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Kenneth Arrow
Uncertainty and the Welfare
Economics of Medical Care
HSPM 714 J50
Fall 2013
• Arrow won his Nobel for laying out in
mathematical terms the necessary
prerequisites for a free market to have optimal
outcomes.
• This is what "welfare economics" in the title
means.
Free market optimality requires
• Buyers and sellers understand the qualities
and prices of all goods or services.
• Anything that affects “welfare” is available for
sale.
• There are so many potential buyers and sellers
that none individually can affect the price of
the thing being traded.
Free market optimality requires
• Consumer sovereignty
– Buyers and sellers understand the qualities and
prices of all goods or services.
– Anything that affects “welfare” is available for
sale.
• Perfect competition
– There are so many potential buyers and sellers
that none individually can affect the price of the
thing being traded.
First optimality theorem
– If we have consumer sovereignty and perfect
competition, then
• The market will reach a general equilibrium of
supply and demand in all markets, such that
• No reallocation could make someone happier
without making someone else less happy.
– “Pareto optimality” or “Pareto efficiency”
Second optimality theorem
• Context:
– There are many possible optimalities
– The distribution of wealth determines which
optimality we get
• If we don’t like what people are getting from
the economy, we can fix that by redistributing
wealth and letting the market go.
Problems with optimality
requirements
• Consumer sovereignty
– Buyers and sellers understand the qualities and
prices of all goods or services.
• Can’t apply if you are buying information
• You, the consumer, can't evaluate the advice that the
doctor gives you.
– Anything that affects “welfare” is available for
sale.
• A free market can’t offer insurance against having a
risk.
Insurance undermines optimality
• Insurance must be offered (marketability)
• But undermines incentive
• Insurance against having a risk can’t be
offered
• Efficiency argument
• Different from saying it’s unfair?
• Assumes: Bad happenstance isn’t bad if you can buy
insurance against it
• Informed consumer choice isn’t possible
• How does society respond?
– Professionalism
• Wear a tie, or scrubs
• No crass business practices
– Trust
– Agent
• Patient is Principal
• Doctor is Agent (fiduciary – not quite)