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What are the distinctive features of healthcare? How do they affect the way in which it would be provided without Gov.? What are the problems of Gov. providing it in a cost effective and equitable manner?

How would you evaluate the effectiveness of the internal market in the UK NHS?


In order to find the distinctive features of healthcare I will first have to explain what the standard features of commodities are. I will then explain why healthcare is different and how markets can fail to provide it adequately. In my third part I will show that governments by intervening to correct the market failure can fail as well. Finally I will try to briefly evaluate the NHS.

Market mechanism is the standard today on capitalist economies. It can be shown that, under certain conditions, markets will provide the most effective allocation (in Pareto sense). However, this says nothing about the distribution of outcome among consumers, or the equality of provision, thus I will describe the equality issue of healthcare separately from markets at the end. Furthermore, there are some other definitions of effectiveness, namely Rawlsian. I will not explore that in this essay.

It was Adam Smith who said that invisible hand guides the actions of free markets to provide optimal allocations of different commodities. When the price is too low, more suppliers will be drawn to the market and vice versa. This however, assumes a lot about the markets. Without going into much detail, I will list the assumptions and then look which ones the healthcare does not satisfy.

The standard assumptions are that there is perfect competitions, meaning everyone is a price taker and has no power over market. Everyone will also maximize utility or profit, meaning that people will not be satisfied with what they have and will not pursue other aims. Markets must also be complete, meaning that all goods must be provided. Thus, there should be no public goods or uninsurable risks. Capital markets must also be complete (no liquidity constraints on borrowing), including the market for all futures. There should be no externalities; my actions should only affect myself. There must be constant returns (i.e. no natural monopolies). And finally, there must be perfect information, meaning information about both true quantities and prices of everything (maybe at a cost) and no information asymmetries. This will imply that individual utility and budget curves are well defined.

Healthcare, as most other goods, obviously does not satisfy all of the standard assumptions.

Firstly, unlike with other goods, the information about the right prices and quantities of healthcare, even when available, is highly technical (Arrow) and people tend not to understand it sufficiently. This will either cause over or under consumption (depending on the information bias). And even when the information is acquired while a disease is being treated, this is of limited use, because the same problem is unlikely going to occur again. However, one can argue that it is optimal for the people not to waste money on information, and thus it is more efficient to be badly informed. However, the mistakes are often very costly. Also, when an accident happens people will normally have no time to gather information.

The Rich should also be in a better position to understand the technical information. So they will get comparatively more out of healthcare. Thus markets will create inequality in providing healthcare. Furthermore, because of superstition, many people will not want to know about medicine. These factors will usually cause consumption of healthcare below optimal. That is why healthcare is called merit good – you need it, but you do not know that in such large quantities.

The market for future healthcare also fails, because some people cannot insure themselves. Mainly, the chronic diseases that are known already cannot be insured against. People can be insured before the birth to eliminate this problem, but with the emergence of genetic tests, diseases that go from generation to generation can be found far before the birth, and no insurance company will take the risks.

There are also standard third party payment problems with insurance. Parties will have asymmetric information and will not face the marginal costs of their actions. This is not peculiar to healthcare insurance. Most common problems are moral hazards (after being insured one does not care about their health enough), and doctors do not facing the real cost of treatment and providing the most expensive one. There is also adverse selection problem - people know more about their health than insurance company, and thus ill people tend to insure more. That is why it is said that HMO-s are often located on the third floor in a house without lift. If customers are fit enough to get there they will get insured.

Even when there is optimal amount of insurance, people want more, because they are risk averse. Thus there will be under provision of insurance in private market. Whether this is a bad thing is a moral judgement. Do we want weak to die, so that evolution can progress, or should we be humanitarian?

The profit maximization assumption is sometimes violated, too. Doctors might not maximize profits, but instead their reputation among other doctors. So they are likely going to opt for more exotic treatment options, which will be more expensive.

There are also externalities with healthcare. Firstly if I am well, I am less likely going to infect others. But I will not get paid for that. Thus I consume too little. This effect should be very small nowadays. Additionally, I care whether other people are well, maybe more than the people themselves. As it does them no harm to be healthier, it would again be more optimal to have more health.

Lastly, there are numerous increases in scale available in NHS. When provided by private oligopoly structure instead of perfect competition, there could be collusion and abuse of monopoly power leading to too high prices and below optimal consumption.

Healthcare also has characteristics of a standard public good. The marginal cost of treating an extra patient is often small. And when the nation has good healthcare system, there could be a free rider problem, because it is hard to exclude anyone from consuming health due to ethical reasons. Thus it is hard to charge privately for healthcare as marginal cost pricing would make the price zero, and excluding will be very expensive and unpopular.

Healthcare has a special meaning for equality and poverty as well. Firstly most people believe that minimal healthcare should be to everyone. Thus people are willing to pay for others who cannot afford it (altruism). But there is a free-rider problem with altruism, because single contribution will not make a noticeable difference, so as long as everybody else is contributing, I will get away without contributing and will not have to look at people dying on the streets. Private charities have overcome this by making the donations go to specific personal families. Healthcare transfers can be politically more feasible than straight income transfers, because the rich will see that their money goes to good cause and thus are willing to contribute more. Transfers might not be optimal for education, because people can survive without being educated, thus the straight income transfer should be cheaper.

Without government intervention too little of the healthcare will be provided and it will be too expensive. By comparing UK systems (public) and US ones (private) this is seen empirically. The life expectancy is similar in both countries. However, US system is more than 2 times as expensive as UK-s one (as a % of GDP). The differences in utility can be even larger, private provision will not soften the impact of hard choices regarding the rejection of insurance and death etc. Under state system these cases are financed out of taxation, in private system the shortage of funds might become too apparent, and cause misery to people who care.

Even when one can identify the cases where market provision will not be efficient, it is not clear that government intervention will help. Governments tend to fail as well. It happens mostly for two reasons – first governments will find it harder to manage the massive quantities of information needed to make optimal decisions. As Hayek says, the man on the spot will more likely know the relevant details, and thus get an effective outcome than some planner far away. So he favors spontaneous order. The second case where governments fail is when they are composed of individuals who behave for their self-interest, not for the common good (Timmerman). This is called the public choice theory.

So what can governments do? Firstly they can, in principle, alleviate the information problems. They can regulate the market (limit the quantity of healthcare to avoid moral hazard with people demanding the most expensive treatment while insured) and set minimum standards for doctors, so that they can decide instead of patients. However, this will mean that the government must actually have all the information, and must understand it. Furthermore, by acting in this manner government opens itself up to political pressure groups that can sway the regulation to their benefit. This can make the system less efficient, and actually more expensive when administration costs are accounted for.

Government can also provide compulsory insurance. This will make healthcare free at the point of consumption, eliminating the income discrimination. However, this will eliminate competition and thus there is no incentive to improve the quality of insurance over time, or to provide different insurance packages. The rich will suffer the most because they would have to pay double if they wanted higher quality from private insurance. Third party payment problem will remain and government is less likely to be able to think something clever to deal with it, compared to private insurance companies (they have found a way to internalize this externality by setting up insurance companies composed of doctors, the HMO-s).

There is some evidence that administration costs are smaller for state administered healthcare (UK compared to US, because no bills are sent out). However, the administration of a proper incentives quasi market will likely be very expensive. But this is required is public administration is introduced.

Government intervention can equalize the society. Transfers in healthcare might be more popular politically. However, this will force everyone in the society to accept the same value judgement about equality/efficiency trade off. This might be viewed as an infringement to individual liberties.

However, there is the second, public choice, issue with government intervention. Although some intervention might improve efficiency, once government is present it tends to grow, because officials will want to earn more and pursue their selfish motives. Thus it is very hard to keep government spending under control and over-provision is likely going to occur.

Thus it is very hard for a government to provide services effectively. It is likely going to invole a lot of slow trial and error, causing suffering in the short run, with the promise that our children will have excellent healthcare.

I will now move on to briefly evaluate the effectiveness of the internal market in the UK at present.

Firstly, there can be two measures of effectiveness – either compared to a theoretical optimal value, or compared to alternative systems abroad, which I will consider in turn.

In current case I am going to define effectiveness as being the provision of as much utility as possible with as little money as possible. So I will leave out equality issues. Furthermore, I will use the cost-utility analysis, not the cost-benefit nor cost-effectiveness analysis, due to various problems with applying them to healthcare. Furthermore, I will look mainly at the effectiveness in distributing the given amount of money and keeping the nation healthy with internationally comparable standards. I will not argue about the optimal size of the healthcare sector, or whether the international level of, e.g., life expectancy is optimal. This is because doing that would force me to explicitly price the human life. And although estimates of 1-10 million dollars have been provided, they are very inaccurate.

So how does the NHS distribute its money? Basically the current system makes GP-s fund-holders and hospitals trusts (more than half of the practices are organized that way). State has decided that it must insure everyone for various reasons. It gives the money to the GP-s. However, to introduce competitiveness the GP-s then have to shop around to provide services for their patients. This is so called the quasi market system. GP-s are paid flat fee per person they cater for. More is paid for elderly and extra is paid for preventive activity. People can change GPs if they are not satisfied. This system eliminates many of the market failures discussed previously. Healthcare is mostly free (=equal to all), some fixed charge must be paid (eliminates moral hazard), coverage is complete (eliminates adverse selection) and doctors will have the right incentives (not expensive). Also hospitals have incentives to be cost-effective, because they compete for GPs money.

However, in practice there are numerous problems. First the system has not become much cheaper than it was without the internal market. Furthermore the administration expenses have increased. Secondly waiting lists have increased. Although there has been an attempt to prioritize waiting lists by using QALY-s, it is not wide spread. Thus in general the concept of NHS is well thought, but it will take a few years to become implemented effectively.

Another problem in NHS is its investment expenditure. The incentives to invest have not been properly laid out in the planning of NHS. Only now has there been an attempt to allocate the hospitals and other resources evenly over the country. Furthermore, the regional pay differences were originally not accounted for causing shortage of doctors in the high-wage areas (London).

Internationally the performance of NHS has been pretty good. The life expectancy and IMR are below the OECD average. However, NHS is one of the cheapest systems around. However, one can argue IMR and life expectancy are biased measures, because the waiting lists and the aging hospitals are not taken into account.

The third measure of the effectiveness of NHS is what people think. In general people prefer state funded health care (Pirie). But the opinion of the public can very easily be changed by political campaigns. Thus it is very hard to tell whether they are actually happy with the system or not at present.

I think this essay illustrates the complexity of planning the state intervention to healthcare. It is also important to get the whole strategy right and not start fiddling with the system once it’s there. When empirical results show shortcomings, a whole new strategy needs to be implemented. Thus the current policy of keeping the NHS for about 40 has been optimal. Although better alternatives might have existed, the reform would have not been cost-effective. It is also sensible that the reform was done in one go, changing as little of the existing system as possible. Because of the complexity it is likely that the intervention will not be perfect the first time around. However, trial and error will provide policy makers with more date each time. So my personal view is that although the costs of NHS in terms of forgone efficiency are high initially, in the long run the investment into the system will pay for itself. But unfortunately we are all dead in the long run.



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