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Uncertainty and The Welfare Economics of Medical Care

Lecture March, 2013

Presentation Outline
I. II.
a. b. c. d. e.

Introduction: Scope and Methods A Survey of the Special Characteristics of the Medical-Care Market
The nature of demand Expected behavior of physician Product uncertainty Supply conditions Pricing practices

III.
a. b. c. d.

Comparisons with the competitive model under certainty


Nonmarketable Commodities Increasing returns Entry Pricing

IV.
a. b. c. d.

Comparisons with the ideal competitive model under uncertainty


Introduction The Theory of Ideal Insurance Problems of Insurance Uncertainty of effects of treatment

I.

Introduction: Scope and Methods

Focus on medical care industry not health Focus on the way the operation of medical-care industry and the efficacy with which it satisfies the needs of society differ from the norm.

1. Introduction
The interest in the competitive model stems partly from its presumed descriptive power and partly from its implications for economic efficiency.

First Optimality Theorem


If a competitive equilibrium exists at all, and all commodities relevant to costs or utilities are in fact priced in the market, then the equilibrium is necessarily optimal: There is no other allocation of resources to services which will make all participants in the market better off (Pareto Optimality)

First Optimality Theorem


Competitive equilibrium achieved depends on the initial distribution of purchasing power Transfer of purchasing power from the well to the ill will increase the demand for health services This in turn will lead to short-term increases in the price of medical services In the long-term it will lead to an increase in the amount of services provided

Second Optimality Theorem


If there are no increasing returns in production then every optimal state is a competitive equilibrium corresponding to some initial distribution of purchasing power What the two optimality theorems state is that if they hold then all one needs to worry about is altering the distribution of purchasing power Competitive markets will take care of the rest If the optimality theorem does not hold the separation of allocative and distributional procedures becomes difficult

Actual Health Market and Competitive Markets


Milton Friedman
Market models should be tested solely on their ability to predict Prices and quantities are the only relevant data

Arrow argues that institutional organization and observable practices of the medical profession should also be included

Competitive Markets
Three conditions need to be satisfied The existence of a competitive equilibrium The marketability of all goods and services relevant to costs and utilities Non-increasing returns The first two conditions ensure that the competitive equilibrium is optimal The third condition states that every optimal competitive equilibrium corresponds to some distribution of income

Social Costs and Benefits (Externality case)


Social benefits refers to the fact that the market does not require an individual to pay for costs that she imposes on others as a result of her action or does not permit her to be paid for benefits/services provided Example is spread of communicable diseases
Person who does not get immunized not only risks own life but also that of others In an ideal pricing system she would have to pay to anyone whose health is endangered (the price will need to be high enough to ensure they feel adequately compensated) or else she will have to be paid enough to get immunized

This is clearly not practical. Therefore collective intervention occurs either a subsidy, tax or compensation

Non-Marketability and Risk Bearing


Illness is an unpredictable phenomenon Ability to shift the risks of illness is a price that many are willing to pay Because of pooling and of superior willingness and ability other are willing to bear the risks. When one introduces risk bearing into the equation it means there is an element of uncertainty. This in turn means that information or knowledge becomes a commodity

Information as a Commodity
If information is a commodity then There is a cost to producing it There is a cost to making it available Therefore it will not be uniformly distributed across the entire population but rather concentrated amongst those who can profit from it Note that we are actually buying information from health providers they have the knowledge and skills to deal with health problems Therefore information departs from the usual marketability assumptions about other commodities

Information as a Commodity
Arrow mentions that one form of knowledge is research Knowledge tends to be increasingly used once it is available It is used over and over without being consumed Cost of reproduction is much less than the cost of production Therefore either a free enterprise economy will under invest in research or patents will restrict access to it

Failure of Preconditions
When one or more of the preconditions does not hold it means There will be a failure to reach Pareto Optimality This means that there will be a loss in welfare Society if it recognizes this problem will take actions to redress it Action typically will tend to be nonmarket social institutions trying to bridge this welfare loss gap

2. A Survey of the Special Characteristics of the Medical-Care Market


A. The nature of individual demand
Not steady in origin Irregular and unpredictable Illness is not only risky but a costly risk in itself, apart from the cost of medical care

B. Expected behavior of the physician


Advertising and overt price competition are virtually eliminated among physicians Advice given by physicians is supposed to be completely divorced from self-interest Treatment is dictated by objective needs of the case and not limited by financial considerations--in theory The Physician is relied upon as an expert in certifying the existence of illness

C. Product uncertainty
Uncertainty as to the quality of the product Recovery from disease is as unpredictable as its incidence The uncertainty is very different on the two sides of the transaction

D. Supply Conditions
Entry to the profession is restricted by licensing (USMLE is only one example) The cost of medical education in the US is a reflection of the quality standards imposed by AMA. Both licensing laws and standards of medical-school training have limited possibilities of alternative qualities of medical care.

E. Pricing Practices
Extensive price discrimination by income Formerly, strong insistence on fee-forservices as against alternatives as prepayment. Problems of implicit and explicit pricefixing. Price competition is not welcome
Important to keep in mind that this was the situation when Arrow wrote the paper

3. Comparisons with the competitive model under certainty


A. Non-marketable goods:

Example: diffusion of communicable diseases


Beyond the public health area, there is a more general interdependence, the concern of individuals for the health of others.--- manifestations are donations and government responsibilities There is a case for collective action if each participant derives satisfaction from the contribution of all

B. Increasing returns
Hospitals show increasing returns to scale up to a point Problems associated with increasing returns play some role in allocation of resources---- particularly in low density and low income areas.

C. Entry
Most striking departure from competitive behavior is restriction on entry to the field. Why entry restrictions important:
Additional entrants would be, in general, of low quality? To achieve genuinely competitive conditions, it would be necessary not only to remove numerical restrictions but also to remove subsidy in medical education. To some extent, the effect of making tuition carry the full cost education will be to create too few entrants, rather than too many

C. Entry
If entry were governed by ideal competitive conditions, it may be that the quantity on balance would be increased, though this conclusion is not obvious. Entry restrictions exclude many imperfect substitutes for physicians.

C. Entry
In the competitive model without uncertainty, consumers are presumed to be able to distinguish qualities of commodities they buy. Under this hypothesis, licensing would exclude those from whom consumers would not buy anyway; but it might exclude too many.

D. Pricing
Pricing practices part sharply from competitive norms Not only is price discrimination incompatible with the competitive model, but its preservation in the face of a large number of physicians is equivalent to a collective monopoly

D. Pricing
Price discrimination is designed to maximize profits along the lines of discriminating monopoly Organized medical opposition to pre-payment was motivated by desire to protect these profits.
Arrow is not convinced that there is sufficient evidence for this in reality. Price-discrimination by income in the extreme case of charity for example shows that social and ethical factors should be considered

Resistance to pre-payment is also because of its relation to closed-panel plans where the physician assumes the risks.

D. Pricing
Price discrimination, for whatever cause, is a source of non-optimality:
Hypothetically, it means that everyone would be better off if prices were made equal for all, and the rich compensated the poor for the changes in 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 different income groups.

4. Comparisons with the ideal competitive model under uncertainty


A. Introduction: - in this section, assume that insurance policies against all conceivable risks are available - There are two risks involved in medical care:
1. Risk of becoming ill 2. Risk of total or incomplete or delayed recovery

A. Introduction
The loss due to illness is only partially the cost of medical care. It consists of:
Discomfort Loss of productivity Possibly death or prolonged deprivation of normal function

From the point of view 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 Insurance


Assumptions: Each individual acts so as to maximize the expected value of a utility function Utility is attached to income. Costs of medical care act as a random deduction from income Illness itself is not a source of satisfaction, therefore it should enter the utility function as a separate variable Individuals are assumed to be risk averters which means that they have diminishing marginal utility of income (wealth)

B. The Theory Ideal Insurance


The expected utility hypothesis is plausible and the most analytically manageable hypotheses that have been proposed to explain behavior under uncertainty.

B. The Theory Ideal Insurance


If an individual is given the choice between a probability of distribution of income, with a given mean m and the certainty of the income m, he would prefer the latter Suppose an agency is willing to offer insurance on an actuarially fair basis; that is, if the costs of medical care are a random variable with m mean and the company will charge m.

B. The Theory Ideal Insurance


Under the assumption 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 this limit, the welfare loss even assuming risk aversion on the part of the insurer, would disappear and there is net social gain.

C. Problems of insurance
1. Moral hazard 2. Alternative methods of insurance payment. Three main methods:
Prepayment Indemnities according to a fixed schedule Insurance against costs, whatever they may be In a hypothetically perfect market, these 3 forms would be equivalent but in reality they do not work in health insurance market easily

C. Problems of insurance
3. Third-party control over payments: Provider and patient moral hazard shows itself here 4. Administrative costs - There are several types of operating costs such as commissions and acquisition costs and selling costs. - Not only does this mean that insurance policies must be sold for considerably more than actuarial value, but it also means there is a great differential among different types of insurance - Expenses constitute 51.6% of total premium for individual policies vs. 9.5% for group policies. - This implies economies of scale. A strong case for widespread plans, including in particular compulsory ones (think of a huge social insurance pool)

C. Problems of insurance
5. Predictability and insurance
From the risk aversion point of view, insurance is more valuable, the greater the uncertainty in the risk being insured against.

6. Pooling of unequal risks


Hypothetically, insurance requires for its full social benefit a maximum possible discrimination of risks.

7. Gaps and coverage

D. Uncertainty effects of treatment


1. There are two major aspects of uncertainty for a person already suffering from illness:
Uncertain about the effectiveness of medical treatment Uncertainty on the part of the physician which is different because of knowledge level differences

2. Ideal insurance
This will involve insurance against a failure to benefit from medical care

D. Uncertainty effects of treatment


3. The concepts of trust and delegation - The information inequality which leads to the setting up of a relationship of trust and confidence, one which the physician has a social obligation to live up to.

Consequences of the information asymmetry: - The physician cannot act, or at least appear to act, as if he is profiting maximizing his income at every moment of the time. - The patient must delegate to the physician much of his freedom of choice

D. Uncertainty effects of treatment


4. Licensing and educational standards The social demand for quality can be met in more than one way. There are 3 attitudes:
The occupation can be licensed, nonqualified entrants being simply excluded The State or other agency can certify or label without compulsory exclusion Nothing at all may be done; consumers make their own choices

Choice among these attitudes


Choice among these alternatives depends on the degree of difficulty consumers have in making the choice unaided and the consequences of the errors of judgment. General consensus: Laisser-faire solution for medicine is intolerable (does Pauly think exact same way?)