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Healthy Markets?
The New Competition in Medical Care
By Mark A. Peterson Duke University Press
Copyright © 1998 Duke University Press
All rights reserved.
ISBN: 978-0-8223-9693-2
CHAPTER 1
Can Markets Give Us the Health System We Want?
Thomas Rice
In recent years there has been a surge of interest in reforming health care systems by replacing government regulation with a reliance on market forces. Although much of the impetus has come from the United States, the phenomenon is worldwide. Spurred by ever-increasing health care costs, many analysts and policy makers have embraced the competitive market as the method of choice for reforming health care. This belief stems from economic theory, which purports to show the superiority of markets over government regulation.
This has led advocates to champion a number of policies, including:
• providing low-income people with subsidies to allow them to purchase health insurance, rather than paying directly for the services they use;
• having people pay more money out-of-pocket in order to receive health care services, especially for services whose demand is most responsive to price;
• also requiring that they pay more in premiums to obtain more extensive health insurance coverage;
• letting the market determine the number and distribution of hospitals and what services they provide, as well as the total number of physicians and their distribution among specialties;
• removing regulations that control the development and diffusion of medical technologies;
• eschewing government involvement in determining how much a country spends on health care services.
This essay attempts to show that economic theory does not support the specific belief that such policies will enhance economic efficiency, or the more general one that they will increase social welfare. This is because the theory is based on a large set of assumptions that are not and cannot be met in the health care sector. Although it is well known among economists and noneconomists alike that some set of assumptions needs to be met to ensure that market forces will result in socially desirable outcomes, what is less understood are the specific assumptions that comprise the list. This essay reviews a number of assumptions that are particularly relevant to health care competition and the theory of demand for care. The above list comprises only a fraction of the total number of assumptions upon which conclusions about the superiority of market forces are based.
This essay is aimed at both health economists and noneconomist health policy researchers. It is an attempt to remind economists that it is inappropriate for them to bring into their work any preconceptions that relying on market forces in health care provides the preferred set of social policies. The arguments are also intended to cast doubt on the validity of various tools that health economists often use to analyze the health care sector.
For noneconomists, this essay should help clarify what economic theory can and cannot conclude about the desirability of market-based health care reforms. Because economics uses a language of its own, it is often difficult for the other professions to comprehend fully the methods used, and evaluate the conclusions reached, by health economists. (In this regard, Joan Robinson stated, "Study economics to avoid being deceived by economists," quoted in Kuttner 1984:1.) It is hoped that this essay can be used by noneconomists to level the playing field when competing with economists for the ear of policy makers.
The essay is divided into two main sections: The first focuses on the economic theory of market competition, and the second on the theory of demand. The competition section discusses three assumptions that affect economic analyses of markets in general, although the applications provided all pertain to health. The section on demand focuses more specifically on applying the assumptions of demand analysis to health care. Each section is divided into three parts: a short review of the relevant economic theory (which can be skipped by those who are familiar with microeconomics), a discussion of problems with the theory, and implications for health policy.
Market Competition
Review of economic theory
The field of microeconomics is devoted to the study of competition—mainly its virtues, but also some of its pitfalls. Although many of the techniques used by economists are fairly new, the emphasis on competition is not, dating back to the writings of Adam Smith over two hundred years ago. Smith believed that people, driven by their own economic interest in the marketplace, are guided by an "invisible hand" to act in a manner that ultimately is most beneficial to society at large.
The notion of competition is intuitively appealing. In a competitive market, people are allowed—but not compelled—to trade their stock of wealth, including their labor, to purchase goods and services. Firms are compelled to produce only those things that people will be willing to purchase, and to do so in the least costly manner. Once everyone stops trading because they see no more advantage, the market is in equilibrium. Such an outcome is desirable for several reasons: (a) people are making their own choices; (b) the only goods and services produced are those that people demand, and they are produced without wasting economic resources; and (c) by not engaging in any more trades, people reveal themselves to be as satisfied with their economic lot as possible, given the resources with which they began.
There are two facets to competitive theory: consumption and production. In consumer theory, people seek to maximize their utility, which is determined by the bundle of goods and services that they possess. To do so, they purchase their ideal bundle based on their desire or taste for alternative goods, and based on the prices of these alternatives (subject, of course, to how much income they have available to spend). In production theory, firms seek to maximize profits. To do so, they purchase inputs and transform them into outputs through the application of some sort of technology. How many inputs of each type are purchased depends on how each affects output, as well as their prices.
When both the consumption and production markets are in equilibrium, and when some other conditions are met, the economy will be in a position called Pareto optimality (named after Italian economist Vilfredo Pareto). If the economy is in a Pareto optimal state, it is impossible to make someone better off (i.e., increase their welfare) without making someone else worse off. In such a situation, the economy has reached a state of allocative efficiency, although as we shall see next, this rests on a number of assumptions.
How does an economy reach Pareto optimality? Economists have shown that if certain conditions are met, a free or competitive market operating on its own will reach such a Pareto optimal state. As a result, allowing competition to occur will result in a situation where it is impossible to make someone better off without making someone else worse off. Taxes and subsidies can then be used to redistribute income so that society's overall welfare can be maximized.
This last point—the need to redistribute income once competition brings about Pareto optimality—is extremely important. A competitive equilibrium can occur when one person has nearly all of the output, and another has almost none. In fact, this can easily occur if the former person begins with the vast majority of initial wealth. This point was made graphically by Amartya Sen (1970: 22), who wrote:
An economy can be [Pareto] optimal ... even when some people are rolling in luxury and others are near starvation as long as the starvers cannot be made better off without cutting into the pleasures of the rich. If preventing the burning of Rome would have made Emperor Nero feel worse off, then letting him burn Rome would have been Pareto-optimal. In short, a society or an economy can be Pareto-optimal and still be perfectly disgusting.
Although it might seem desirable to transfer wealth from the rich person to the poor person, this cannot be viewed as improving the economy from a Paretian viewpoint because it will involve making the rich person worse off. If society cares about both efficiency and equity, then it will have to redistribute income—a process that obviously involves value judgments—for it to reach its highest level of welfare.
Problems with the economic theory
It would appear that the traditional economic model of competition has a strong grip on health economists. This is supported by a 1989 survey of health economists in the United States and Canada (Feldman and Morrisey 1990). One of the questions asked was whether the competitive model cannot apply to the health care system. Respondents were evenly divided on this question; half thought the model could apply, and half did not. More noteworthy, perhaps, were some of the response patterns to the question. Two-thirds of respondents who received their doctorates from top economics departments thought that the competitive model could apply, versus 53 percent with degrees from other economics departments. Few of those who received their training in noneconomics departments believed that the competitive model could apply to the health care system. Similarly, in his recent survey of health economists, Victor Fuchs (1996) found a great deal of agreement on so-called positive issues, but very little on normative ones, which would presumably include whether health economists believe that the competitive model should be applied to the health care market.
There is thus evidence that many, if not most, health economists believe that the competitive model is an appropriate means for studying (and perhaps reforming) health care systems. The remainder of this section examines three reasons why such a belief is not warranted; each of these reasons is tied to one of the assumptions around which the purported superiority of the market-based model is based. The following section then applies this to health care.
The Pareto Principle. As noted here, if certain assumptions are met, then allowing competition to occur will result in a state of the world called Pareto optimality, where it is impossible to increase one person's welfare without lowering that of another. Rarely do economists step back and consider whether Pareto optimality is indeed a desirable state of the world. But if the Pareto principle is thought to be problematic, then market competition—which leads to Pareto optimality—would not necessarily be the best way to bring about socially desirable outcomes. Rather, other policies, involving perhaps the regulation of certain industries and even restrictions on what consumers can purchase, could be superior.
It is not hard to see the appeal of the Pareto principle. Why not let people engage in trade until they are satisfied with their lot and no longer wish to engage in further trades? Similarly, why not enact policies that convey benefits to some people and no cost to others? Wouldn't encouraging such trade and enacting such policies be in everyone's best interest?
The answer to this last question is, perhaps surprisingly, "not necessarily." As noted before, under the standard economic theory, consumers derive utility from the quantity of each of the alternative goods that they possess. It is important to think about what is not part of this conception of utility. There is no consideration given to how one's bundle of goods and services compares to, and affects or is affected by, those possessed by other people. Stated simply, only one's absolute amount of wealth matters; one's relative standing is irrelevant.
We therefore need to asks, Which conception of utility best represents people's actual behavior—one in which only absolute wealth matters, or one where relative standing is important as well? Intuition would tell us that the Pareto conception, in which only one's own possessions matter, is implausible if not downright wrong. It implies that people are indifferent to their rank or status in society. Rather, all that they care about is what they themselves have, irrespective of whether this is more or less, better or worse, than others with whom they have contact. Suppose that this is not the case, and that people do care about these issues. Then the fact that one person has increased his or her utility by obtaining more goods could in fact lower the utility of another person who does not obtain more goods.
In this regard, A. C. Pigou (1932: 90), one of the founders of modern economics, quoted and affirmed John Stuart Mill's statement, "Men do not desire to be rich, but to be richer than other men." In a lighter vein, Robert Frank (1985:5) noted that "H. L. Mencken once denned wealth as any income that is at least one hundred dollars more a year than the income of one's wife's sister's husband." Lester Thurow (1980: 18) has stated that once incomes exceed the subsistence level, "individual perceptions of the adequacy of their economic performance depend almost solely on relative as opposed to absolute position."
Is there any evidence to support the belief that people care about their relative standing in addition to their absolute level of wealth? Richard Easterlin's (1974) study of human happiness in fourteen countries is particularly relevant here. He found that in a given country at a particular time, wealthier people tend to be happier than poorer people. Within a given country over time, however, happiness levels are surprisingly constant, even in the wake of rising real incomes. Furthermore, average levels of happiness are fairly constant across countries; people in poor countries and wealthy countries claim to be about equally happy. The only way such findings can be reconciled is if both relative wealth and absolute wealth matter. Easterlin's findings contradict the notion that people care only about their own level of wealth.
Suppose that one accepts the notion that people are concerned with how they compare with others. It could still be argued that, even so, it is an irrational and/or flawed character trait that should not be respected by the analyst or policy maker. But this argument doesn't hold up for two reasons. First, the traditional economic theory does not evaluate where preferences come from or whether they are good or bad. Instead, it views them as what has to be satisfied in order for an individual, and ultimately, a society to be in a best-off position. Second, concern about one's status, rather than being irrational or even undesirable, is an essential element of human nature allowing not only individuals, but also a society, to prosper. In this regard, Tibor Scitovsky (1976:115) has written: "The desire to 'live up to the Joneses' is often criticized and its rationality called into question. This is absurd and unfortunate. Status seeking, the wish to belong, the asserting and cementing of one's membership in the group is a deep-seated and very natural drive whose origin and universality go beyond man and are explained by that most basic of drives, the desire to survive." What others have can also be viewed as necessary information for a person in formulating his or her individual desires: It shows what can be had, what is reasonable to expect.
Why is the Pareto principle so important to the belief that markets are superior? It is because markets are able to satisfy individuals only if people care about their absolute bundle of possessions rather than how they stand relative to others. Although health applications will be provided later, an example may help illustrate this. Suppose that an extremely expensive therapy is developed that can substantially reduce the chance of contracting a fatal disease, but only a few people can afford it. Under a market model, this therapy will be available only to those few. This will obviously increase their utility, but it would likely reduce the utility of a far greater group who would know that a life-saving technology was available—but not to them. Relying on markets would therefore tend to reduce overall social welfare. To improve society's overall lot, it might be better if government intervened either to ensure equal access to the technology, or perhaps even to thwart its availability.
(Continues...)
Excerpted from Healthy Markets? by Mark A. Peterson. Copyright © 1998 Duke University Press. Excerpted by permission of Duke University Press.
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