HCA 320 Module 1 assignment: applied paper: why health care is not an ordinary market, a full sample

Not an Ordinary Market: What Arrow and the RAND Experiment Teach About Health Care Economics and Policy

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Health Care Administration Program, Aspen University

HCA 320: Healthcare Policy and Economics

Instructor Name

Month Day, Year

Not an Ordinary Market: What Arrow and the RAND Experiment Teach About Health Care Economics and Policy

Health policy debates often assume that health care can be bought and sold like other goods, so that competition and prices will sort out cost and quality. Economists have long argued that medical care differs in ways that limit how well ordinary market forces work. This paper explains those differences using Kenneth Arrow's classic analysis, examines what the RAND Health Insurance Experiment showed about how people respond to prices for care, and draws implications for current policies that rely on patients sharing costs.

Arrow's Argument

In 1963, Arrow argued that the special features of medical care arise from uncertainty: people cannot predict when they will become ill, and when they do, they cannot easily judge what treatment they need or whether it will work (Arrow, 1963). Several consequences follow. The physician knows far more than the patient, so the patient must trust the physician's advice rather than compare products as a shopper would. Professional norms and licensure developed partly to support that trust, but they also restrict who can enter the market. And because illness is unpredictable and costly, people seek insurance, yet markets for insurance against every health risk may not form on their own.

Arrow's point was not that markets are useless in health care, but that the standard conditions for a competitive market, informed buyers, predictable demand, and free entry, are largely missing. A patient choosing a surgeon is not like a shopper choosing a television; the patient often cannot tell, even afterward, whether the purchase was a good one.

Insurance and the Response to Price

Insurance solves one problem and creates another. By lowering the price a patient pays at the point of care, insurance may encourage people to consume care they would skip if the whole bill were theirs, an effect economists call moral hazard. How large that effect is became the central question of the RAND Health Insurance Experiment, which randomly assigned families to insurance plans ranging from free care to plans in which families paid most costs up to a yearly cap on their spending. Its core results, published by Manning et al. (1987), showed that a catastrophic plan, in which families paid most costs until they reached a cap, reduced medical spending by 31 percent compared with free care, and put the price elasticity of demand at about negative 0.2. That means a 10 percent increase in the price patients pay reduces the care they use by about 2 percent: people do respond to price, but not strongly.

Did Using Less Care Harm Health?

The more difficult question is whether the care people gave up mattered. Brook et al. (1983) examined the health of 3,958 adults in the experiment. Patients who shared costs made about one-third fewer physician visits and were hospitalized about one-third less often than those with free care. For the average participant, the researchers detected no significant effect on eight measures of health status and health habits. But free care did improve blood pressure control among low-income participants with high blood pressure, lowering the calculated risk of early death for those at high risk, and it improved vision for those with poor vision. Cost sharing, in other words, reduced care that did not matter much for the average person along with some care that mattered a great deal for poorer patients with treatable conditions.

Prices, Not Just Quantities

If Americans used far more care than people in other countries, cost sharing might be the obvious remedy. But cross-national comparisons suggest otherwise. Comparing the 30 countries that belonged to the OECD in 2000, Anderson et al. (2003) found that the United States spent more on health care than any other country while falling below the median on most measures of service use, and concluded that the difference in spending was caused mostly by higher prices. This matters for policy: cost sharing works on the quantity of care patients choose, while much of the U.S. spending problem lies in the prices paid for each service, which patients have little power to negotiate.

Implications for Current Policy

Three implications follow for policies built on cost sharing, such as high-deductible health plans. First, because demand responds only modestly to price, large increases in cost sharing produce modest reductions in spending, and they shift costs to patients. Second, because patients cannot easily distinguish valuable care from low-value care, as Arrow predicted, cost sharing reduces both; the RAND results for low-income patients with high blood pressure show what that can cost. Third, policies that address prices directly, such as payer rate setting, reference pricing, or price transparency paired with the ability to act on it, may do more to control spending than policies that ask sick patients to shop.

A policy that exempts high-value services from cost sharing, such as blood pressure and diabetes medications, is one response that the evidence supports. It preserves the price signal for discretionary care while protecting the care whose loss the experiment showed could harm health.

Limitations of the Evidence

The RAND experiment ran in the 1970s and early 1980s, when health care cost less, managed care was rare, and many of today's drugs did not exist. Its participants excluded people aged 62 and older. The broad findings about the price response have held up in later studies, but the magnitude of effects in today's system may differ. Arrow's analysis is theoretical and does not measure how large each market problem is. Policy makers should treat both as a foundation rather than a final answer.

Conclusion

Health care departs from an ordinary market because of uncertainty, unequal information, and the need for insurance, as Arrow argued more than 60 years ago. The RAND experiment showed that people use less care when they pay more, but not much less, and that the care they give up is not always care they can afford to lose. With U.S. spending driven largely by prices, policies that focus only on patient cost sharing address the smaller part of the problem, and they should protect high-value care when they do.

References

Anderson, G. F., Reinhardt, U. E., Hussey, P. S., & Petrosyan, V. (2003). It's the prices, stupid: Why the United States is so different from other countries. Health Affairs, 22(3), 89-105. https://doi.org/10.1377/hlthaff.22.3.89

Arrow, K. J. (1963). Uncertainty and the welfare economics of medical care. American Economic Review, 53(5), 941-973.

Brook, R. H., Ware, J. E., Rogers, W. H., Keeler, E. B., Davies, A. R., Donald, C. A., Goldberg, G. A., Lohr, K. N., Masthay, P. C., & Newhouse, J. P. (1983). Does free care improve adults' health? New England Journal of Medicine, 309(23), 1426-1434. https://doi.org/10.1056/NEJM198312083092305

Manning, W. G., Newhouse, J. P., Duan, N., Keeler, E. B., Leibowitz, A., & Marquis, M. S. (1987). Health insurance and the demand for medical care: Evidence from a randomized experiment. American Economic Review, 77(3), 251-277.