Table

14-1, p.

272].

This

striking differential

would seem

to

imply

enormous

economies of

scale in the

provision of

insurance, quite

apart

from the

coverage of the

risks

themselves.

Obviously, this pro-

vides a

very strong

argument for

widespread

plans,

including, in par-

ticular,

compulsory

ones.

5.

Predictability

and insurance.

Clearly,

from the

risk-aversion point

of

view,

insurance is

more

valuable, the

greater the

uncertainty in the

risk

being insured

against. This

is usually

used as an

argument for

putting

greater

emphasis on

insurance against

hospitalization and sur-

gery

than

other

forms of medical

care. The

empirical

assumption has

been

challenged by 0.

W.

Anderson and

others [3, pp.

53-54],

who as-

serted

that

out-of-hospital

expenses were

equally as

unpredictable

as

in-hospital

costs.

What was in

fact shown

was that the

probability of

costs

exceeding $200

is about the

same for

the two

categories, but this

is

not, of

course, a

correct

measure of

predictability, and a

quick glance

at the

supporting

evidence shows

that in

relation to the

average cost

the

variability

is much lower

for

ordinary

medical

expenses. Thus,

for

the

city

of

Birmingham,

the mean

expenditure

on

surgery

was

$7,

as

opposed

to $20

for

other

medical expenses,

but of

those who paid

something

for

surgery

the average bill

was

$99,

as against

$36

for

those

with

some ordinary

medical

cost.

Eighty-two

per cent of

those inter-

viewed had no

surgery,

and

only 20

per cent

had no

ordinary medical

expenses

[3,

Tables

A-13, A-18, and

A-19 on

pp. 72, 77, and

79,

re-

spectively].

The issue of

predictability

also has

bearing

on

the merits of insur-

ance

against chronic illness

or

maternity.

On a lifetime

insurance

basis,

insurance

against chronic

illness makes

sense,

since

this

is

both

highly

unpredictable

and

highly significant

in

costs.

Among

people

who

al-

ready

have chronic

illness,

or

symptoms

which

reliably

indicate

it,

in-

surance

in

the

strict

sense

is

probably pointless.

6.

Pooling of unequal

risks.

Hypothetically,

insurance

requires

for

its

full

social

benefit

a

maximum

possible

discrimination

of

risks. Those

964

THE

AMERICAN

ECONOMIC

REVIEW

in

groups

of higher

incidences of

illness

should pay

higher premiums.

In fact,

however,

there is a

tendency

to

equalize,

rather than to

differ-

entiate,

premniums,

especially in the

Blue

Cross and similar

widespread

schemes. This

constitutes,

in

effect,

a

redistribution

of income

from

those with a

low

propensity

to

illness to

those with

a

high

propensity.

The

equalization,

of course,

could

not

in

fact

be

carried

through

if

the

market were

genuinely

competitive.

Under

those

circumsances,

insur-

ance

plans

could

arise which

charged lower

premiums

to

preferred

risks and

draw

them off,

leaving the

plan

which does

not discriminate

among

risks

with

only an

adverse

selection of

them.

As we

have

already seen

in the

case of

income

redistribution, some

of this

may be

thought of

as

insurance with

a longer

time

perspeCtive.

If

a

plan

guarantees to

everybody a

premium

that

corresponds

to

total

experience but

not

to

experience as

it might

be

segregated by smaller

subgroups,

everybody is, in

effect,

insured

against a

change

in

his

basic

state

of

health which

would

lead to a

reclassification.

This

corresponds

precisely

to the

use of a

level

premium in

life

insurance

instead of a

premium

varying

by age,

as would

be the

case for

term

insurance.

7.

Gaps

and

coverage.

We

may

briefly

note

that,

at

any

rate

to

date,

insurances

against

the cost

of

medical

care

are

far from

universal.

Cer-

tain

groups-the

unemployed,

the

institutionalized,

and

the

aged-are

almost

completely

uncovered. Of

total

expenditures,

between

one-fifth

and

one-fourth are

covered

by

insurance. It

should be

noted,

however,

that

over

half of

all

hospital

expenses

and

about

35

per

cent

of

the

medical

payments

of

those

with

bills

of

$1,000

a

year

and

over,

are

in-

cluded

[26, p.

376]. Thus,

the

coverage

on the

more

variable

parts

of

medical

expenditure is

somewhat

better than

the

over-all

figures would

indicate,

but it

must be

assumed

that the

insurance

mechanism is still

very

far from

achieving

the full

coverage

of

which

it is

capable.

D.

Uncertainty of

Effects

of

Treatment

1. There are

really

two

major

aspects

of

uncertainty for

an indi-

vidual

already

suffering

from

an

illness. He is

uncertain about the

effec-

tiveness

of medical

treatment,

and

his

uncertainty

may be

quite differ-

ent from

that

of

his

physician, based oni the

presumably quite

different

medical

knowledges.

2.

Ideal

insurance. This

will

necessarily involve

insurance

against

a failure to

benefit from

medical

care,

whether

through

recovery, relief

of

pain,

or

arrest of

further

deterioration.

One

form

would be

a system

in

which the

payment

to the

physician

is

made in

accordance

with the

degree

of benefit.

Since

this

would

involve

transferring the

risks from

the

patient

to

the

physician,

who

might

certainly

have an

aversion to

bearing

them,

there is room for

insurance

carriers to

pool

the risks,

ARROW:

UNCERTAINTY

AND

MEDICAL

CARE

965

either by

contract

with

physicians or by

contract with

the potential

patients.

Under ideal

insurance,

medical care

will always

be undertaken

in any

case

in

which

the

expected utility,

taking account of the

prob-

abilities,

exceeds the

expected

medical cost.

This

prescription

would

lead to

an economic

optimum.

If we think

of the

failure to

recover

mainly

in

terms of

lost working

time, then

this

policy

would,

in

fact,

maxi-mize

economic

welfare as

ordinarily

measured.

3. The

concepts of

trust and

delegation. In

the absence

of

ideal

in-

surance,

there

arise

institutions

which

offer some

sort

of

substitute

guarantees. Under ideal

insurance the

patient

would

actually

have

no

concern

with

the

informational

inequality

between

himself and

the

physician, since he

would only

be paying by

results

anyway,

and his

utility position

would

in

fact be

thoroughly

guaranteed.

In

its absence

he

waants

to

have

some guarantee

that

at least the

physician

is

using

his

knowledge to

the best

advantage.

This

leads to the

setting up

of a

relationship

of

trust

and

confidence, one

which

the

physician

has

a

social

obligation to

live up to.

Since the

patient does not,

at least

in

his

belief,

know

as much as

the

physician, he

cannot

completely

enforce

standards

of

care.

In

part,

he

replaces

direct

observation by

gener-

alized belief

in

the

ability

of

the

physician." To

put it

another

way, the

social

obligation for

best

practice is part of

the

commodity the

phy-

sician

sells,

even

though it is a

part that is

not subject to

thorough

in-

spection

by the

buyer.

One

consequence

of

such

trust relations is

that

the

physician cannot

act,

or

at

least appear

to act, as if

he is

maximizing his

income at

every

moment

of

time.

As

a

signal to

the

buyer of

his

intentions

to act as

thorouglhly

in

the

buyer's

behalf as

possible,

the physician avoids the

obvious

stigmata

of

profit-maximizing.

Purely arms-length

bargaining

behavior would be

incompatible, not

logically, but

surely psychologi-

cally,

with

the

trust

relations.

From

these

special relations come

the

various forms

of

ethical behavior discussed

above,

and so

also,

I

sug-

gest,

the

relative

un-importance

of

profit-making

in

hospitals.

The

very

word,

"profit,"

is a

signal

that denies

the

trust

relations.

PriCe

discrimination

and its

extreme, free

treatment for

the

indigent,

also

follow. If the

obligation of the

physician

is understood

to be

first

of

all to

the

welfare

of

the

patient, then

in

particular it

takes

preced-

ence

over

financial

difficulties.

As

a second

consequence

of

informational

inequality between

phy-

siclan and

patient

and

the lack of

insurance of

a

suitable type,

the

patient

must

delegate

to the

physician

much

of

his

freedom of

choice.

"

Francis

Bator

points

out

to

me

that

some protection

can be

achieved, at a

price,

by

securing

additional

opinions.

966

THE

AMERICAN

ECONOMIC

REVIEW

He

does

not

have

the

knowledge

to

make

decisions

on

treatment,

re-

ferral, or

hospitalization. To

justify

this

delegation,

the

physician finds

himself

somewhat

limited,

just

as any

agent

would

in

similar

circum-

stances.

The

safest

course

to

take to

avoid

not

being

a

true

agent

is

to

give the

socially

prescribed

"best"

treatment of

the

day.

Compromise

in

quality,

even

for the

purpose

of

saving

the

patient

money, is

to

risk

an

imputation

of

failure

to

live up

to

the

social

bond.

The

special

trust

relation

of

physicians

(and

allied

occuptions,

such

as

priests)

extends to

third

parties

so

that the

certifications

of

phy-

sicians

as to

illness

and

injury

are

accepted as

especially

reliable

(see

Section

IJ.B

above).

The

social

value

to

all concerned

of such

pre-

sumptively

reliable

sources

of

information is

obvious.

Notice the

general

principle here.

Because there are

barriers

to

the

information

flow

and

because

there

is no

market

in

which

the

risks

involved

can

be

insured,

coordination

of

purchase

and

sales

must talke

place

through

convergent

expectations,

but

these

are

greatly

assisted

by

having clear

and

prominent

signals, and

these,

in

turn,

force

pat-

terns of

behavior

which

are not

in

themselves

logical

necessities

for

optimality.37

4.

Licensing

and

educational

standards.

Delegation

and

trust

are

the

social

institutions

designed

to

obviate the

problem of

informational

in-

equality.

The

general

uncertainty

about tne

prospects of medical

treat-

ment is

socially

handled

by

rigid

entry

requirements.

These

are de-

signed

to reduce

the

uncertainty

in

the

mind of the consumer

as

to

the

quality

of

product

insofar

as

this

is

possible.38

I

think

this

explana-

tion,

which

is

perhaps

the

naive

one,

is

much

more

tenable

than

any

idea of

a

monopoly

seeking

to

increase

incomes. No

doubt

restriction

on

entry is

desirable

from

the

point

of

view of

the

existing

physicians,

but

the

public

pressure

needed

to

achieve

the

restriction

must

come

from

deeper

causes.

The

social

demand

for

guaranteed

quality

can be

met

in

more

than

one

way,

however.

At

least

three

attitudes

can

be

taken

by the

state

or

other

social

institutions

toward

entry into

an

occupation

or

toward

the

production

of

commodities in

general;

examples of

all

three

types

exist.

(1)

The

occupation can

be

licensed,

nonqualified

entrants

being

simply

excluded. The

licensing

may

be

more

complex

than

it is in

medicine;

individuals

could be

licensed for

some,

but not

all,

medical

activities,

for

example.

Indeed, the

present

all-or-none

approach

could

"The

situation

is

very

reminiscent

of

the

crucial

role of

the

focal

point in

Schelling's

theory of tacit

games,

in

which

two

parties

have

to

fin-d

a

common

course

of

action

without

being

able to

communicate;

see

[24,

esp.

pp.

225

ff.].

'

How

well

they

achieve

this end

is

another

matter.

R. Kessel

points

out to me

that

they

merely

guarantee

training,

not

continued

good

performance

as

medical

technology

changes.

ARROW:

UNCERTAINTY

AND MEDICAL

CARE

967

be

criticized as

being

insufficient with

regard

to

complicated

specialist

treatment,

as well as

excessive with

regard

to

minor

medical

skills.

Graded

licensing

may,

however,

be

much

harder

to

enforce.

Controls

could

be

exercised

analogous to

those for

foods;

they

can be

excluded

as

being

dangerous,

or

they

can be

permitted

for

animals

but

not

for

humans.

(2)

The

state

or

other

agrency

can

certify

or

label,

without

compulsory

exclusion.

The

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