Saturday, November 28, 2009

There are two college economics courses

College catalogs list many economics courses, but there are really only two: a theory course and an applied (?) course. (I’ll explain the question mark later.) The former, by which the student is introduced to economics, explains the free choices by intelligent and informed individuals (consumers or entrepreneurs) of their preferred consumption and production paths subject to the limitations set by market prices, incomes, and production possibilities. The model abstracts from uncertainty (except within well-defined limits) and the costs of information and transactions. Its simplicity is revealed by the fixed availability of well-defined goods and technology (there is no innovation) and the uniqueness of prices. There is one price per good/market, that is, no spread between what the buyer pays and the seller receives.

It is taught that these conditions produce efficient outcomes such that trade-offs between the utilities and costs of goods are equal. Selfish interests are led as if by an invisible hand to promote the general welfare. This theoretical construct defines economics, and students of its finer details, such as the existence and stability of equilibria, are the most prestigious of their profession and are rewarded by Nobel prizes.

Notwithstanding these simplifications, advocates of free markets point to their practical successes. The societies in which the behavior described above is given freest rein are the world’s richest, healthiest, and most egalitarian.

Having learned economic theory, students look forward to its application to real world problems. They look in vain, for the lessons of the first course are rejected or ignored. They find that transactions costs are large, information is lacking or perverse, uncertainty is insuperable, individual actions have external effects whose costs and benefits are not fully captured by prices, and most of all, preventing solutions to these problems, individuals are dull and passive. Students learn that these disabilities result in market failures which requiring the government’s correction.

We saw in earlier blogs how these views have resulted in financial regulations, and will come back to financial markets next time. In preparation, it will be useful to learn more about the strategies of those opposed to free markets. A good place to begin is medicine, where arguments for market failures are carried furthest. Regulated utility monopolies are justified by economies of scale (because unregulated cost minimization is presumed to be inconsistent with profits) and the regulation of financial firms is justified by externalities (a firm’s failure has wider effects) and imperfect information (leading to bank runs), but it seems that no part of economic theory is satisfied in medical markets.

The seminal article on the economics of medical care was Kenneth Arrow’s “Uncertainty and the welfare economics of medical care” (1963). He contended that the market for medical services differed from ideal markets in (1) the irregularity and unpredictability of demand, (2) supply restricted by the high cost of training and doctor licensing, (3) patient (demanders) relations with their doctors (suppliers), who have superior information and emphasize patients’ welfare relative to profits, (4) uncertainty as to the quality of the product, and (5) price discrimination (bills depend on ability to pay). Leading textbooks cite these differences as sufficient reasons for the allocation of medical services according to official cost-benefit analysis (Phelps 2003).

We have not yet determined the best system of medical care, nor will we. We can say, however, that it does not follow that because the assumptions of the ideal model are incompletely satisfied, government intervention is an improvement. Arrow also made this leap of logic in other places (1971). General equilibrium theorists have developed sufficient conditions (summarized above) for the existence of an unregulated ideal system, and then concluded that because these conditions are incomplete, regulation is necessary. But sufficiency does not imply necessity. The markets seen by Arrow might work as well, or better, if left alone than when regulated. He is a devotee of the nirvana approach that chooses between “an ideal norm and an existing ‘imperfect’ institutional arrangement,” which must therefore be rearranged (Demsetz 1969).

It is often not clear that the resulting rearrangement is an improvement, and in the case of medical care it sometimes looks quite the opposite. Many actual and proposed interventions worsen the problems seen by Arrow. Consider his primary theme of uncertainty, where Arrow neglects the most important theoretical and practical approach to its resolution, which is reputation based on experience. We know nothing about anything until we’ve tried it. Arrow’s argument is like those simple textbook introductions that consist of one-period cases with no learning, or indeed any chance of learning. George Akerlof received a Nobel Prize for his “market for lemons” paper that proved the impossibility of a used-car market. This market does exist, of course, because people invest in information. The practical point of that article, and others on insurance and other contracts affected by uncertainty, is that information has value. Arrow’s implied suggestion that people will not invest in information about the performances of doctors and hospitals, as they do in other markets, is not to be believed. Nor are the other problems raised by Arrow beyond remedies by consumers and suppliers.

In addition to discouraging investment in the reduction of uncertainty, another unfortunate effect of some health-care proposals is the rejection of information through bureaucratic cost-benefit analyses. Only patients can know the value of their medical services (as with other services, however uncertain the outcomes), which is not realized unless their choices are based on the costs they bear. The high cost (to society) of medical care is due to a related problem: subsidies that cause excess demands which are paid for by third parties (taxpayers).

Markets are never ideal, but we should ask why the advocates of change prefer further departures from free-markets to the opposite. The case that medical care is less amenable than other markets to deregulations bringing it closer to the conditions of economic theory has not been made.

Economic analysis is rejected in the market for medical care, as in other markets, in favor of politically powerful interests who hope to benefit from regulations and subsidies. They should be grateful to Arrow and other economists of the second sort.


Akerlof, George. 1970. “The market for lemons: quality uncertainty and the market mechanism," Quarterly J. Economics.

Arrow, Kenneth. 1963. “Uncertainty and the welfare economics of medical care,” American Economic Rev.

_____ and Frank Hahn. 1971. General Competitive Analysis. Holden-Day.

Demsetz, Harold. 1969. “Information and efficiency: another viewpoint,” J. Law and Economics.

Phelps, Charles. 2003. Health Economics, 3rd ed. Addison-Wesley.