Tag Archives: externalities

Why Health Care Markets Don’t Work Well By Themselves

I love free markets. Free, unregulated markets are by far the most efficient and effective way of allocating goods and services, bar none.

Except when they’re not.

Much as economists hate to admit it, lots of things can cause markets to fail. Sometimes it’s well-intended government policies. More often it’s characteristics of the market that cause the failure. Health care is a great example. Health care markets, left alone, simply don’t allocate resources efficiently, for reasons that are well-understood by economists.

So why is health care different? What is it about health care that make it such a poster child for market failure?

The answers vary from country to country – U.S. health care markets are more problematic than other countries – but here are some of the reasons.

Health Care Information is Extraordinarily Imperfect.

Information is essential for markets to work – information about prices, quality, costs, benefits, availability, and every other aspect of the good or service.

For a market to be efficient, you’ve got to have good information. Consumers and firms have to know about every aspect of the product and the market. That might not be unreasonable when you’re dealing with corn or wheat. But health care?

The human body is the most complex machine on the planet. So complex that it takes nearly a decade to become a medical doctor. What we know about the body is constantly changing, and even experts disagree about what goes wrong with it and what to do about it.

Because of the volume and complexity of health information, health care consumers have no choice but to rely upon health care providers to tell them what they need to buy. And no matter how ethical and well-intentioned people in the health care industry may be, they’re only human. They can’t help but respond to the incentives they face, whether or not these are in the best interests of the consumer. Economists call this “information asymmetry”, and it leads to unbalanced outcomes in any market.

Your Health Care Decisions Effect Others.

If you’re out sick for a week with the flu, your coworkers will probably have your work dumped on them, and may even catch the flu themselves. If the other children at school don’t get vaccinated, your son is more likely to get sick, whether he is vaccinated or not. If your neighbor doesn’t get the urgent mental health care he requires, he could become a mass murderer, devastating home values in your neighborhood. Economists call these sorts of problems “externalities”, because they involve things that are external to the market relationship been the individual and the firm. Health care markets are full of externalities, and that can be deadly for market efficiency.

Health Care Markets Aren’t Competitive.

Lots of things about health care markets lead to a lack of competition, which in turn causes market failures that are particularly bad for consumers. For starters, providing most types of health care involves economies of scale. This means that larger firms – hospitals, clinics, labs, whatever – can produce it at a lower cost than smaller firms. These economies of scale are no one’s fault, but they result in large firms with lots of market power. This in turn leads to market inefficiencies, to the great disadvantage of consumers.

Efficient markets require that buyers be able to change sellers whenever it makes economic sense to do so. With health care, it’s also difficult change health care providers. It can take a doctor a long time to determine what exactly is wrong with you, and how best to treat it. This decreases health care competition even more.

The information problems in health care (see above) also to less competition in health care markets as well. When you don’t even know what’s wrong with you, it’s pretty hard to know what you need to do about it. That makes it hard for you to make informed choices, resulting in even less competition.

Competition is (virtually) always good for consumers, and the lacks of it is equally bad.

And That Ain’t All.

This isn’t a complete list of market failures involved in health care. Moral hazard, patents, administrative inefficiency, institutional problems, long timeframes, public goods, legal incentives – the list goes on. But even with the market failures discussed here, it should be clear that health care markets are inherently problematic. In fact, they’re the most problematic markets out there.

This is why government is deeply involved in health care markets in every developed country. When a market has so many characteristics that cause it to fail, the only solution is for government to step in a try to make the market work better. Government involvement in any markets is fraught with risks – any government action can produce unintended consequences – But in some cases, outcomes in an unregulated market are so bad that taking these risks are justified.

Given the current situation in U.S. health care markets, we have no choice but to turn to government to regulate these markets more closely. It would be difficult for any well-designed government policy to make things worse.