Reflections on Kenneth Arrow and health economics

Kenneth Arrow’s 1963 paper Uncertainty and the welfare economics of medical care created health economics as a coherent field.  It argued that markets do not work well in medical services.

Medical services demand is unpredictable.  People look through a veil of ignorance about future health risks.  Adverse selection and moral hazard mean risk-bearing devices such as insurance do not allocate resources efficiently.  Medical service prices may be unrelated to value.  Revealed preference may be revealed ignorance.

To counter such problems, medical services are heavily regulated and publicly funded.   High professional expectations and the trust they give rise to reduce the risk of doctors exploiting information asymmetry between themselves and patients.

Medical qualifications confer property rights on practitioners.  These property rights also create duties to patients.  When there are more qualified candidates than places, medical school entry can favour those best able to overcome cultural barriers that impede information flows and healthcare access.

In his 1963 paper, Arrow was aware of but did not address wider sociological health drivers.  Health is an indivisible social phenomenon: no-one is an island.  Diseases can be contagious.  Low socio-economic status within rank-based hierarchies can create stresses that erode immune systems.

Antibiotic drug resistance is an unintended negative externality arising from doctors doing the “right thing” for an individual patient without recognising the cumulative impacts of many other doctors also doing “the right thing”.

Medical systems should therefore be managed within a social cost benefit framework that takes account of all private and social costs and benefits, whether or not they are revealed through market trades.

The opioid epidemic reflects US health care system weaknesses. The US lacks comprehensive and affordable medical care coverage.  Drug companies overly influence the FDA regulatory system.  Without social cost benefit analysis that measures all relevant variables it appears “cheaper” to give patients a prescription than to support wider approaches to pain management such as physio and cognitive therapy.

Kenneth Arrow preferred the contemplative to the activist life. He liked the freedom to see the world from others’ perspectives, the weaknesses in one’s own arguments, the ironies, and the freedom to unlearn as well as learn anew.  His 1963 paper was mainly concerned with information (knowledge) asymmetry. He might also have noted that a fundamental health sector problem is the difficulty specialists have in “unlearning” what is untrue.

In 1847 Ignaz Semmelweis discovered that many women who had given birth died from infections caused by doctors with poor hygiene practices.  His reward was ostracism, and death in a lunatic asylum.

Barry Marshall in the 1980s inferred that bacteria rather than stress or spicy foods caused stomach ulcers. The medical establishment initially rejected his insights, until a 2005 Nobel Prize vindicated him.  Marshall’s work advanced understanding of links between the Helicobacter pylori bacterium and stomach cancer.

Today’s challenges include the incentives governing how new knowledge is created and turned into technology.

Alexander Fleming and Graham Liggins captured little private benefit from their great medical advances.  However, much innovation requires the incentive of intellectual property (IP) rights granted in exchange for public access to knowledge.

Excessively long-term rights can lead to monopolistic rents (supernormal profits).  Single “buyer” agencies such as Pharmac can countervail monopolistic power.  Contestable market theory suggests that the simple threat of competitive entry can erode rents and expand access to medical technology.  For example, the Four Thieves Vinegar Collective publishes instructions for making low cost versions of drugs and devices without itself actively making and marketing them.

However, there are deeper problems to address than countervailing market power.  The potential for IP rights can distort research targets and therefore inventive activity towards what might deliver a profitable proprietary drug rather than what can deliver the best health outcomes.

For example, billions are spent trying to develop drugs to counter amyloid plaque build-ups in the brain associated with Alzheimer’s.  An effective drug would be a mass market blockbuster since patients have years to live and generate profits.  This prize may be channelling Alzheimer’s research into narrow scientific pathways based on what may deliver a proprietary drug rather than what may lead to the most effective treatment.  This may be at the expense of, for example, non-appropriable stem cell research.

Neuroplasticity treatment of some cognitive conditions may come from free on-line resources and cultural products more so than from drug advances.  Some immunological, vaccine-based and combinational off-patent drug therapies may be unattractive to the pharmaceutical industry but effective in improving health.  For example, cervical cancer can be prevented through low cost vaccinations.

The basic science community’s self-referenced nature creates different problems for  research pathways and methods.  It shapes research to fit its methods and win peer respect rather than to create technology.  Scientists become accountable to each other more so than to patients.

Both research directed at creating proprietary rights, and undirected self-referenced basic research may be misallocating human capital and financial resources on a massive scale.

Medical research should create technology that works, regardless of the property rights potential.  Technology connects science to the real world.  It creates demand for and gives targeted direction to basic research.  Pragmatic trials on how treatments can be brought into clinical practice need to complement randomised control trials.

It is plausible that medical research priorities should initially exclude cost benefit considerations when research targets are first defined.  This ensures the most effective research routes are followed.  The cost effectiveness of any resulting treatments may be inescapably prohibitive.  However it is more likely that cost benefit will be mainly dependent on how society chooses to define property rights over knowledge.

Since 1963, behavioural psychology has given deeper insights into economics.  “Baumol’s cost disease” afflicts industries such as health services where tasks are hard to automate.  However, psychology also plays an important role.  People are not dumb objects that can be manipulated like steel parts on an assembly line.   There is near infinite individuality, making it difficult to develop standard operating procedures or predict how individuals will behave.

The finance, gambling and advertising industries have long manipulated human psychology.  The health sector has lagged, though the gains could be enormous.  For example, overcoming psychological hurdles to regular medical check-ups would boost early cancer diagnosis and successful treatment rates.

Behavioural psychology suggests that too many options to choose from leave people confused.  Like Kiwisaver offerings, patients need a choice of credible, regulated options.  If patients can’t decide doctors should do so for them.  In some cases, the government should determine through regulatory intervention.

Government can use its regulatory powers more actively in an evidence-based way, and within a social cost benefit framework.   After all, huge health gains have come from fluoridation, iodised salt and banning lead in paint and petrol.

A social cost benefit analysis of a regulatory ban on smoking would factor in greater longevity, productivity and well-being.  Tobacco tax revenue would drop, and superannuation and other age related costs would rise.  However, money spent on cigarettes would be spent more wisely.  People would be more productive longer in the paid and unpaid workforce.  The end result would be net lifecycle wellbeing enhancement.

Medical knowledge is vast and it is more and more difficult to detect the signal in the noise.  Specialists dominate medicine, and information may flow within but not between disciplines.

Complex problems such as pain, mental health and obesity that may have genetic, psychological, biomechanical and sociological dimensions are addressed as if they have one reductionist cause.  The “solution” is profitable such as proprietary drugs or surgery, or simplistic such as a sugar tax.

Obesity likely arises from a combination of sociological, cultural and genetic factors, and the food industry’s manipulation of behavioural psychology and neurological pathways to drive food and beverage consumption patterns.  Integrative solutions are needed, and most of these will be non-proprietary.

Given this, do we need an amplified General Practitioner speciality, or competencies within it?  Can we embed within specialities more explicit connections with other disciplines?

Kenneth Arrow was a conceptual, mathematical and theoretical genius.  He was famously kind to people.  Right up to his death at 95 he was also an economic technologist, tackling real world problems.

As our thinking grows from the foundation he created, health economists and medical researchers must become technologists. That is, they should aim to get things done.  However, they must be wary of simplistic solutions to complex problems that traverse disciplinary boundaries, where psychology, individual variance and social context matters, and where received wisdom can be as dangerous as ignorance.

Perhaps the greatest challenge for health economics and medical innovation itself is the ability to see with fresh eyes, undistorted by financial prizes, peer networks and today’s textbooks, and to create technology that makes what is learnt productive in the real world.

As a small, agile country without a politically powerful pharmaceutical industry New Zealand may be well placed to take a lead in niche areas of medical innovation opportunity.  Let’s invest more in medical research, do things more cleverly, and see what we can achieve!



About Peter Winsley

I’ve worked in policy and economics-related fields in New Zealand for many years. With qualifications and publications in economics, management and literature, I take a multidisciplinary perspective to how people’s lives can be enhanced. I love nature, literature, music, tramping, boating and my family.
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One Response to Reflections on Kenneth Arrow and health economics

  1. David Lillis says:

    Hello Peter.
    Another topical and informative essay from you. One question emerging from your discussion is whether barriers to regular medical check-ups are mostly psychological or whether mostly they are based on financial concerns or simply low levels of awareness within at-risk populations. Also – in New Zealand we have very UV-intensive sunlight that poses a danger even in winter. Why do our family doctors not check us out for melanoma pro-actively, rather than waiting until a benign growth has become malignant?

    It is very curious that Arrow noted that medical specialists may have difficulties in unlearning what is untrue. However well trained medical specialists may be, they are as prone to misjudgment as other professionals, but the results of misjudgments or oversights in medicine can have catastrophic repercussions for patients. However, possibly specialists these days have monopoly on a smaller stock of the untrue than when Arrow originally made his comment. A lot has changed since the 1960’s.


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