Economics of healthcare


I recently read Case’s and Deaton’s Deaths of Despair, a book about how America’s working class (more specifically: white, non-college-educated, middle age people) are suffering an increase burden of “deaths of despair” like alcoholism and drug overdose.

The authors cite a 1963 article, Kenneth Arrow’s “Uncertainty and the Welfare Economics of Health Care”, as mathematical proof that a free market cannot deliver “socially acceptable” healthcare. I found these claims very interesting, especially because I knew of Arrow from his impossibility theorem which says that there’s essentially no perfect (ranked) voting system. (I don’t pretend to understand it all, but I found it comforting, in a sense, that there’s no perfect way to do voting.)

Arrow’s article on healthcare focuses on how healthcare is different from other goods traded in a marketplace, and why a true free market for healthcare will never work in a way that we think is reasonable.

Why do we care about free markets?

Free markets are Pareto optimal. A state of affairs (e.g., a distribution of resources that arises from a choice of economic system, such as a free market) is Pareto optimal if there is no change in the state of affairs that would make anyone worse off. Arrow points out that this is a kind of optimality, but it’s not necessary the best kind of optimality. We might be very happy to make a few people a little less happy if it makes many people much more happy.

Free markets are also appealing because they separate allocation and distribution. In Arrows’ terminology, “allocation” is what the market system does: based on demand, it sets prices and optimizes supply. “Distribution” is what social policy does: it taxes and gives subsidies to ensure that purchasing power is distributed in a fair way. In a market that meets the technical definition of “free”, a government can confine itself to ensure that purchasing power is fairly distributed and leave the market to itself.

Is healtcare in America not a free market?

This is the curious part: American healthcare is not fully free, nor does it seem “unfree” enough to get the full benefits of being unfree. Case and Deaton hit this point squarely:

[Americans] like to believe that the [healthcare] system is a free-market one, in spite of the fact that the government is paying half of the costs, is paying the prices demanded by pharmaceutical companies without negotiation […], is granting patents for devices and drugs, is permitting professional associations to restrict supply, and is subsidizing employer-provided healthcare through the tax system.

That list is bewildering, so I think it’s worth some recapitulation and explanation (which you can find elsewhere in Case’s and Deaton’s book):

  • Federal and state governments pay about half of healthcare costs in America, largely through Medicare and Medicaid. The government isn’t “interfering” in a free market; it is the key player in that market.
  • The 2003 law that established Medicare Part D (which pays for prescription drugs) had a “noninterference” clause that prevented Medicare from negotiating on drug prices with pharmaceutical companies. There’s no way one could call this a “free” market.
  • The Federal Patent Office issues patents, which essentially prevent companies from making profits off of another company’s innovations for some time, and the FDA creates periods of exclusivity during which a drug too similar to an existing, approved drug will not be approved. Patents and exclusivity certainly help innovation, but they aren’t part of a truly “free” market, and they are examples of government “interference” in a market that is generally welcomed.
  • Federal and state governments essentially allow the medical profession (i.e., associations of physicians) to control medical education, licensure, and certification. In other words, the government allows doctors to decide how many doctors there are. It would be like the government allowing US car manufacturers to collude in deciding how many cars to sell each year (thus increasing the price) and preventing foreign cars from being imported.
  • Employer-provided healthcare is tax free. If your employer increases your compensation by \$1 in wages, then you and your employer may tax on that dollar, approaching half of it. If your employer gives you that \$1 as healthcare coverage, then neither you nor your employer pays tax. This is an enormous tax break for healthcare: we don’t get, say, office furniture tax-free.

Healthcare can’t be a free market anyway

Arrow, writing some 60 years ago, did not have his eyes on the healthcare system we have today, but he still saw how Americans’ overall approach to healthcare, which hasn’t changed fundamentally in that time, could never be a “free” market in the technical, economics-jargon sense.


An important feature of a free market is that things that are valuable are bought and sold. This is not the case in health. Arrows gives the example of communicable diseases, which feels very pertinent during Covid. In a free market, if someone is not vaccinated (or doesn’t wear a mask) and presents risks to those around them, they would need to pay others for the privilege of putting them at risk (or the others would pay the risky individual to get vaccinated). This is clearly not how we think about healthcare.

Another critical thing that would be marketable in a free, competitive market, the kind that can qualify for optimality as described above is risk-bearing. Ideally, you could get free-market insurance against the costs of illness. However, no plausible healthcare insurance policy could distinguish between unavoidable and avoidable risks, which creates moral hazards, i.e., the temptation for covered individuals to take less care of their health because they know someone else will bear the financial cost. We feel more confident in something like car insurance that we can assign blame because car insurance doesn’t cover the unavoidable wear and tear on your car, while health insurance does.


The trouble with insurance and risk-bearing is principally about information. If we knew what was wrong with us and why (and what will become wrong with us), then the situation would look very different. But as it is, the purchased good in healthcare is, to a large degree, information, such as a doctor’s diagnosis or recommendation about what action to take. It’s very hard to know how much to pay for information. In other words, it’s hard to know how much what you will learn from a doctor is worth. If you knew that going to a doctor would provide information that would relieve your pain, then you could put a price on that, since you know your pain. But if you don’t know if you will get relief, or even the probability that you will get information that will give you relief, how can there be a sensible market?

One of the reasons this problem with information arises is because, unlike other goods, we cannot test healthcare many times to determine our preferences. I buy groceries many times, and I can compare different foods side by side, and so I can get a sense of what I like and don’t. But if I’m sick and need some operation or treatment, I can’t run many tests, or try a little bit of two kinds of healthcare and decide which one would suit me better for that situation. For this reason, we demand an element of trust in our relationships with physicians: they should be recommending what is best for us in a way that we don’t expect a car sales person to do. Or, stated the other way, we find it clearly immoral for a doctor to try to upsell up or whatever in the way we expect that a car sales person might.

Range of goods offered

When I buy something off of Amazon, there is a wide range of products I can get, from cheap and low-quality to expensive and high-quality. For products like food, there is a greater guarantee of quality: I can feel confident that most food I can legally buy is not going to make me sick. This creates some market restriction: I, as an enlightened consumer, simply cannot buy food below a certain quality, even if I would rather pay less money in exchange for an increased chance of disease.

Healthcare is even more restricted: medical associations control the content of medical education and the processes of licensure and certification, which produces a floor on the type of care you can get. This isn’t necessarily a bad thing —I’m not saying I want a pre-Flexner Report world where anybody can hang a shingle and say they’re a doctor— but it does show that healthcare isn’t a free market. Indeed, we don’t want it to be a free market, precisely because we’d rather have all our physicians meet a certain standard of training. (We have gotten clever in more recent years about how to redistribute the workload of care between physicians, nurses, physician assistants, and so forth, but it’s important to remember that all these other people practice under a physician. The only potentially interesting example are chiropracters, or maybe physical therapists, although even they have their own methods of certification.)

What this means for healthcare policy

Even in Arrow’s day, there was concern about growing healthcare costs:

Insruance removes the incentive on the part of individuals, patients, and physicians to shop around for better prices for hospitalization and surgical care. The market forces, therefore, tend to be replaced by direct institutional control.

In other words, health insurance (in the sense of protection against costs, not a guarantee of care) improves social welfare, but we can’t expect insurance to function well enough on its own, in a free market.

Arrow also notes that there are apparently “enormous economies of scale in the provision of insurance”, based on data about how much insurance companies have to spend to administer individual versus group healthcare plans. In other words, the simple administrative costs of selling an insurance policy are so much higher when selling to an individual compared to selling to a group. Arrow notes that this makes “a very strong argument for widespread plans, including, in particular, compulsory ones.”