Health Care Markets Fail So Government Must Intervene? Kenneth Arrow Said No Such Thing

We’ve all heard the ritual incantation: Kenneth Arrow showed that markets fail in health care, so government must intervene.

What comes next is dealer’s choice. You may be in for a pitch on regulating nurse practitioners. Or against physicians dispensing medicines. Or for price controls on pharmaceuticals. Or for abolishing profit, private health insurance, and human nature itself on our way to a glorious future with Medicare for All. To the cantors, there is no part of health care where markets don’t fail, no corner where government would not improve efficiency.

Only…Kenneth Arrow said no such thing.

In 1972, Arrow won the Nobel Prize in Economics for “pioneering contributions to general economic equilibrium theory and welfare theory,” in part for demonstrating that democracy kinda stinks.

Nine years earlier, the American Economic Review published Arrow’s “Uncertainty and the Welfare Economics of Medical Care.” The Nobel committee did not mention that article. Still, as Berkeley health economist James C. Robinson wrote, Arrow’s 1963 essay is “a good article by a great economist, a creative application of the theory of risk and uncertainty to the thorny problems of the health sector, exactly the sort of boundary-crossing, barrier-penetrating work that opens the possibility of progress in thought and action. Would we have more of the same.”

Indeed, Arrow (1963) became the seminal work in health economics, mostly because it concludes that multiple market failures prevent health care markets from reaching the efficiency-maximizing outcome. “The central proposition of his article,” Robinson summarized, is “that health care information is imperfect and asymmetrically distributed.” Those departures from theoretical perfect competition mean that consumers and producers often can’t determine the socially optimal choice—or rationally choose not to make it. Arrow then observed that government and market actors often attempt to overcome those limitations using government or other measures (e.g., codes of professional ethics). Along with George “The Market for ‘Lemons’” Akerlof, Arrow belongs in the pantheon of premiere market-failure theorists.

Which is why Arrow (1963) has perhaps become more seminal that it should have. The health sector enjoys a surplus of interest groups who want special privileges from government. What better way to press one’s case than to cite the Nobel Prize-winning economist who showed (read: theorized) that health care markets don’t deliver socially optimal outcomes? Robinson explained that Arrow (1963) achieved fame largely because, for both the industry and ideologues, there’s gold in them thar hills:

[Arrow’s] article…has been seized upon to justify every inefficiency, idiosyncrasy, and interest-serving institution in the health care industry…It has served to lend the author’s unparalleled reputation to subsequent claims that advertising, optometry, and midwifery are threats to consumer well-being, that nonprofit ownership is natural for hospitals though not for physician practices, that price competition undermines product quality, that antitrust exemptions reduce costs, that consumers cannot compare insurance plans and must yield this function to politicians, that price regulation is effective for pharmaceutical products despite having failed in other applications, that cost-conscious choice is unethical while cost-unconscious choice is a basic human right, that what consumers want is not what they need, and, more generally, that the real is reasonable, the facts are functional, and the health care sector is constrained Pareto-efficient.

It would no doubt surprise the median health economist that Arrow (1963) also says that government intervention can make matters worse; that many problems that existed in 1963 were due to such nonmarket interventions; that government should not limit med school slots or subsidize medical education; that government makes health care less universal by increasing prices through various mechanisms; that insurance encourages higher prices; that maximizing the benefits from health insurance requires “maximum possible discrimination of risks”; and that preexisting conditions are uninsurable and insuring them is “probably pointless.” Ideologues and rent-seeking special interests cite Arrow (1963) more than they read it, read it more than they understand it, and distort it more than they embrace it.

It might further surprise them that Arrow was not a terribly attentive student of the sector his work so dramatically shaped. By 1999, the health sector had overtaken every other economic sector in terms of congressional lobbying expenditures, a distinction it has held ever since. Such expenditures enable the industry to influence the regulations, tax policies, and subsidies that Arrow’s work helped to spur. In 2016, when advocating the creation of a Canadian-style health system in the United States, Arrow shrugged, “Of course, [Nobel Prize-winning economist] George Stigler would say that there could be regulatory capture, but so far it doesn’t seem to have happened really.”

When theory and reality conflict, what’s a social scientist to do?

Click here to read Arrow in his own words. For highlights of how Arrow (1963) differs from how ideologues and special interests portray it, read Kenneth Arrow’s 1963 Article on Health Care Doesn’t Say What You Think.

Michael F. Cannon (MA, JM) is director of health policy studies at the Cato Institute.