DRAFT: This module has unpublished changes.

Darius Muniz

Professor Chibber

American Capitalism

March 6, 2011

                                              Health Care: A case of market failure

            The current structure of the health care system negatively affects a large majority of the people in the United States. As health care remains a for-profit industry with steadily increasing costs and reduced quality, the resulting outcome is an unavoidable path encompassing inequality, allusiveness for many, and inefficiency described in economics as market failure. Since in the United States health care can be bought and sold as a commodity, is run by private corporations, and is increasingly structured by profit seeking insurance companies reliant on the risk model in determining who gets coverage, the end result is that a large portion of the population goes without access to basic health services that are necessities for a healthier, and prolonged life.

            Health care is something which touches all of our lives. Everybody at some point needs to visit the doctor or dentist and many of us have been treated in hospitals. Yet health care seems to be in almost permanent crisis often times restricted in its ability to provide universal, comprehensive coverage to all that need it. Resources are increasingly allocated in response to profit opportunities rather than medical need, unnecessary medical care is provided for profit and administrative expenses are high resulting in escalating costs. The bottom line is health care as a necessity of life for every living person, should not be run as a market to be bought and sold by private corporations and insurance companies whose profit maximizing strategies ultimately lead to human suffering.

            The free market by design and principal will harm people’s health and affect the quality and reliability of our health care system. The corporate obligation to increase profits and ensure a return to shareholders unavoidably affects public health. The private insurance system's main techniques of holding down costs through practicing risk selection, limiting the services covered for patients, constraining payments to providers, and shifting costs to patients, will limit the quality and accessibility of important, potentially lifesaving health care . Such mechanisms of capitalist market run institutions pose formidable challenges to social justice and public health. The recognition of the public health risks created by corporation controlled markets should have important implications for public policy dictating that reforms are required to limit the power of corporations.

            For economists the market is described as any process of exchange between buyers and sellers. More specifically, a market can be defined as any set of arrangements which allows buyers and sellers to communicate and arrange the exchange of goods, services or resources. Classical liberals believe a free market is where such exchange should occur without interference from the government. Information is a vital ingredient for any market where both buyers and sellers need to have access to sufficient information to allow them to make rational decisions.

            A market for health care must involve two groups: the buyers and the sellers, who interact to trade health care. We all want good health and so most of us would be prepared, if necessary, to purchase medical treatment to cure an illness. This suggests that everybody is potentially a buyer or consumer of health care. A buyer would be anybody who was ill or who wanted preventative medical treatment such as a vaccination or who wanted guidance about their health. The sellers would be those people who could provide medical and health care services. It is said by classical liberals that a free market will automatically produce an equilibrium price and quantity. This is what Adam Smith, the founding father of economics, referred to as the "invisible hand".

            According to Freidman (1979) in a free market, consumers would decide how much health care is to be produced. They go out and buy treatments and services and the price they are prepared to pay sends signals to the health care providers. These providers respond by producing either more or less treatment. The market not only allocates resources automatically, it does so efficiently. Providing certain conditions are met, the free market will achieve an efficient allocation of resources through the price mechanism. One thing the market is supposed to do very well is act as a powerful and efficient information system. Changes in consumers' tastes are quickly communicated to producers through market prices.

            Friedman (1979) suggests, for the producer or seller of health care, the price they are willing to accept measures the cost of the resources involved in the production including the supplier's own time and effort. This fulfills the condition for allocative efficiency. Competing producers chasing maximum profits will always choose the least cost combination of factors to produce a given output. Consequently, the free market will also be productively efficient. The search for profits drives producers to offer new products or services and to make them in more cost effective ways.

             If the market were free and competitive, then different health care providers would offer different qualities of service, and some would be more sought after than others. The health care provider offering the services consumers want would have lots of customers and would be able to charge higher prices than their competitors. This would force the other health care providers to modify the services they are selling to try to capture back the consumers. This process of competition would be continuous, particularly as other factors influencing supply and demand, such as levels of income or the state of technology, are also likely to change. This example is what classical liberals would suggest is the reason why free markets are the perfect mechanism for health care to be operated in.

            In theory, according to Friedman (1979), markets produce the goods and services we want in the right quantities and at the lowest possible cost. This is suggested by classical liberals as the reason why markets are so powerful. But in the real world, as suggested by Tilly (1989), markets do not always work in the way theory predicts. It is often demonstrated that it is possible for a free market to produce inefficient results that are deemed as market failures. According to Friedman (1979), the 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. If this information is less than perfect, then the market will fail. In health care we face very complex information problems which make rational purchasing decisions difficult if not impossible. Most people do not know the best way to treat a stomach ulcer so they would find it difficult to buy such treatment.

            According to Friedman (1979), an efficient free market requires that producers operate under conditions of perfect competition. This requires a set of conditions set forth by Adam Smith’s “invisible hand” theory which includes, perfect information, many buyers and sellers, producing for the lowest possible cost and only earning normal profits. According to Tilly (1989), 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 giving rise to the problems of risk and uncertainty.

            The U.S. 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. When we do need care, the insurer then pays the bills, however large they are. So a free market in health care requires an effective health care insurance market. Unfortunately, according to Sered and Fernandopulle, the health care insurance market itself is often not efficient. Moral hazard and adverse selection Practices both cause significant market failure. Instead of directly buying health care from doctors and dentists, people often buy health care insurance from insurance companies.

            Doctors 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. Patients are dependent on doctors for the information they need to make their buying decisions and the fact that they are often not in the position to make rational purchasing decisions about health care, often times put doctors in an unequal power position to exploit the patient. As an example set forth by Kuttner in “the limit of markets”, in the health care market information is not equally shared between buyers and sellers, instead the doctor has far more information than the patient.




            Most medical information is technically complex and so is not easily understood by the average person. The costs of a mistaken choice are much greater and less reversible than in other cases. For instance, in the worst situation if you make the wrong decision that decision could lead to death. It is also often difficult to postpone treatment and so virtually impossible to shop around. The dependence of patients upon their doctors is increased by the fact that most people are anxious about being ill; this 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 and to act as our agent. Which means we are expecting our doctor to divide themselves in half, on the one hand to act in our interests as the buyer of health care for us and on the other hand to act in their own interests as the seller of health care.

            As Kuttner suggests in “The limits of markets”, 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 causing supplier induced demand. Traditionally a doctors' behavior 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. Kuttner would state that licensure and a professional code are in themselves also a source of market failure.

            Suggested by Friedman (1979), the free market model envisions large numbers of buyers and sellers, all of whom have no power individually to influence the market price. Tilly (1989), however, would point out that a significant proportion of health care is delivered by hospitals and these hospitals can often exercise monopoly power within the health care market. Hospitals have an incentive to grow in size and in the range of services provided. This leads to the emergence of one large hospital in an area rather than a large number of small hospitals. Friedman (1979), would point out that the average cost of providing treatment should fall as a hospital becomes larger. According to his theory for a free market, there are a number of reasons for this. A large institution is able to make more use of specialization. This can involve both people and capital. A large hospital is able to develop specialized medical units employing both highly skilled surgeons and special equipment. Such a hospital is also able to employ specialized managers and additional staff which will allow it to operate more efficiently. A large institution is able to achieve purchasing economies of scale through bulk buying. 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.

            An alternate view on this situation, as Kuttner in “the limits of markets” would suggest, the hospital as supplier of health care services has considerable power to bargain over price, which instead of it being a price taker it is transformed into a price maker. In this situation a free market does not lead automatically to an efficient outcome. In particular, if the hospital is profit maximizing then it will set prices above marginal costs giving, as Kuttner would state, an allocatively inefficient outcome, and also likely make the hospital productively inefficient, since it lacks the incentive to reduce costs which would be provided by competition.

            Kuttner states in “the limits of markets”, that externalities 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. For instance, as a negative externality, the extra cost to the patients’ family comes into play as additional costs that spill over from the patient’s medical bills. A positive 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 in the U.S. very upset. In other words, the poor sick person's pain and lack of treatment causes emotional discomfort 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 like the health care system employed in Canada as stated by Armstrong, Armstrong, and Fegan in “Universal Health Care: why the United States can learn from the Canadian experience”.

            Efficiency is not everything. Since we are morally concerned with what is fair, and we have a market distribution of health care, then only those who could afford to pay are most times able to purchase it. Most people regard that as unacceptable. This is a major reason why most societies regard health care as different from other commodities. According to Armstrong, Armstrong, and Fegan, the introduction of public health insurance in Canada in 1971 "was explicitly stated to be motivated by a concern to make health care utilization less dependent upon income". As an example of market assumptions and realities, Tilly (1989) would point out that here in the U.S., which has the most market oriented health care system in the developed world, the state intervened to provide Medicare and Medicaid to help the poor afford health care. For health care the question is not a simple choice between a pure free market and a pure command system, it is a mixture of the two that has allowed our current health care system to continue to exist the way it is.

            Everybody agrees that health care markets fail to some degree and that this contributes to the USA's unflattering position in international comparisons of health-care efficiency. Pharmaceutical and insurance corporations use strategies such as making biased inferences, influencing scientists and physicians, marketing rather than informing the public, and lobbying to control their own industry regulations to create market advantage. Successful marketing leads to the increased use of costly profit-making drugs and procedures over cheaper, non-patented therapies. Because resources are limited, the overuse of costly modalities contributes to expensive health care, which presents a challenge to universal coverage in the U.S.

             But does this automatically mean society is better off with some sort of command allocation system where the State makes all the decisions? Government intervention also imposes costs and creates inefficiencies. For instance, management structures are often bureaucratic and inflexible, leading to outcomes which do not reflect consumer demand and which are wasteful. Regardless of this fact, the current state of our health care system has proven to be a great travesty on the American public. As health care establishments put profit maximizing in front of the health care needs of millions of Americans, inequality, inefficiency, and rising costs constantly put millions of people at risk.

            The beloved free market system of the classical liberals has shown itself to be outside the model of an efficiently market like entity when it comes to health care. The idea that health services should be bought and sold and that private health providers and insurance companies will operate above moral hazards has proven itself to be untrue. The very fact that a capitalist free market rewards an entity if it maximizes profits and limits costs, will always lead to unmoral decisions that are beneficial for the company, yet detrimental to the American public. Also, previously demonstrated by numerous examples of market failure, and contradicted by Canada’s single payer, universal and comprehensive version of a health care system, it is overwhelmingly apparent that the health care system of the United States is crucially in need of reform from a capitalist free market system to a more Canadian like universal system.

DRAFT: This module has unpublished changes.