IE NATURE OF THE COMMODITY'HEALTH CARE AND ITS EFFICIENT ALLOCATION Sfod Ecmomic Papern (pre-/986): Jul 1971: 23. 2: ABUINFORM Globk pg189 THE NATURE OF THE COMMODITY 'HEALTH CARE, AND ITS EFFICIENT ALLOCATIONI By A J CULYER SINCE economists began to turn their attention to matters concerning the efficient allocation of resources devoted to preventing, curing, and alleviating ill health round about the end of the 1950s a whole new are posing intriguing new questions has been opened up. Many of the most fundamental of these problems have yet to be cleared up(for example, the definition of the product'of health care institutions and how it may be measured). The purpose of this article is to attempt to resolve just one of these difficulties, namely, whether the commodity health care defined generically as the kinds of service provided by surgeons, physicians rses, hospitals, etc, is different from other commodities in particular and crucial ways such as to make some forms of organization of the health industry intrinsically inefficient and others intrinsically efficient. As i well known, this question has been the subject of frequent controversy over the last twenty years, a controversy that is today as lively as when it began, but a controversy, it is hoped to show here, that has been largely unproductive because it has been characterized n both sides by a surprising propensity to leap from certain interesting(and mportant)descriptive characteristics of health care to conflicting(and gain important) policy prescriptions What is even more surprising, most of this discussion has been conducted at an entirely a priori level with the practical conclusions being inferred in an ad hoc fashion, without a proper logical foundation. One reason for this may be that an explicit social welfare function has rarely been stated, though some contributions have been cast in a Paretian welfare economics mould. 3 There are how ever,other more powerful reasons why different analysts'conclusions have not been the same, and it is upon these that we shall concentrate 1 Acknowledgement is made to the NufField Provincial Hospitals Trust for a researc rant to the Institute of Social and Economic Research, University of York, for research into the social and economic problems of health care provision. The Trust is not, of course, been Loes[24][25][26] he Jewkeses [20][21]in particular. More cautious analysts include Buchanan and Lindsay eciwo woula explain the oxistonoo of tho ns titation of which th nomic analysis. For a recent attempt, and the only one to date to'explain'the NHS, ee Lindsay [30]
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. THE NATURE OF THE COMMODITY 'HEALTH CARE' AND ITS EFFICIENT ALLOCATION A J CULYER Oxford Economic Papers (pre-1986); Jul 1971; 23, 2; ABI/INFORM Global pg. 189
implications that have been drawn for the appropriate organization of health care in terms of the Pareto criterion; i.e. changes which improve someone s welfare without placing a net harm on anyone else are deemed an improvement, while changes that yield net benefits to some and net arms to others cannot be evaluated in terms of whether society as a whole better off Current orthodoxy is adequately summarized in an early article by Martin Feldstein in this journal: the availability of private heaysjisn does not remedy the most basic defects of the market mechanism as a method of providing health care. Although it can permit some people with adequate foresight to escape from the precariousness of major medical expenses,, if medical care is allocated according to the patient,s financial position rather than his medical condition, the nations health-care resources will not be used as productively as possible[15, pp 22-3)1. The ajor reasons why this may not come about will be discussed later, but the diligent reader of the a priori health economics literature will search in vain for a clear alternative objective function. Feldstein, to be sure, in the article mentioned does ask '. should not health care be allocated to maximize the level of health of the nation instead of the satisfaction which consumers derive as they use health services?'(loc. cit ) 1 But even supposing that a satisfactory measure of the nations level of health existed, the unconstrained maximization of such a level is an absurd objective since it seems unlikely that the stage of negative(or zero)marginal returns would be reached short of incredibly large investments in health Not that Feldstein suggests this objective, for he later prescribes that " in making their decisions, doctors and health-care administrators should look for the optimal use of resources by weighing the benefits and costs of alternative programmes and methods of treatment indeed, much of his own subsequent work has been directed toward elping them to do just that. But a dilemma still exists, for if individual preferences are not to be counted, what are the benefits and costs to be weighed? If some benefit is foregone, no matter who loses it, is not a social ost incurred to the same value? It matters little whether the difference between benefits gained and necessary production costs is maximized, or hether production costs plus all other foregone benefits are minimized, imal consumption remains the same since it is, quite rightly, independent of the accounting conventions used. By a roundabout route, therefore, it however, the maximization of social welfare according to indications given criterion is emphasized
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seems that the Pareto criterion may have been implicit in economists analyses all the time. But if this was the case, the qualitative arguments for and against various market structures, as compared with the quantita- tive arguments for improving the workings of extant institutions,are without a logical foundation. This is partly because of a nirvana approach to the problem, i.e. comparing the actual operation of an existing system with the hypothetical operation of an ideal system(see Demsetz [14]) but also partly because of a failure by some commentators to recognize that organizational reforms cannot abolish economic problems, though they may change their form I. The characteristics of health care There can be no doubt that health care is not the same thing as other economic goods. It has, moreover, some intriguing characteristics which appear to make for conceptual difficulties in defining the nature of an optimal allocation. Some are shared with education, another good requently provided publicly, for example the direct involvement of the onsumer in the production process and the difficulty of separating or onsumption and investment elements and the very substantial cost that nay fall on individuals giving rise to major distributional problems Others, however, are probably unique in the extent to which they apply to health care compared with other goods or services. The purpose in this is to these for the evidence they provide for public or private provision of health care. I Consumer rationality Welfare economics makes two crucial assumptions regarding consumer rationality. The first is the normative judgement that the individual's own interpretation of his own welfare is the one that counts. The second is the non-normative(but also untestable) assumption that choices reveal preferences. Our purpose is neither to defend nor criticize these assumptions but to discover whether health care characteristics conflict with them Three arguments concerning rationality have been put forward which are alleged impediments to the optimization of welfare in open markets (a) many consumers, though sick, do not desire treatment and may even be ignorant of their sickness (b)the mentally sick fit oddly into a'consumers'sovereignty'model (c)patients requiring emergency treatment are frequently not in a sition to reveal their preferences culiar characteristics of health care are to be found in Arrow [1]. d Mushkin [35] among others. Boulding [4] provides an interesting. iscugsion of the need for care. uced with permission of the co
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1. The first of the alleged impediments has been well documented Spectacular evidence for the truth of this proposition was discovered in the famous 'Peckham experiment'of 1935-9, where 64 per cent of the ersons examined had identifiable disorders but were unaware of them In 1964, for example, it has been estimated that there were 150, 000 unknow diabetics in Britain. It also appears that the problem has similar dimen- sions in other countries. Such evidence appears to violate a fundamental and necessary condition for the attainment of an optimum through open First, the problem of ignorance is not a problem characterizing markets only. Knowledge must be economized in all social systems, and by using patient ignorance as a stick with which to belabour private medicine attention is diverted from the more important problem of assessing the optimal amount of ignorance. There is little evidence that post-war British patients are any less ignorant of their state of health than their pre-war parents were or that a nationalized health care system devotes more resources to preventing sick as than other systems (Office of Health Economics [37]). This, of course, is not evidence for or against the efficiency of any particular system of provision, but it is evidence for the view that the description of a theoretical optimum does not tell one how it may be achieved. Secondly, the inference ignores the possibility that the degree of ignorance measured in experiments such as that at Peckham may, in fact, be optimal. If information about one' s health is costly to collect, it may be irrational to dispel all ignorance; i.e. it is perfect information ather than ignorance, that is a priori more likely to be inconsistent with the postulates of welfare economics. The fact that one set of individuals es a social benefit in reducing the ignorance of others is a problem of xternalities, to which we shall return later, but it does no damage to the conclusions here that the observation of ignorance is not sufficient to infer inefficiency in resource allocation and that the specification of an optimal distribution does not indicate the most appropriate form of social organiza tion for attaining or approaching that optimum, What is required if a of how individuals operating within the framework of constraints implied by that form of organization can be expected to act compared with their behaviour under an alternative form. This, however, is 1 See Israel and Teeling-Smith [19], and the references cited therein. seems clear that for any hich it may indeed be(Culyer [12]), though there are some possible in practic Reproduced with permission of the copyright owmer. Further reproduction prohibited without permission
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urned, and to which a satisfactory answer has yet to be reached. 1 A similar conclusion must hold with regard to patients who, though knowing that they are sick, fail to demand treatment. Given their pre ferences, information, fears, etc, there is no a priori reason for supposing that they are behaving irrationally, nor that they would behave differently nder an alternative system. On the other hand, if there exists another set of individuals who would prefer them to receive more care than they choose, then there may again be marginally relevant externalities which should be taken into account in describing the nature of the optimum The point here, however, is not that the individuals in question are behaving irrationally, violating any of the postulates of utility theory by, for example, acting inconsistently with their own preferences, but that they re behaving inconsistently with the preferences of an entirely different set of individuals. 2 3. Similar conclusions hold with respect to the emotionally disturbed, children, and emergency cases. If there is evidence that these individuals are actually behaving irrationally or are not in a position to choose, then it must follow that welfare economics, based as it is on an assumption of rationality, has nothing at all to say about their subjective utility maxi mization. It cannot therefore be used to assess alternative forms of pro vision. On the other hand, welfare economics can be used to describe the characteristics of an optimum if there exists an external demand for the care of such people. Since the problem of external demands emerges as a general problem in health economics its discussion is, however, postponed until a later point in this paper. It is, however, dangerous to overstate the degree of irrationality in the behaviour of patients, and the discussion here is not intended to lend support to any presumption that individuals, even those who are emotionally disturbed, are in general irrational in matters of personal health Uncertaint Four points in particular have been raised, which may affect the ability of an open market to satisfy the necessary optimal conditions, all arising 1 For some attempts in connection with the medical care industry see Newhouse [36 and Weisbrod [46]. For a different context (universities)see Culyer and the costs of the appropriate treatment nottoo high, the Hypo (almost)entirely logically, are Arrow [1]. Lees and Rice [28], Arrow [2], Pauly [38], and Crew [11]. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission
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from various aspects of patient uncertainty about various dimensions of health care service ( d)Patients frequently will not be able to calculate the cost they will incur in receiving medical treatment; (e) they are frequently ignorant about the quality of the care they receive, (f)fair insurance may not be obtainable; and (g) moral hazard prevents an optimal insurance pricing structure 4. Consumers who seek medical care usually do so before they know how much cost they will be incurring. In the face of this uncertainty it is clearly ossible that they may take decisions which subsequently they may come to regret. They may, for example, take too much care and discover they have run up a bill higher than they would have been prepared to pay before consultation; or they may take too little if they overestimated the probable cost and the appropriate treatments are highly indivisible(e.g. having embarked upon a cheap course, an expensive and more effective course would add too much to the cost given the wealth effects that have already happened as a result of treatment already received; or that alternative courses are mutually incompatible, e.g. having embarked upon a cheap course the expensive course would not be medically feasible). Partly, the problem here is one that has already been met, namely how one can tell whether the optimal amount of information about the relevant choice parameters has been obtained. Under a zero pricing system, such as one may imagine the ideal National Health Service to be, the optimal amount of information about direct costs for any patient to collect will ormaly be zero, since the costs of his choices are spread over the whole of society and the burden upon him is effectively zero, though the collective burden of the decisions of the rest of society clearly is not zero. In this system, the cost of care falls on an individual not as a result of his ow individual choices but as a result of the choices of others through the payment of a(hidden) tax-price. The result of society-wide risk pooling is thus to reduce to negligible proportions the incidence upon him of the costs mplied by his own choices whilereducing to quite a low level the uncertainty about the costs that will be thrust upon him by the rest of society. The "ideal NHS system may therefore appear to have two major built-in allocative inefficiencies. The first of these derives from the pooling element. As arrow has shown, insurance requires a maximum degree of risk dis crimination for its full social benefit to be realized, while pooling implies no discrimination. Thus, under conditions of uncertainty, options on 1 The'ideal'NHS is characterized by zero pricing for all health care services, public inputs, and general fund tax financing. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission
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uture consumption would be purchased some of whose expected benefit exceeded expected cost at the margin(where the premium exceede actuarially predicted cost)and some of whose expected benefit fell short of expected cost at the margin (where the premium was less than the actuarially predicted cost)(Arrow [1]). The second derives from a zero price implying excess demand and a failure to satisfy the necessary condi tion that expected marginal valuation should equal marginal cost. Neithe of these two objections, however, can be regarded as sufficient to show the relative inefficiency of the NHS. First, the ma a dis crimination ment is a condition relating to a hypothetical world of zero transaction contract, and information costs. All real world institutions have degrees of pooling built into them as a means of economizing on the costs of collecting enough information for thecorrect'premiuims to be found. The comparison is properly one between different conceivable real world institutions where second-best solutions must be discovered. At least, such solutions may be second-best by comparison with a hypothetical ideal, but they may be first-best in terms of what can actually be done. This is clearly not a matter to be settled by a priori reasoning since the correct degree of pooling- depends upon the costs of administering various pooling/discrimination. gan empirical matter. There is also an alternative argument which asserts that pooling as under the NHS is actually more efficient than risk discrimination. Risk discrimination requires that individuals in groups. having a higher incidence of sickness should pay higher premiums since they impose higher social costs. With pooled risks in the NHS, however, he premium takes the form of a tax- price which, to the extent that the NHS is financed out of general funds and the tax-system is progressive, divorces the premium from the individuals risk and relates it instead to- come. Since the poor would tend to be less discriminated against under his system than one in which risk discrimination was the rule, there may be some social benefit from such a form of organization relative to one in was less prominent. This argument is an important one which we return later. At this point, however, it is observed that whatever merit the argument may have, it is not related to the matter of optimizing cost uncertainty. Instead it concerns the incidence of absolute costs. It is therefore not relevant to the discussion of this section The second objection to the NHS system is also derived from comparing the real world with a hypothetical ideal instead of a realistic, or conceivable alternative. In any known health care system, however, there is some response to the problem of the uncertainty of costs which incorporates insurance or pooling elements by which all fail the test of comparison with a hypothetical ideal. The reason for this is that so long as the tax-price (or premium) does not exceed the expected value of consumer's surplus
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she operation of a zero price for use of the service(as under the NHS or even a full insurance system with risk discrimination) will ensure that individuals will, under either type of institution, try to adjust so that their marginal valuations become zero. Any differences between alternative institutions must arise because of differences in behaviour that are implied about how individuals can adjust by, for example, coinsurance in the market, or by political voting processes in the NHS case, which reduce total supply below the rate of consumption implied by zero marginal valuations. These are, however, more or less empirical questions about the processes by which preferred positions are attained and have very little on of an optimal solution. Before a judgement about the relative merits of the market or the nhs can be reached one therefore requires far more information about these processes and about how the excess demands under either institutional framework are actually removed. Currently, we lack even a satisfactory positive theory of anagerial behaviour as a framework in which such an empirical investi- gation could be conducted. 1 Thus, at the microeconomic level, one's preference for one system or another will depend upon how resources in excess demand are actually rationed out. Since a prime health service pplying agency, the hospital, is charac ofit in eithe system, there must be substantial initial uncertainty about any behavioura differences between them, which further whittles away any a priori case favouring either one over the other. This problem is additional to another concerning the determination of the size of the excess demand, which in the case of the NHS requires some theory of public expenditure(since marginal valuations are not, in practice, equated with zero)and in the market case requires analysis of the means used to reduce the effects of moral hazard 5. Uncertainty about the quality of care received by consumers is more important in the health services than in many other areas of economic life, since the patient is frequently prevented, in the nature of his case, from shop ping around and learning about the quality of the service of rive suppliers by trial and error. Even if second opinions are feasibly obtainable as they frequently are, the patient may not be able to weigh one against the other. The typical case, however, is probably that second opinions are obtainable but that they are not sought because of the mystique associated with the medical profession and the assumption that'the doctor knows est. The difference in the amount of information available to doctors on the one hand and to patients on the other is not of the same type as occurs with most other goods and services. Typically the producer knows more about the technical methods by which a product (in this case, say, a course of But see the references cited in p. 193, n. 1. Reference 13 has some further references of a more general kind. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission
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treatment)is supplied. In the case of medical care, however, an additional differential exists in that the doctor will usually also have a substantially greater idea of the usefulness to the patient of alternative'products whereas with other commodities the consumer is presumed to know this better. As the purveyor of a service, this puts the doctor in a special position ince he presumes to tell the patient what he needs as well as supply ing those needs. In an ideal world, as Arrow has pointed out [1], one can conceive of devices which would enable such risks to be insured optimally One possible schemel would be to pay doctors by results so that they had an appropriate incentive for using their superior information as efficientl as possible, with doctors transferring the risk of failure to insurance agencies. The reasons why such mechanisms do not operate are, however easy to identify. The major one must certainly be the enormous costs of discovering whether treatment had been 'successful. How successful is eatment that saves a person's life but renders him permanently disabled How does one measure a treatment that relieves but does not eliminate particular set of symptoms? How successful is a treatment that prolongs life for two months or three, or four? Instead of this kind of mechanism for reducing the costs of uncertainty for the patient, most societies have evolved what is usually called 'the doctor-patient relationship,, the special trust relation between doctors and patients which gives the medical profession a high social status in the unity as trustworthy and partial. It is the same ethic, one may argue, that calls for an absence of any obvious commercialism in the physician's dealings with his patients. It is an ethic which is as old as Hippocrates, and one which appears to be commonly shared across different societies and across different institutional frameworks, in both the market-type health systems and the NHS Whether a periodic bill from one's family physician or the periodic spectacle of an entire profession threatening disruptive action in support of a pay claim is more conducive to this special relationship is difficult to say, and there seems to be no obvious grounds for a priori choice between alternative institutions here 6. a common complaint against health care that is organized in a market is that actuarially fair insurance is not available, apart from the problems due to pooling elements, because charges are loaded by administrative costs. Clearly, if marginal social costs are incurred in administering which social welfare could be increased: assuming a negative sloped demand curve for risk avoidance, too many people would be insured. The absence of an actuarially fair'price cannot therefore be held to be an inefficiency of the market save in comparison with the hypothetical ideal world where 1 Suggested by Arrow, op cit, P. 964. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission
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administrative costs are absent. The existence of self-insurance is not a fficient condition for sub-optimality. The relevant comparison is, as has been emphasized above, between conceivable real world institutions In practice, one suspects that a pooling system with compulsory member ship will provide lower unit administrative costs than a voluntary risk discriminatory insurance system, though the matter is an empirical or and one' s suspicions are not always well founded. The problem is more complicated than this, however, since both compulsion and pooling imply. social losses to be offset against any cost reductions, so the conceptual argument is less unambiguous than might appear and the empirical exercise would involve some quite heroic cost-benefit efforts 7. The problem of moral hazard, which has previously been alluded to, rises with some forms of insurance because the consumer of medical care is confronted with a marginal cost at the point of receiving care that is less than the true marginal social cost of provision, hence leading to some loss of welfare. If an individual would consume X'units'of medical care if he contracted a particular sickness(and had to pay the full cost)his behaviour changes when he insures against the costs, whatever they may amount to, of that contingency. Ignoring transaction, etc, costs, with unit costs of providing care at c, he might expect to pay an actuarially fair premium of p(cx), where p is the probability of falling sick. Being insured, however, the marginal cost of further treatment(e.g. more days convalesce- ing in hospital, more physican visits, hiring more eminent physician) is ro to him, leading him to consume X units of care where x>x,at a cost to the insurance company of p(ex), assuming constant costs per unit of care. The actuarially fair price therefore rises, leading to a reduction in the number ofinsured persons, i. e. an increase in the number of uninsured risk-averse persons. In addition, each insured person incurs a dead-weight loss on all extra-marginal units of care consumed beyond the point at which marginal valuation equals marginal social cost. The problem is miliar to that faced by the NHS-type organization, which has zero user prices and which satisfies demands in excess of the optimal amount. There are, however, differences in the way the two types of system distribute their excess burdens. In the market, the excess burden can be avoided by lf-insurance, but the self-insured also lose, of course, by virtue of being confronted with a range of premiums which, although they may reflect the ill sooial costs incurred by the mpany, do not reflect the lower premia that would exist if moral hazard were absent. In the NHS he excess burden is incurred by all. 1 It does not follow that because the market permits individuals to escape the excess burden(though at a cost 1 And some individuala'dead weight utility loss may exceed, with compulsory the utility gain from risks avoided. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission
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