An Interview With Kenneth Arrow, Part Two

[UPDATE: part three is here.]

Part one is here. There is one more part to come, which I'll post tomorrow. Part two, which is pasted below, is mostly about health economics. Arrow wrote the definite modern health economics paper -- "Uncertainty and the Welfare Economics of Medical Care"; I believe the PDF is here -- which is required reading for every student of the subject. My questions are in bold.

Conor Clarke: I wanted to ask about health care. As I'm sure you know that the House and Senate are...

Kenneth Arrow: It keeps on changing! I never quite learn all the provisions. But I do follow it, more or less.

Well, that's OK. I'm more interested in the famous paper you wrote in 1963 on the economics of medical care -- the paper that identified a lot of the big problems that afflict the market for health care.

Yes. In all modesty, I do think that paper changed a lot of people's opinions

Well, tell me about the origin of the paper. And do you think it's relevant to the current situation? How much of it is still an accurate representation of the problems the health market faces?

I think the fundamental questions are the same. I also think there are more problems in the market today than when I wrote the paper. But I think the basic analysis hasn't changed. There are wars over the details but the basic analysis is accepted.

Some specifics have changed. If you look closely at my argument there is a sociological structure. There is a kind of sociological thesis. The market won't work -- it doesn't work well in the health context. But something else supplements the market, and the thing I put stress on in the paper are the elements that put a non-economic influence on the market: professional commitments to provide a service, to engage in services that aren't self-serving. Standards of caring decided by non-economic actors. And one problem we have now is an erosion of professional standards. In a way there is more emphasis on markets and self-aggrandizement in the context of healthcare, and that has led to some of the problems we have today.

But the basic problems are outlined in the paper. The common theme is that some people in the health market know more then others.

Information asymmetry.

Yes, that's the key. I started working on this thing when I was commissioned by the Ford Foundation, which had an idea to do economic analyses of policy problems. It was health, education and welfare, really -- welfare in the sense of programs designed to help poor people. And somebody had the idea -- Victor Fuchs, who is a colleague of mine -- to get economic theorists to work on these policy problems.

And in the case of health care that was you?

Yeah, he called me up and wanted know if I'd do it. And I wanted a challenge. Some of my best work has been from someone asking me to work on a problem I've never thought about before! Being a theorist, people think you might be useful in a practical area. So I did the background readings caught up on the health materials.

One point was that health is a random event. It's not like buying automobiles. Whether you're sick or not is hard to predict. Some get sick and some don't. That uncertainty makes it an ideal scenario for insurance. Some houses burn and some don't, but you know whose. So you have fire insurance. (And by the way, financial problems have the same characteristics, and I was always interested in the subject -- the uncertainty.) But the question that I started with was why health insurance coverage was limited. There was virtually no insurance outside of hospitalization, which was limited and heavily taxed. When I heard about this myself, it was just as a consumer. My first health-care plan as a professor had a $15,000 ceiling. A ceiling? I was thinking that should be a floor! $15,000 I can handle, but above that... it would be a problem.

Anyway, that was the nature of insurance. It was a cautious time for insurance, and the question was why. And then it occurred to me that the insurance company couldn't be sure about what it was getting involved with. It's not like a fire when you know the problems: Did you set it? How did it happen? It's all pretty definite. But in the case of health care there are three players: the insurance company with the health plan, the physician, and the patient. The physician presumably has a better knowledge of what the patient needs -- at least better than the insurance company does. So the insurance company could never put together a bill. There is also a Physician and patient relationship, but the physician knows more than the patient.

There are information asymmetries in this story. Health insurance is limping along. It's limited in scope, and then you other consequences. Insurance companies have high premiums to protect themselves. The ones who come to the insurance company are sicker and the people have to pay more. You have adverse selection. You have moral hazard. And the doctor does what's on the safe side -- defensive medicine -- without regard to cost. These are fundamental conditions that make health insurance difficult. You have some things that help. Some doctors understand that they shouldn't abuse the system. But you still see problems in the way doctors behave towards patients. They goof off. Sometimes it's too much work. Some things are difficult and risky to diagnose.

You described the origins of the paper as a situation in which you were asked to bring theoretical insights to an empirical situation. So how well does the empirical situation of 45 years ago -- issues like adverse selection and so forth -- line up with the empirical situation today? I take that you say that it lines up pretty well?

It lines up well. And again, the medical profession develops standards to compensate for those market failures. They don't overdo diagnosis. They tell the insurance company what's really going on. The trouble is that those standards can erode over time. There have been strong professional signals for a long time: say, that hospitals are predominately non-profit and don't advertise. But these things have been eroded a lot. The number of for-profit enterprises in the medical profession is much higher today than it was when I wrote the paper.

Do you think this is one reason why the cost is higher today? One issue that's come up recently is why medical costs vary so much around the country. I can't cite the Medicare statistic off the top of my head, but it's something like, you have areas in the country that spend two or three times the national average per capita Medicare spending. Why do you think that is?

Well I don't think this is limited to Medicare, but those statistics sound right. It's easy to study, and it's true even in the working age population. The Dartmouth group has done a lot on this. You could look at two places like New Hampshire and Vermont. Vermont has twice the per capita health spending of New Hampshire. And there's no evidence that the health care provided is any better in Vermont.

And if one explanation is the professional standards, why do you think the professional standards have changed?

Sometimes I think it's because of the Chicago School. I think there has been a general drift around the country towards the idea that greed is good. Look at Wall Street. All of these industries involve a professional element in which information is flowing. You're supposed to be constrained to be honest about it. I don't really know why. But there is now more of an emphasis on popularization, which does improve efficiency but can also lead to an erosion of professional standards. There was this idea that professional standards were a mask for monopoly power--a Chicago theory, which I believe came from George Stigler. I don't know if they were that influential, but they seemed to be saying a lot of things that people were taking up in practice. I'm not totally sure why these professional standards changed, but it's more than medical reasons.

As far as cost goes, could technology be the case? As society gets wealthier it might be rational to spend relatively more money on health as opposed to other consumption demands.

Oh, why health costs increase? The basic reason why health costs increased is that health care is a good thing! Because today there is a lot more you can do! Consider all these expenses that are diagnostic. Cat scans, X-rays, MRIs and now the proton-powered whatever-it-is. Something that is the size of a football field, cost $50 million, and has all sorts of diagnostic powers. A lot of these technologies clearly reveal things that would not be revealed otherwise. There's no question about it. Diagnostics have improved. Technology has improved. You know, sending things through your blood stream to help in operations, instead of cutting you open. It's incredible. But these things are costly. But for older people longevity is increasing by a month each year. Now, whether that creates other problems with retirement and social security is another question. But, nevertheless, preserving life is a good thing.