Kenneth Arrow and the birth of health economics.

Abstract

Forty years ago, Kenneth Arrow published "Uncertainty and the welfare economics of medical care" in The American Economic Review (1). This paper became not only one of the most widely cited articles in the field of health economics--indeed, it marked the creation of the discipline--but also a source of reference in other fields. A search on the ISI Web of Knowledge generated 771 citations that include journals in all parts of the world and in fields as varied as public choice, sociology, banking, education, environment, law and clinical practice, and even space policy. Furthermore, the article's relevance is far from diminishing over time: citations between 1991 and 2000 were five times more numerous than those between 1963 and 1972 (2). The first reason for this article's continuing popularity is its intellectual elegance and insight. The second is that if touches on a core feature of public health policy debates: the extent to which market or non-market institutions play fundamental and socially desirable roles in the provision and distribution of health care services. In 1963, Arrow was already well established as a leading economist, having published (with Debreu) seminal work on competitive equilibrium that provided the foundation for modern economic thinking about the extent to which markets can or cannot reach welfare-maximizing equilibria. Previously, he had developed the impossibility theorem for which he later won the Nobel Prize. In that work, he demonstrated the difficulty of finding any collective decision-making process that can provide consistent ordering of social preferences. Arrow had nor previously written about health and rarely returned to the subject in his subsequent work. The article extracted here resulted from an invitation from the Ford Foundation to promote greater exchange between economists and other professions in the areas of health, education and welfare. Arrow therefore had to learn about health rare and health insurance services before he could apply himself to the question. The article begins with reference to the desirable properties of perfectly competitive markets, using concepts from Arrow's general welfare theorems. He then explores how the existence of "uncertainty in the incidence of disease and in the efficacy of treatment" leads competitive markets to generate an inefficient allocation of resources and contributes to the emergence of nonmarket institutions (such as trust and norms) that compensate for these market failures. In demonstrating the kind of market failure that derives from uncertainty and related problems of information, Arrow helped to generate a vast literature dealing with problems in markets ranging from health insurance to used cars (3, 4). He also opened the way for agency models to be applied to studies of physician behaviour (5). By developing the implications of uncertainty on markets and market equilibria, Arrow established principles that have been round useful in subjects other than health. His insight applies many analysis in which costly information compromises a system's ability to generate preferred aggregate outcomes from decentralized actions. It is this generalized applicability that accounts for the article's wide range of citations across various fields. The article was written, however, specifically about health care (Arrow is careful to stipulate that he is discussing only medical services and not health per se), and its longevity also drives from its comprehensive treatment of the central issue in most public health policy debates: what roles are effectively played by markets and what roles are best left to non-market institutions. The article is sometimes cited to demonstrate that health care is not as exceptional as many people claim and that market mechanisms can play an effective role in the medical rare industry in the same way as they do in other economic activities (including sectors with an effect on health, such as food and housing), in contrast, it is also cited to demonstrate that market failures in health care justify the creation or preservation of non-market institutions. …