Arrow and the Information Market Failure in Health Care: The Changing Content and Sources of Health Care Information

Kenneth Arrow's "Uncertainty and the Welfare Economics of Medical Care," published in the American Economic Review in 1963, makes profound contributions in the areas of health economics and, more generally, in the economics of information.

At the time Arrow was writing this article, unlike today, there was almost no scholarship on the economics of information. The only article on this topic published at that time in the economics literature was "The Economics of Information" by George Stigler (1961), and its focus was on consumers' information about price rather than quality. In Public Health Reports, however, Selma Mushkin had published "Toward a Definition of Health Economics" in which she discussed how consumers' lack of information about quality could result in market failure in medical markets. She wrote, ". . . they [consumers] reveal considerable absence of accurate knowledge about the quantity and quality of health services required. The nature of the medical service itself and its intangible character reinforce the consumer's lack of knowledge about his purchases, and impede a rational choice that could guide the allocation of resources" (Mushkin 1958: 787).

This essay is organized into three parts. First is a description of Arrow's contributions with respect to information problems leading to market failures in medical care markets. Second, it is shown that theoretical work by economists since 1963 is consistent with Mushkin's and Arrow's thinking--specifically, information imperfections result in market failure. Third, it includes a discussion of the changing nature of the informational asymmetry between physicians and patients since 1963.

Arrow's Understanding of the Nature of Information in Medical Markets

Arrow recognized that medical care markets are characterized by extremely high levels of uncertainty and, in particular, patients' uncertainty about the consequences of purchasing medical treatments. Patients' inherent uncertainty about the effectiveness of medical treatments--uncertainty about which treatments can best cure their illnesses or relieve their pain--makes it extremely difficult for patients to learn about and evaluate the quality of medical care services. "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. . . . 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 automobiles, even though these are also expenditures sufficiently infrequent so that there may be considerable residual uncertainty" (951).

Second, Arrow recognized that under conditions of uncertainty, accurate information becomes a very valuable commodity and that, in many ways, medical markets are really markets for information. "When there is uncertainty, information or knowledge becomes a commodity. . . . but, information, in the form of skilled care, is precisely what is being bought from most physicians" (946).

Third, Arrow recognized that information's "elusive character" limits its marketability on both the demand and supply sides of the market. In his analysis there are limits on consumers' abilities to acquire information and limits on consumers' abilities to process information. Specifically, for cases of severe illness the limits on acquiring information are "the uncertainty due to inexperience" (inadequate number of trials to learn from) and "the intrinsic difficulty of prediction" (951).

With respect to limits on consumers' abilities to process information, he described consumers as not knowing the value of the information being bought from physicians. ". . . if, indeed, [the consumer] knew enough to measure the value of the information, he would know the information itself" (946). Further, Arrow understood illness and ". . . 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" (949). Compared to periods of good health, in periods of poor health (especially...