Cover Image
close this bookHealth Economics for Developing Countries: A Survival Kit (London School of Hygiene and Tropical Medicine, 1998, 134 p.)
View the document(introduction...)
View the documentPublication Series - Health Policy Unit
View the documentAcknowledgements
View the documentPreface
View the documentChapter 1: Health Economics and its Contribution to Health Planning
View the documentChapter 2: Economic Development and Health
View the documentChapter 3: Financing Economic and Health Development
View the documentChapter 4: Health Care: the State versus the Market
View the documentChapter 5: Demand, Supply and the Price System
View the documentChapter 6: Concepts of Economic Efficiency
View the documentChapter 7: Inputs, Resources and Costs
View the documentChapter 8: Outputs, Health and Health Indicators
View the documentChapter 9: The Techniques of Economic Evaluation
View the documentChapter 10: National Accounts and the Health Sector
View the documentChapter 11: Health Sector Finance and Expenditure
View the documentChapter 12: Sources of Finance for the Health Sector
View the documentChapter 13: Budgetary Procedures: Budgetary Reform and Programme Budgeting
View the documentChapter 14: Approaches to Financial Planning: Resource Allocation Planning and the Financial Master Plan
View the documentSelected Bibliography
View the documentGlossary
View the documentBack Cover

Chapter 4: Health Care: the State versus the Market

1. Introduction

“Is health care in some way fundamentally different from food, clothes or any other commodity which is distributed through the market? Are there special characteristics distinguishing medical care from these other goods? Why should society's objectives be better achieved by non-market provision?” (Le Grand and Robinson 1976 pp. 32-33).

These questions are typical of those that are frequently raised in the debate on the nature of the commodity 'health' and the most appropriate organizational context for its optimal production, allocation and delivery. They reflect the two aspects of the debate: first, technical arguments about the functioning of the health care market; and second, more fundamental arguments about the nature of society's objectives. The second concern more basic issues because only when society's objectives are established can 'optimal production, allocation and delivery' be defined and understood.

However, the current debate focuses around the technical issues. For example, there are those who argue that health care is not different and can be allocated via market mechanisms in the same way as other goods and services. On the other hand, there are those who argue that health care is in some ways different, and requires the modification or replacement of market mechanisms. This focus reflects the establishment of efficiency as the central societal objective and the understanding of 'optimal' as 'most efficient'. However, a second important objective is that of equity, which is still a central policy objective within many government health care systems. It remains important for practical policy-making, therefore, to consider whether, and to what extent, the operation of the health care market achieves equity. The changing balance between equity and efficiency as policy goals helps to explain why the extent to which governments have intervened in the free operation of the health care market varies from country to country and has changed over time within countries.

In considering these issues three groups of questions will be addressed in this chapter.

- first, technical issues: what is the rationale for the market and the price mechanism? What are the requirements for the market and the price mechanism to function? What are the economic characteristics of health care? Is health care different? Are the conditions of perfect competition satisfied in the case of health care?

- second, what are society's objectives? Are they considered or realised through the functioning of the market?

- third, what do the answers to these questions imply for the organisation of health care services?

2. Markets and the Price Mechanism

What is a market? What do markets do? How do they work? The features of markets are usually described in relation to consumer choice and producer competition:

“A market economy may be defined as an economic system in which the mechanism of variable prices functions freely to signal consumer preferences and, through its effect on profitability, to encourage the allocation of resources - manpower, capital and raw materials - so as to satisfy those preferences. The consumer exercises choice by voting with his purse. It is an impersonal system which permits decentralised initiative in the use of resources; this in turn promotes competition and efficiency while maximising the range of consumer choice.” (Centre for Policy Studies, Why Britain needs a social market economy, Barry Rose, Chichester 1975.)

A central feature of the market is the price mechanism (see Chapter 5). On the demand side, price is a measure of how much income must be sacrificed in order to obtain a commodity. The more something is valued, the more consumers will be willing to give up to obtain it. On the supply side, prices indicate to producers the strength of these consumer values. The price at which a producer can offer a commodity for sale reflects both his efficiency, and (to the extent that the prices of the resources used in production measure their scarcity value) the opportunity cost of the commodity as well.

Within the context of the market it is argued that the price mechanism, if allowed to operate free of constraints, will result in an optimal pattern of allocation, distribution and exchange. This is because:

- it transmits information about consumer preferences and the strength of those preferences; and also information about resource costs, about scarcity, about the efficiency and opportunity costs of production

- it provides incentives both to produce what is most highly valued in society, and to produce it in the most efficient manner

- given an initial distribution of resources or of income, prices determine who in society gets what goods and services.

In other words, prices signal what society wants, how much it wants it, what this costs in terms of resources or alternative options sacrificed and how efficiently producers are able to satisfy these wants. 'Optimal' allocation in this sense is efficient: i.e. a situation where no reallocation can make one individual better off without making at least one worse off (allocative efficiency). The price mechanism, in this argument, also has the advantage of securing efficiency in resource use: i.e. achieving maximum output at given cost or a given output at minimum cost (operational efficiency).

This type of structure stands in contrast to non-market systems which require conscious decision-making about what will be produced, how, when, where, in which ways, and for whom. Some writers have argued that the very complexity of a modern industrial economy makes it more difficult for a central planner to comprehend all the knowledge and information necessary for efficient management than in smaller and simpler economic systems.

The claimed advantage of the price mechanism as a rationing system is that it allows the decentralized coordination of a large number of separate activities. All of this happens automatically without the need for conscious planning or centralized decision-making. Or does it? What are the requirements for markets to function in this manner? Do markets operate this way in practice? The theoretical analysis and rationale for markets are usually explored using an idealized model of the real world known as perfect competition. For the price mechanism to operate in the way described above, a number of conditions must be simultaneously satisfied. These conditions are known as the conditions of perfect competition.

2.1 The model of perfect competition

The conditions of perfect competition are as follows:

- a large number of buyers and sellers, each small in relation to the total number so that they are unable to control price or output. With only a few sellers, competition may not operate

- no barriers to entry: producers are free to enter or leave the market, while factors of production are mobile

- no significant economies of scale which would give a price advantage to large-scale producers and imply a tendency towards monopoly. A natural monopoly describes the situation where it is more efficient in terms of production at least cost to have just one large producer, but this eliminates the competitive controls on price, quantity and quality

- no product differentiation or brand names; products are homogeneous, without quality differences etc.

- assumption of self interest: producers aim to maximize profits and consumers aim to maximize utility (i.e. benefits)

- no externalities or spillover effects in production or consumption. An activity creates an externality if people who are not involved in the decision to produce/consume are affected by it

- no risk or uncertainty: there exists perfect knowledge of prices, of products, of the implications of consuming or not consuming a product etc.

Market failure refers to the situation in which these conditions (necessary to achieve the market-efficient solution) are absent, or are contravened in one way or another.

3. Is Health Care Different?

Health care is not different from other goods in the sense that like other commodities it is scarce, and therefore requires allocation and institutions to organize its allocation. A number of characteristics are, however, often mentioned as distinguishing health care from many other goods and services:

- health care has both a consumption and an investment element (i.e. good health yields direct consumption benefits from being healthy, and contributes to greater production and investment)

- the costs of health care can be high in relation to income, and ill-health may also affect earning capacity

- patients have a direct involvement in the production as well as in the consumption of health care

- consumption or non-consumption decisions may well be irreversible (i.e. decisions may lead to death or permanent disability).

Although these characteristics are unusual they do not in themselves mean that health care cannot be treated in the same ways as other commodities, nor do they necessarily imply a particular form of organization. For example, insurance schemes have developed in order to minimize the adverse effects of high health care costs and the effects of illness upon earning capacity.

However, the health care market does not, in practice, function according to the theory of perfect competition. The main market failures are discussed below.

3.1 Consumer rationality and consumer sovereignty

Rationality implies consistency and in particular that decisions are consistent with the principle of utility maximization (i.e. that consumers use their economic resources in order to maximize their utility or benefit). In a few instances in health care, rationality would appear to be absent or impossible. Those who are mentally ill, and who reject or who do not recognize their need for treatment, are incapable of pursuing rational ends. Others, such as those who are unconscious, are temporarily unable to exercise rational choice. Health care may, therefore, in some circumstances be a merit good which must be distributed by the government because it will be under-consumed if left to the willingness-to-pay of individuals (who are not always rational in their demand for health care).

3.2 Risk and uncertainty

The need for health care is difficult to predict. If the cost of health care was small in relation to income this would not be important but it is not. Costs associated with illness are uncertain and often large. Insurance is of course the mechanism that has developed in order to cope with the problems of risk and uncertainty, and in many countries insurance systems exist to cover the expenditures arising from ill-health. Insurance systems do not necessarily imply state involvement, although many existing schemes operate with varying degrees of government support or control.

The chief problem with the operation of insurance in a market system is in the way risks are treated. Private insurance systems must at least cover their costs. To do this they set a premium based on the observable characteristics of those applying for insurance, and the estimated costs of treating certain conditions. Some individuals have characteristics that make them bad risks (such as the very young or very old, those with existing chronic conditions, and smokers); some conditions imply high treatment costs as a result of expensive procedures or long periods of treatment (such as the problems arising from chronic illness, haemophilia, or old age). A private insurance system is unlikely to cover these individuals. Some form of state intervention is therefore essential to ensure that all individuals secure access to health care, irrespective of their age, initial state of health, or ability to pay.

3.3 Information

For many commodities the consumer has some understanding of the product, or can acquire such information by experience. With medical care, patients have little idea of the effectiveness, of the quality, or of the consequences of having or not having treatment. Individuals may not even realize that they are ill. Furthermore, consumer entry into the market is infrequent, knowledge acquired from past experiences becomes rapidly outdated, while the urgency of some conditions precludes time-consuming and often costly information gathering. There is little incentive for producers to provide information, and although patients may try to obtain more information through 'second opinions', doctors are traditionally reluctant to provide conflicting information or to disagree with colleagues. The irreversibility of much medical care emphasizes the importance of making the right decisions based on adequate information. Many professional groups and agencies have developed to provide information but for ethical reasons there are often controls imposed on the advertising of services.

These problems have in part contributed to the unusual relationship between producers and consumers in health care. The doctor is consulted and acts as an agent on behalf of the patient. The consumer chooses to delegate decisions about consumption to the doctor, thus demand for health care is often initiated by the supplier (demand may even be supplier-induced). An obvious danger of this is that consumers may be exploited: depending on the price of health care, and the method used to pay for it, doctors may stand to benefit from generating demand for their own services.

3.4 Externalities and public goods

There are numerous instances in health care where the consumption or production behaviour of one party spills-over to affect another party. Inoculation against infectious diseases, and public health measures such as sewerage and drainage are the most frequently quoted examples of these physical external effects. There may also be a caring externality underlying the provision of health care - this is discussed later.

A particular type of externality is known as a public good. The two distinguishing characteristics of this type of commodity are non-rivalness in consumption, and non-excludability. In simple terms this means that once the good is provided, it is possible for additional individuals to consume it without reducing the consumption of others, and that at the same time, it is impossible, or at least prohibitively difficult, to exclude others from consumption. The classic example of a pure public good is the lighthouse. The practical implications of such goods are that individuals have an incentive to understate their valuation of such commodities, and/or once they are provided, not to pay for them.

Certain health care services are characterized by the problems associated with public goods. Malaria control through environmental management (e.g. cleaning ponds) is an often-used example where one person's consumption does not impede another's, and where it would not be practical (or would be prohibitively expensive) to exclude non-payers from the benefits. Such services, if they are to be provided at all, will require some form of collective action.

The practical significance resulting from the presence of externalities and public goods is that left to market mechanisms alone some commodities will not be produced at all, whereas others will be produced in inappropriate amounts.

3.5 Competition and barriers to market entry

The medical care market is not conducive to free competition. A number of professional groups have developed to control entry of suppliers to the health care market. The arguments in favour of this control are that it is important to maintain standards of practice, and to reduce the uncertainty regarding professional competence. The disadvantages are that such controls, by reducing supply, tend to increase costs.

A number of barriers to entry exist - professional licensure, licensing of drugs and pharmaceuticals, controls on the establishment of new facilities and/or services. Professionalization may have increased the numbers of highly trained personnel and reduced uncertainty about competence, but it is essentially anti-competitive.

3.6. Economies of scale and monopoly

There are some instances of economies of scale and tendency to natural monopoly in health care. Examples include pharmaceutical firms, and hospitals. More often, the market will be characterized by a limited degree of competition between a few large producers (i.e. oligopoly). Price competition may be reduced in these circumstances by collusion, and competition limited instead to, for instance, advertising of brand names.

4. What are Society's Objectives?

The current debate about the most appropriate organizational context for the optimal production, allocation and delivery of health care has focused on whether efficiency can be achieved through the market. Yet equity remains an important goal for most societies. Although difficult to define, equity is associated with social justice and distributional fairness. The balance between the goals of efficiency and equity within any society is essentially an ideological issue. Three main perspectives have influenced this balance, to different degrees and at different times. They suggest alternative social arrangements for the treatment of human beings, and concern the importance of the individual, the nature of individual liberty, the functioning of the free market and the role of the state. They also suggest different views about the importance and nature of social justice.

4.1 Libertarian views

Libertarians analyse society in terms of its individual members and give importance in policy-making to the protection of individual freedom, defined narrowly as the absence of restraint (but including political liberty, free speech and economic freedom). The free market is seen as the most beneficial means of the production and distribution of goods because it is both efficient and protects individual freedom.

State intervention in the market is not acceptable for two reasons: 'natural rights libertarians' argue that it is morally wrong, and 'empirical libertarians' argue that it is wrong because it will reduce the total welfare in society. To the natural rights group, the allocation of earnings and goods by the market is just because the market procedures are themselves just (efficient and protective of individual liberty). Private property (wealth) is, therefore, outside government control and taxation is seen as a form of theft.

Empirical libertarians assert that the pursuit of social justice through market interventions is fruitless because something is just or unjust only if it has been caused by the action or inaction of an individual or individuals. Allocation via the market cannot, therefore, be judged in terms of justice because the market is an impersonal force. Moreover, they argue that the pursuit of social justice by governments is actively harmful (reduces welfare) because it entails the subjugation of individuals to government control and so undermines individual liberty. They do concede, however, the necessity of some taxation for the provision of a limited range of public goods such as poverty relief and law and order, where no method of private supply can be found.

4.2 Liberal views

Liberal theory also analyses society in terms of its individual members and emphasizes individual liberty. The definition of liberty, however, embraces economic security or need and so goes beyond that of libertarians. As a result, although the market theoretically allows the efficient distribution of goods, state intervention is deemed appropriate when the market fails to safeguard the security of all society's members. The market can fail to meet individual need because those who already have property rights (wealth and power) are favoured in comparison with those with fewer property rights. There is, therefore, a conflict between the efficiency and liberty that the market theoretically secures and the need to protect the economic security of some individuals. Taxation and income redistribution can be appropriate policy tools but should be used with reference to their effect on the trade-off between efficiency and equity.

This trade-off is most clear in the utilitarian position, in which the aim is to distribute goods (including rights, freedoms and political power) so as to maximize the total utility (welfare) of the members of society. Such maximization involves both the efficient production and allocation of goods and their distribution in accordance with equity. However, primary importance is given to efficiency and so utilitarianism can sanction what some would call injustice because it can justify harm (failure to protect economic security) to the least well-off if this maximizes total utility. Utility can be associated both with the process of distribution as well as its result, and the primary importance of efficiency may be lessened where utility results from the process of allocating goods equitably.

An alternative liberal view (Rawlsian liberalism) makes equity and justice the primary aims of policy, resting on the principle of 'the maximin' i.e. maximizing the position of the worst-off in society. In practice, the approach implies that there is a legitimate redistributive role for the state, and goods are to be distributed equally unless an unequal distribution of any or all of these goods is to the advantage of the least favoured.

4.3 Collectivist views

Collectivist theories are varied but have three central goals: equality, freedom and fraternity. Analysis of society is based primarily on groups, such as social classes, rather than individuals and the goal of fraternity emphasizes co-operation, duties and the good of the community.

The collectivists' concept of freedom is broad, including both equality and economic security, and it underlies their view of social justice and their rejection of allocation via the market. It is argued that fundamental inequality (of power and wealth) results in the free market inevitably distributing ever more unequally. A more or less continuous redistribution of rights and wealth is required if egalitarian aims (including economic security) are to be met.

Government action (taxation, public production) is, therefore, justified because only it can create the conditions for the full exercise of freedom by all people. The creation of equal opportunities in the distributional process may not be sufficient because substantial inequality in end-states (and freedom) may still persist. Rather, positive equalizing measures are needed - although not necessarily complete equalization. Collectivists disagree about whether such measures should adjust market mechanisms or replace them: socialists believe that the market system can be harnessed to their goals; Marxists argue that the system is inherently in conflict with those goals and so give the state the primary role in production and allocation.

4.4 Underlying behavioural assumptions

These theories of society contain implicit views about human behaviour that influence the just balance between efficiency and equity. Libertarians represent the extreme end of welfare economics, and assume that individual decision-making is based entirely on self-interest and the pursuit of welfare (efficiency). Liberals and collectivists are concerned, to different degrees, with establishing equity principles for decision-making based on the assumption of more altruistic behavioural patterns. The source of value for efficiency judgements is ultimately the preferences of individuals. The pursuit of equity, in contrast, is often determined independently of the interest of the individual and promotes altruism, caring or other values.

A number of specific views about equity and health are based on this concept of rational altruistic behaviour. For example, altruism has been used as the basis for the defence of the National Health Service (NHS) in the UK and its concern for equity. Equity can also be seen as a caring externality - based on the proposition that individuals care about one another, and in particular care about each others' health status. Their decisions are based, therefore, not just on their own welfare but also on their perceptions of the welfare of others. In practice, the caring externality suggests that as the other person's welfare increases (decreases) so does one's own. More strongly, the concept of 'commitment' suggests that an individual may choose an act that will yield less personal welfare than an alternative act also available for selection. Such a decision runs counter to the view of behaviour based on self-interest in the pursuit of personal welfare.

5. Is Equity Achieved Through the Market?

From this discussion it can be seen that, from an equity perspective, there are two theoretical arguments against the market-based allocation of goods.

First, while the market does not require any particular pattern of income distribution to function, it will reinforce the pattern in existence. This pattern is generally inequitable and is based on accidents of birth, property and education. The market exacerbates income inequalities by allocating goods according to the individual's ability to pay for them, and so, in theory, allocation via the market will undermine the health of those who are both least able to afford health care and are most vulnerable to ill-health (the low-income groups). The pursuit of equity involves allocating goods such as health care in a way that counterbalances income inequalities (i.e. favouring the low-income groups), together with a pattern of taxation that falls more heavily on high- than low-income groups. In practice, health care must be allocated in accordance with the objective of achieving a net subsidy for low-income groups and a net contribution from high-income groups.

Second, the market assumes that individuals are basically self-interested in their behaviour and seek to maximize their own utility. A concern for equity, however, reflects less selfish behaviour; it represents a concern for the well-being of others.

These theoretical arguments are supported by the practical realities that there is often an inverse relationship between income and ill-health, that ill-health may further limit income earning capacity and that the cost of health care is often high in relation to income. Consequently, at a minimum, intervention in the market is required to protect those who are both most likely to be sick and least able to afford health care.

6. Health Care: The Role of Government Intervention

Government intervention in the health care market may be promoted on either efficiency or equity grounds. It can attempt to restore the conditions necessary for the market to work or to limit the undesirable effects of markets and market failure. For example, allocative measures are designed to restore the conditions of perfect competition; and distributive measures are designed to correct an undesirable distribution of economic resources, and then to allow markets to work. Distributive measures may work through the tax system via transfer payments to the poor or negative income taxes; or through price regulation via price support (e.g. minimum wages) or tariffs.

Moreover, government intervention can be minimal, limited to that of umpire, referee, information provider or regulator of market fixing by vested interests. Or government can have a more extensive role ranging from the regulation and control of the health care system to the provision of the finance for services to the direct provision of services for all.

A fully socialized health care system - meaning, in this instance, a system in which health care is provided without charge to the consumer and financed from general revenue - carries the remedial measures to their logical conclusion. For example, with free service (equivalent to a 100% subsidy) there is little distortion of demand through differences in income. Recognition of such advantages of government production is not denied in orthodox Western economics; in the applied field of public finance it has always been recognized that there might be merit goods which the state might choose to provide independently of the market, with education and health care as conspicuous examples.

However, like the competitive market, the socialized health care system does not exist in its ideal form in the real world. Among the qualifications are:

- even with zero price and wide geographical dispersion of services, there will persist some non-price impediments to access that make complete equality hard to achieve

- a socialized system of health care in a non-socialized economy will be exposed to some residual market pressures, for example in the supply and price of inputs it purchases from the rest of the economy

- the degree of equity attained in a socialized health care system depends partly on the nature of the lax system from which it is financed (and on the nature of other sources of finance such as foreign aid). If it is regressive (bearing more heavily on the poor than the rich) a zero price is not enough to achieve overall equality in the health care system

- as a socialized system does not rely on market forces for resource allocation, it must be planned. Its properties therefore depend on the efficiency and cost of the planning system

- at a lower level, the allocation of services is likely to be left largely in the hands of health professionals. In any conflict between consumer needs and demands the result is likely to be biased towards professionally assessed needs, especially when the consumer does not pay and therefore may have less influence

- a socialized health care system, like any other large organisation, is always in danger of bureaucratization, with all this implies in terms of inertia and emphasis of the interest of the producer above those of the consumer.

In practice, neither ideal form of health care organization, the market or a socialized health care system, functions according to theory. Mixed systems exist in reality, involving different degrees of government intervention and reflecting different balances between the two central aims of society, equity and efficiency. Practice tempers theory in policy-making and the realities both of scarce resources and of unequal distribution (of income, of ill-health) are recognized. There is a great need for examination of the specific form that is appropriate for a particular country and period, in order to minimize its side-effects.