General Equilibrium and Marketability in the Health Care Industry

Kenneth Arrow's 1963 article, "Uncertainty and the Welfare Economics of Medical Care," has become a seminal essay in the field of health economics. Its fundamental contribution is a detailed and thoughtful comparison of the deviations between the workings of markets for medical care and the competitive ideal. As Arrow demonstrates, a variety of factors prevents the medical care market from yielding an optimal allocation of resources. Prime among those factors is the "lack of marketability" for many products. Essentially, certain products that would improve the allocation of resources if they existed are not available for purchase (nonmarketable).

Arrow provides a complementary analysis of how "nonmarket social institutions" may arise to fill the gaps left by the lack of markets for certain products and thereby improve resource allocation. By nonmarket social institutions, he largely means norms of behavior that deviate from those typically observed in a competitive model.

This essay examines nonmarketability in the health care sector. The first section outlines Arrow's notion of general equilibrium in the health care sector and the problem of nonmarketability. The second section examines the markets (and market failures) in the early 1960s and how those market failures can be traced to a lack of markets for several types of products. It concludes with a discussion of how nonmarket institutions could be viewed as filling the gaps for those missing markets. The final two sections discuss how, since 1963, there has been an expansion in markets and an associated change in the role of nonmarket institutions. The central thesis of this essay is that market and nonmarket institutions have a symbiotic relationship, with nonmarket institutions serving to improve resource allocation in areas where markets fail or do not exist. As the role of the market has expanded, the role of social institutions has changed to fill new gaps that have arisen in the increasingly market-oriented environment.

Arrow's General Equilibrium Orientation and the Problem of Nonmarketability

Much of Arrow's acclaim reflects his exposition of the theory of general equilibrium. In economics, general equilibrium refers to the situation in which all markets (consumer and producer markets as well as markets for inputs such as labor and capital) are in equilibrium (namely, supply meets demand). It is largely a theory in which prices adjust to achieve this balance, and the theory recognizes the interconnection between markets.

The theory of general equilibrium is founded on decentralized action by consumers and firms, with consumers maximizing their well-being (utility) and firms maximizing profits. In standard models, individuals are assumed to be perfectly informed. Perfect information does not mean that everyone knows what the future will hold, only that they know the probabilities with which different events may occur. Outcomes are uncertain, but individuals are not uninformed (or misinformed). General equilibrium models also assume that, when faced with a set of prices, individuals (and firms) are cognitively capable of maximizing their well-being through their behavior. A variety of other assumptions, such as those that relate to market power (or lack thereof), complete the general equilibrium model but are less salient for this discussion.

As Arrow notes in his essay, much of the appeal of the general equilibrium model relates to its implications for economic efficiency. Specifically, in general equilibrium settings two theorems of welfare economics link optimal resource allocation and competition. First, if a competitive equilibrium exists, it will be optimal; second, if we do not like the particular competitive equilibrium that arises from the market, we could reallocate incomes to achieve, through competition, any other optimal allocation we desired.

Such an analysis relies heavily on one's definition of optimal resource allocation, and Arrow is careful to introduce early in his essay the standards he uses and their precise meaning. Specifically, he adopts the economic concept of Pareto optimality, which defines an optimal allocation of resources as one...