This document summarizes Kenneth Arrow's seminal paper "Uncertainty and the Welfare Economics of Medical Care". It discusses several key points from Arrow's paper, including the unpredictability of demand for healthcare, barriers to entry in the medical profession, the importance of trust in the doctor-patient relationship, asymmetrical information between doctors and patients, and idiosyncrasies of healthcare payment systems. It also examines Arrow's analysis of the role of insurance in healthcare markets and problems that can arise like moral hazard.

1. UNCERTAINTY AND THE
WELFARE ECONOMICS OF
MEDICAL CARE
KENNETH J.ARROW
PRESENTED BY: ANIRBAN SAHA (16617002)

2. • The paper is the exploratory and tentative study of specific differentia of medical care
as the object of normative economics. It is contended here, on the basis of
comparison of obvious characteristics of the medical care industry with the norms of
welfare economics, that the special economic problem of medical care can be
explained as adaptations to the existence of uncertainty in the incidence of disease
and efficacy of the treatment.
• The focus of the operation is on studying the operation of the medical care differ
from the “norm” the norm referred by the economist is the operation of the industry
in the perfectly competitive situation.
• The first step then in the analysis of medical care market is the comparison between
the actual market and the competitive model

3. • In this paper, the institutional organization(concerned of interaction of firm in the
market) and observable mores of medical profession are included among data to
asses the competitiveness of the medical market.
• The major competitive precondition are:
The existence of competitive equilibrium
The marketability of all goods and services relevant to cost and utilities.
Non increasing returns
• The first two insures competitive equilibrium is necessary for optimal and the third
one insures that every optimal state is the competitive equilibrium corresponding to
some distribution of income.

4. A survey of special characteristics of the medical care market
Unpredictability of demand: Arrow points out that people’s needs for health care are
unpredictable, unlike other basic expenses like food and clothing. But while we can skip the
occasional meal or sale at Old Navy, our need for health care can be far more urgently necessary.
Medical services apart from preventive services, afford satisfaction only in the event of illness,
departure from normal state of affairs.
Barriers to entry: Arrow notes that you can’t just set up shop on the side of a road and practice
medicine: you must have a license to be a physician, and gaining that license requires years of
expensive schooling and training. As a result of this constraint on the supply of physicians, there
is a constraint on the supply of medical services.
The importance of trust: Trust is a key component of the doctor-patient relationship; if a
surgeon makes a serious mistake during an operation, for example, the patient may die or become
permanently disabled. The patient must trust that the surgeon knows what he’s doing, and can’t
test-drive the surgery beforehand.

5. Asymmetrical information: Doctors usually know far more about medicine than do their
patients. Therefore, the consumer of medical services (the patient) is at a serious disadvantage
relative to the seller (the doctor). Patients are therefore vulnerable to exploitation. In addition,
third-party payers of medical bills, such as insurers or the government, are that much more
removed from the particulars of a given case, and unable to effectively supervise medical
practice.
Idiosyncrasies of payment: Unusually, patients pay for health care after, not before, it is
received (that is, if they pay for health care at all). Because patients don’t see the bill until after
the non-refundable service has been consumed, and because patients are given little information
about price and cost, patients and payers are rarely able to shop around for a medical service
based on price and value. Compounding this problem is the fact that patients rarely pay for their
care directly.
Cont…

6. Role of the insurance
There are two kinds of risks involves in medical care:
• The risk of getting ill
• The risk of total or incomplete or delayed recovery.
The loss due to illness is partially the cost of medical care. It also consists of discomfort and
loss of productive time during illness and in more serious cases death or prolonged
deprivation of normal function. Both losses are risk with which individuals would like to get
insure and nonexistence of suitable insurance policy is loss of welfare.

7. Problem of insurance
Moral Hazard: The insurance is affected by the problem of moral hazard. An ideal insurance try to keep
the events that take out the insurance keep outside of the control of the individual but in practical life it
is not possible. In medical policies the cost of medical care does not depend completely on the illness but
also on the choice of doctor and his willingness to provide medical service. Often the physician acts as an
agent of insurance agent by certifying the treatment necessary for the illness.
Alternative method of insurance payment: There are three different methods of coverage of the cost
of medical care have arise: pre payment, indemnities according to a fixed schedule, and insurance against
costs. The prepayment include the payment in the form of medical service for any disease, the indemnities
include payment involving the contingency situation of any medical service in advance, while in the other
case the insurance carrier bears all the cost and later repaid by the company. Their mode of compensation
to the physician , pre payment plans are inevitable bound up with closed panels so that the freedom of
choice of the physician by the patient is less than it would be under a scheme more strictly confined to
the provision of insurance

8. Administrative cost: There is always a cost of operating an insurance company . There are several type
of operating cost but one of the most important categories includes commission and acquisition costs,
selling cost in usual economic terminology. Not only this mean that insurance policies must be sold for
considerably more than the actuarial value, but it also means there is a great differential among different
type of insurance.
Pooling of unequal risk: Hypothetically , insurance requires for its full social benefit a maximum
possible discrimination of risks. Those in group of higher incidence of illness should pay higher
premiums. In fact there is however a tendency to equalize, rather than to differentiate. This constitute the
effect of redistribution of income from the persons with lower propensity to illness to those with high
propensity to illness. If the market is competitive then the premiums can be differentiated since it removes
the problem of adverse selection.
Cont…

9. • This shows that the uncertainty in the medical service sector can be corrected by the
insurance but it suffers from various drawbacks so there should be free market
operation with some government interventions so that it can prevent market failure.
• The logic and limitation of idea competitive behavior under uncertainty force us to
recognize the incomplete description of reality supplied by the impersonal price
system
• The real solution is to increase the degree to which patients pay directly for non-
catastrophic health care, so that health insurance can function as insurance does in
other fields: as a way to protect people from catastrophic financial and medical loss.

10. CRITICISM
• Unpredictably is hardly a remarkable phenomenon. In the half-century since Arrow’s
paper came out, a large industry has emerged to address it. Extended warranties,
overdraft protection, travellers insurance, etc. etc. are all products designed to smooth
out the unpredictability of life. Most of these products have managed to function
well with minimal government intervention.
• Indeed, nearly every economic transaction involves some asymmetry between the
buyer and the seller. The ancient Latin aphorism, “caveat emptor” (let the buyer
beware), has been enshrined in property law for centuries as a way of reminding
people that sellers know more about the defects of what they are selling than do
buyers. Nonetheless, we hold buyers responsible for understanding what they are
buying, so long as the sellers haven’t engaged in fraudulent misrepresentation.

11. • The Internet has done much to democratize medical information. We speak to
physicians all the time who say that their patients know more about new drugs
than they do. A parent whose child has Lyme disease is likely to know as much,
if not more, about available treatments than is your garden-variety family
practitioner. That isn’t to say that going to medical school doesn’t matter — but
it is to say that there are ways in which the gaps in information are narrowing.
Electronic medical records, and on-line postings of medical prices and costs,
will do even more.