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Journal of Health Politics, Policy and Law 26.5 (2001) 967-992

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Can Efficiency in Health Care Be Left to the Market?

Uwe E. Reinhardt
Princeton University

Kenneth Arrow's "Uncertainty and the Welfare Economics of Medical Care" (1963) was published at a time when health economists were still a small sect of adventurous scholars. Regular economists wondered why any ambitious young academic would venture into such strange, uncharted territory from which one might never be able to return--to the comfort of academic tenure. The natives of the uncharted territory, on the other hand, greeted the sect as arrogant missionaries bent upon imposing neoclassical economic doctrine on a people who viewed their land as a semireligious place that would forever remain impenetrable to commercial forces. What greater comfort for the adventurous sect than to receive from the hand of one of the world's most renowned regular economists a treatise that not only lent professional respect to the sect's exploits, but also served as an authoritative road map for much bolder incursions into health care.

Arrow's script is dated by the graceful prose then still customary among social scientists. It is, however, so richly laden and so compact that it demands from readers nothing less than the academic analogue of talmudic scholarship. As James Robinson remarks at length in his essay in this volume, casually read, or selectively cited, the article can be made to serve all manner of entrenched economic interests or preferred ideology.

Arrow's objective in his article was to identify the special characteristics [End Page 967] of medical care that set it apart from the standard norms of welfare economics. To that end he described in passing the main pillars of these norms: the fundamental concept of Pareto optimality (also known among economists as Pareto efficiency) and the First and Second Theorems of Pareto Optimality. He concluded from this exercise that health care differs from the conditions posited for standard welfare economics mainly because two types of markets were insufficiently developed in health care. The first type was markets for the risk inherent in the uncertainty in the incidence of disease and in the efficacy of treatment. The second type was markets for the information assumed to be accessible for all participants in perfectly competitive markets.

Naturally, Arrow's conclusion kindled the hope among legions of younger economic disciples that, with the aid of better information technology, the missing markets could be developed in the foreseeable future. If that could be accomplished, then the efficient allocation of health care resources could be entrusted to the "invisible hand" of a price-competitive marketplace, which economists are uniquely qualified to understand, and public health policy could be confined to sundry externalities (e.g., halting the spread of contagious diseases) and to the redistribution of purchasing power for the sake of social equity. It is now a deeply held credo that has fueled health economics and U.S. health policy ever since. In fact, a good part of the theoretical and empirical work in health economics since the appearance of Arrow's article reminds one of the medieval scholastics who, under Saint Anselm's motto fides quaerens intelligentiam [faith seeking understanding], conducted their research to give rational content to their faith (Columbia Encyclopedia, 5th ed.,1993: 2447).

Remarkably, nowhere in his article did Arrow himself ever dream that boldly. If he had thought that the missing markets could be developed one day soon, presumably he would have counseled policy makers to see to the careful development of these markets first before turning the health sector to the mercies of a commercial free-for-all. Sadly, U.S. health policy since Arrow's writing has proceeded in precisely the reverse order, as the so-called procompetitive strategy during the 1980s and of managed competition with managed care during the 1990s so amply demonstrate. If the experience of these past two decades in U.S. health policy is to persuade the general public that a market approach will move health care closer...


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