Market Failure in Health Care- Concept and Issues

n theory, markets produce the goods and services we want in the right quantities and at the lowest possible cost. This is why markets are so powerful. But in the real world markets do not always work in the way theory predicts. It is possible for a free market to produce a Pareto inefficient result - i.e. the market fails.

An information system

A market is an information system. We get the right goods at the lowest possible cost because the market is able to transmit all the information about benefits and costs between producers and consumers (see page 19). If this information is less than perfect, then the market will fail.

Think about buying a CD. You know what a CD is, and you will also have a good idea of the kind of music on the disc.

So you are able to relate your benefit to the price of the CD. If we look at the market for CDs, people will go on buying CDs until the extra satisfaction from the last CD is exactly equivalent to the price of the CD. We have reached the situation where we as a society are consuming the 'right' quantity of CDs in the sense that we are gaining the maximum possible satisfaction from CDs given their price.

Why might markets fail?

But health care is rather different from CDs. We face very acute information problems which make rational purchasing decisions difficult if not impossible. For instance most people do not know the best way to treat a stomach ulcer so they would find it difficult to buy such treatment.

This analysis also assumes that the only people receiving benefit or satisfaction from the CDs are the people buying them. In other words, the price of a CD accurately conveys the level of satisfaction received. This ignores the possibility of externalities or 'spillovers'. Think about someone hearing your CD and enjoying it - they are also receiving satisfaction from the disc but the market is unable to provide any information about the benefits they are receiving unless they specifically share the cost of buying the CD. Whenever externalities occur, the market fails. Many economists believe that there are strong externality effects related to health care. For example caring for a sick person can impose financial costs on that person's family. We discuss externalities more fully in subsection vi of this Unit.

Perfect competition

An efficient free market requires producers to be operating under conditions of perfect competition. This requires a stringent set of conditions - perfect information, many buyers and sellers, a uniform product and freedom of entry and exit - which ensure that firms are price takers, producing for the lowest possible cost in the long run and only earning normal profits.

If producers do not operate in this way and, in particular, if they have a significant power to influence price or the total quantity being produced, then the market will fail. Doctors and other suppliers of health care often have this power.

If we are going to buy health care in a free market, then we have to have enough money to pay for it. But health care is expensive and we cannot predict when we are going to be ill. What makes this worse is that postponing buying health care is often risky. So we face the problems of risk and uncertainty.

The market response to this problem is to develop an insurance market to remove the uncertainty and risk from health care spending. We pay an agreed amount of money per year whether we need health care or not. But then, when we need care, the insurer pays the bills, however large they are.

So a free market in health care requires an effective health care insurance market. Unfortunately, the health care insurance market itself is often not efficient. Moral hazard and adverse selection both cause significant market failure.

Instead of directly buying health care from doctors and dentists, some people buy health care insurance from companies like British United Provident Association (BUPA) or Norwich Union.


Moral hazard

Having insurance can change the way in which we act. Imagine you are in a cinema and the film is just about to start. Then you remember that you have left your bicycle unlocked. What do you do? If you have comprehensive insurance which will compensate you against any loss you are much more likely to carry on watching the film. Your attitudes have been changed by the fact that you have got insurance - this is what economists call moral hazard. Moral hazard can affect any insurance market but is a particularly serious problem for health care insurance. Consumers who are insured have an incentive to over-consume health care - to demand operations and treatments which they would not choose if they were directly paying for them. They may also not bother to follow a healthy lifestyle or to get preventative check-ups. As a result when they do fall ill, the cost of treatment is higher than it would otherwise have been.

Doctors too are affected by moral hazard. They know that the costs of treatment are covered by insurance so the temptation is to over-treat and over-prescribe medicines for their patients. Moral hazard thus leads to an inefficiently large quantity of resources being allocated to health care.


The price of health insurance is often too high for people like this to afford.

Adverse selection

A company selling health care insurance has to estimate the level of risk accurately . This is difficult because they will not have complete information on the risk status of the person they are insuring. One solution is to set the premium at an average risk level. But this makes the policy expensive for low risk customers who therefore may choose not to buy the insurance. This process whereby the best risks select themselves out of the insured group is called adverse selection.

Insurance companies know that this is likely to happen so they offer different premiums according to the level of risk and the person's experience of ill health. This is why most companies will offer non-smokers a lower premium than smokers. Offering low insurance premiums to low risk groups, often called 'cream skimming' or 'cherry picking', means high premiums have to be charged to high risk groups such as the elderly or chronically sick.

So in a free market, health care insurance is likely to be too expensive for many people, and especially for those most in need of health care.

Continued from previous

Moral hazard and adverse selection help to explain why a free market in health insurance is unlikely to be efficient. However, health care markets face even more fundamental information problems. We are now going to examine the problems caused by unequal information and the consequent role of doctors as agents for patients.

Doctors use an electrocardiogram (ecg) to monitor a person's heart.

Monitoring the heart

"The pains in my chest intensified. I tried to remember if I was wearing sensible or frivolous underwear. I knew that within a few minutes all would be revealed. My doctor arrived looking unfamiliar in his Sunday morning clothes, and took me into a side room where he hooked me up to an electrocardiograph machine. There was trouble at t'mill. A lockout. The blood couldn't easily get into the heart. There was an obstruction of some kind. I was wheeled into Intensive Care, more of my frivolous underwear was revealed, I began to feel peculiar and for a split second I thought I was going to die.......So this is what it is like to have a heart attack, I thought. No clasping of the throat and dramatic staggering around before falling on the floor, more a sliding into helplessness and then a murky, confused leaving behind of your body"


Sue Townsend's description of how she felt as she had a heart attack emphasises the fact that we are often not in the position to make rational purchasing decisions about health care.


Patients are dependent upon doctors for the information they need to make their buying decision.

Rational choices

When you go into a shop to buy a CD you have enough information to make a rational choice: you do not need the shop assistant to tell you what you should buy. Going to the doctor is very different. You know that you perhaps do not feel well and that you have particular symptoms, but most people are not able to diagnose their complaint: they want the doctor to do that. What is more, you then rely upon the doctor to specify the treatment - if the doctor says you need an expensive operation then you buy it.

In the health care market information is not equally shared between buyers and seller, instead the seller, the doctor, has far more information than the buyer, the patient. This asymmetry of information undermines the separation of buyers and sellers.

This situation is not unique to health care but there are a number of factors which make this information asymmetry particularly acute there.

Information problems

Most medical information is technically complex and so not easily understood by a layman and this is made worse by the fact that many illnesses do not repeat themselves, so that the cost of gaining the information is very high. You could argue that the only way a patient could become fully informed would be by training to be a doctor!

The costs of a mistaken choice are much greater and less reversible than in other cases: in the worst situation if you make the wrong decision you will be dead. It is also often difficult to postpone treatment and so virtually impossible to shop around, and anyway how do you judge between different doctors' opinions?


The dependence of patients upon their doctors is increased by the fact that most people are anxious about being ill.


Doctors as agents

The asymmetry of information makes the relationship between patients and doctors rather different from the usual relationship between buyers and sellers. We rely upon our doctor to act in our best interests, to act as our agent. This means we are expecting our doctor to divide herself in half - on the one hand to act in our interests as the buyer of health care for us but on the other to act in her own interests as the seller of health care.

In a free market situation where the doctor is primarily motivated by the profit motive, the possibility exists for doctors to exploit patients by advising more treatment to be purchased than is necessary - supplier induced demand. Traditionally, doctors' behaviour has been controlled by a professional code and a system of licensure. In other words people can only work as doctors provided they are licensed and this in turn depends upon their acceptance of a code which makes the obligations of being an agent explicit or as Kenneth Arrow put it "The control that is exercised ordinarily by informed buyers is replaced by internalised values"

Supplier induced demand

So if doctors behaved like some financial advisers or computer salesmen in the past and maximised profits without any limit from a professional code, we would expect supplier induced demand to be a very major problem. But any system of licensure strong enough to provide the internalised values that Arrow talks about is also likely to give the medical profession power to limit the number of doctors operating. Thus licensure and a professional code are in themselves also a source of market failure

Continued......

Continued from previous

Imperfect Competition

The free market model envisages large numbers of buyers and sellers - all of whom have no power individually to influence the market price. However, a significant proportion of health care is delivered by hospitals and these hospitals can often exercise monopoly power within the health care market in the local area.



Monopolies

Why should hospitals be able to act like monopolies? The answer is that hospitals have an incentive to grow in size and in the range of service provided. This leads to the emergence of one large hospital in an area rather than a large number of small hospitals. The incentive to grow is falling unit costs - what economists call internal economies of scale and economies of scope.


Internal economies of scale have led to the emergence of large hospitals which often are the only hospital in the area.


Economies of scale

Why should the average cost of providing treatment fall as a hospital becomes larger? There are a number of reasons.

1. A large institution is able to make more use of specialisation. This can involve both people and capital. A large hospital is able to develop specialist medical units employing both highly skilled surgeons and specialist capital equipment. Such a hospital is also able to employ specialised managers and ancillary staff which will allow it to operate more efficiently.

2. A large institution is able to achieve purchasing economies of scale through bulk buying.

3. A large hospital prevents wasteful duplication of facilities. There will only be a limited number of patients with a particular condition needing particular skills and equipment in any one area. Concentrating the treatment in one place allows the most efficient use of resources.

Economies of scope

In many cases it costs less to provide a range of services in a single hospital than to have several hospitals each just producing one or two services. For example, emergency surgery and treatment of heart attacks are more cost effectively provided in a single hospital rather than two separate ones.

Price maker

In this situation, the hospital as supplier of health care services has considerable power to bargain over price. Instead of being a price taker it is a price maker. In this situation a free market does not lead automatically to a Pareto efficient outcome. In particular, if the hospital is profit maximising then it will set price above marginal costs giving an allocatively inefficient outcome. Also it is likely that the hospital will be productively inefficient, since it lacks the incentive to reduce costs which would be provided by competition.

Externalities or spillover effects provide another source of market failure. Again the problem is related to information. This time the market price does not accurately contain all the information about the benefits and costs of the market transaction. Earlier we outlined how this might occur when a consumer bought a CD. Now we are interested in how this might operate in a health care market.

Vaccinations

Suppose vaccination against infectious diseases were bought and sold through a free market.

You are thinking about the benefits to you of not catching whooping cough - the price you are prepared to pay for vaccination will depend on your personal, private valuation of the benefits you receive. Going from a single consumer to the market, we can analyse the interaction of supply and demand for vaccinations using a diagram.



In Figure shown above, DD shows the market demand for vaccinations. The amount of vaccination that private individuals will be prepared to buy at each price will depend upon their estimate of their personal benefit from being protected against whooping cough. In formal terms this means that DD represents the marginal private benefit (MPB) that consumers receive. The market supply of vaccinations is shown by SS. The free market equilibrium is at price P' giving Q' vaccinations.

However, when you are vaccinated against whooping cough you are not the only person to benefit. Other people also gain because they are now protected against catching whooping cough from you. This extra or externality benefit is missed by the free market. We can show the effect of this on the diagram. MSB represents the marginal social benefit from vaccination, that is all the benefits received by society. MSB is made up of all the private benefits consumers receive (MPB) plus the additional externality benefits. The Pareto efficient equilibrium is E" which corresponds to Q'' vaccinations. A free market will thus under-provide vaccinations and this in turn will impose a cost upon society. This societal cost is shown in the diagram by the shaded area E'FE" which equals the excess of MSB over the cost of producing the further Q" – Q' vaccinations.


People are prepared to make charitable donations to fund medical care for others because they gain utility from helping others.

"Selfish" versus "caring" externalities

Some economists refer to this type of externality as a 'selfish' externality to distinguish it from a 'caring' externality. A 'caring' externality occurs when individuals receive benefit from knowing that other people are receiving medical treatment. Knowing that someone is in pain simply because they cannot afford medical treatment makes many people upset. In other words, the poor sick person's pain and lack of treatment causes disutility for other people in society.

This helps to explain also why some people are prepared to pay higher taxes to fund health care for all. Again a market demand curve reflecting each individual's wish to buy care for themselves is unable to express this willingness to pay for external benefits. So a free market will further under-provide health care.[img]