If you are new to health policy, here’s a warning. You won’t spend very much time in the field before you hear the claim that Stanford University economist Kenneth Arrow has shown that free markets can’t work in health care. Here is Paul Krugman making the claim and here is Arnold Kling taking me to task for not responding to Arrow’s critique and a more recent variation on it by economist Joe Stiglitz in my book Priceless.

Mea culpa. I did ignore these arguments in Priceless, mainly because I don’t take them very seriously. But if Arnold thinks they deserve a rebuttal, let’s have at it. I’ll deal with the Arrow critique in this post and turn to Stiglitz on another occasion. (See Avik Roy’s summary of the Arrow arguments here and here.)

Basically, it all has to do with “asymmetry of information.” The doctor knows more than the patient. Therefore the patient has no choice but to trust the doctor and rely on her advice. There are quite a few problems that flow from this fact, but here is a big one: since the doctor has a financial interest in persuading the patient to overconsume health care, this “market imperfection” will lead to too much spending on medical care (to say nothing of the wrong kind of spending) and too little spending on everything else.

The problem with the Arrow critique of health care markets is that it implies that government intervention can make us all better off. But government faces the exact same asymmetry of information that you and I as patients face. And, as it turns out, government attempts to deal with the problem are demonstrably inferior to private sector alternatives.

What’s the worst thing that asymmetry of information can lead to? Basically, it’s fraud. Potentially, doctors (and other providers) can induce us to get care we don’t need — even risking our lives in the process. They can claim they have skills they really don’t have. They can bill us for services we never received. And make other “billing mistakes” that line their pockets at our expense.

The largest single buyer of health care in the United States, however, is government. And, it too faces an asymmetry problem: the providers have information the bureaucrats don’t have.

How well does government handle this problem? Miserably. Credible estimates put the amount of fraud in Medicare and Medicaid at 10%, or one out of every ten dollars spent. This amounts to a staggering $100 billion every year. Nor can there be much doubt about government incompetence in this regard. 60 Minutes managed to take its cameras to Florida and demonstrate obvious fraud in front of millions of television viewers. The New York Times and the Chicago Tribune at different times have documented rampant fraud in the Medicaid programs in their respective cities.

All in all, “government failure” in this sphere is so well documented, the claim that it exists is not even controversial.

To consider how things might be different, consider the credit card industry. Think how often you hand a credit card to a waiter or waitress or store clerk. Think how often a credit card of yours completely disappears from your view. Think about all the times you give your credit card information to a vendor over the telephone. Every time these things happen there is an opportunity for someone to use your card in a fraudulent manner.

Yet how often do you think credit card fraud actually occurs? Less than 1% of all credit card transactions are fraudulent.

I don’t have the space here to go into all the things the credit card companies do to deter fraud. But I will tell you two things worth noting: (1) they all cooperate with each other (and are allowed to do so under anti-trust law) and (2) they use highly sophisticated computerized systems. Interested readers can learn more here.

If the government would just privatize fraud deterrence (say by contracting it out to the credit card companies), I suspect that billions of dollars could be saved almost overnight.

In addition to the problem of outright fraud, health care differs from other markets in other ways. In general, there is no price transparency — patients rarely know how much a service will cost until after it is delivered. Hence there is no price competition and, for that reason, providers do not compete to lower costs either. Further, as I pointed out here, here and here, when providers don’t compete on price, they generally don’t compete on quality as well.

But these are all problems of the third-party payer system and readers of this blog know that we regard that system as one shaped and molded by government policies rather than free market forces. That’s why there is very little difference between government insurance and private insurance. When BlueCross is managing its private plans it acts pretty much the same as when it manages Medicare.

These problems are also the result of the efforts of organized medicine over many decades to suppress price competition and quality competition in the market for doctor and hospital services and to suppress normal market forces in the market for health insurance as well.

But how best to deal with these problems? Government or competitive markets? The way Medicare tries to keep doctors and patients from acting in their own self-interest with taxpayer money is by imposing all kinds of rules and restrictions and challenging the bills it receives. In fact Medicare actually denies more than one of every ten claims submitted to it by the providers of hospital care.

Contrast this approach with the behavior of competitors in markets dominated by people spending their own money out of pocket. Walk-in clinics not only post prices (thereby creating before-the-fact transparency), the nurses who run them, following computerized protocols, follow best practices more closely than traditional primary care doctors. If Medicare and Medicaid would simply pay the market price for the services offered by these clinics, the government could forget about denying claims and save money in the process.

Ironically, one of the goals of the Obama administration is to force the provider community to follow computerized protocols routinely. Doctors will understandably resist such “cookbook medicine,” especially where it is inappropriately encouraged. But the private sector seems to have no problem utilizing cookbook procedures where they are appropriate (e.g., in walk-in clinics) — without mandates or bureaucratic harassment.

For more serious surgical procedures, the market seems to outperform government as well. Both in the market for international medical tourism and domestic medical tourism, one finds price and quality transparency, package prices quoted in advance and competition on price, quality and amenities. Interestingly, Canadians who come to the United States for knee surgery (to avoid rationing by waiting in Canada) usually pay less than what Medicare pays!

I believe we are about to see an explosion of private sector services and products — all designed to deal with the so-called imperfections of the medical marketplace. The reason? There will be millions of consumers who will want it. Currently, there are about 27 million people who have a Health Saving Account (HSA) or a Health Reimbursement Arrangement (HRA) and employers are increasing the deductibles for just about everyone else. In addition, the Obama administration is about to announce a regulatory rule change allowing Flexible Spending Accounts to roll over year to year — thereby converting about 35 million use-it-or-lose-it accounts into use-it-or-save-it accounts.

As evidence of the need for heavy government involvement in the field of medicine, Arrow pointed to medical practice statutes that highly regulate who can deliver medical care. Yet as Milton Friedman pointed out in Capitalism and Freedom, these laws are mainly not protecting patients. They are instead protecting the providers. As Adam Smith observed of the medieval guild system, occupationally licensing is not guaranteeing that providers have the skills they claim they have. It is protecting the seller it the expense of the buyer. In medicine, it is propping up doctor incomes by restricting access to the medical marketplace.

In place of licensing, Friedman called for certification. Let government certify the skill levels of doctors, nurses, paramedics, etc. Then let patients make non-coerced choices among them based on their own preferences and needs.

The issue of occupational licensing brings into focus the most important fallacy in the Arrow critique of free market health care. There is also asymmetry of information in the political sector — politicians and bureaucrats have far more information than ordinary voters. In fact asymmetry of information in the political sphere is a far more serious problem than it is in almost any private market. This is one reason why occupational licensing almost always favors the producers and rather than the consumers. (See Monday’s post on Public Choice.)

What is needed is to combine an analysis of the “imperfections” of a free market for medical care with an analysis of the imperfections of government intervention in that market. In other words market failure must be weighed against government failure. When that is done, I am convinced the desired role for government will be one that is very small.

Fr John C. Goodman is President of the National Center for Policy Analysis, Research Fellow at the Independent Institute, and author of the bookPriceless:Curing the Healthcare Crisis.  

The Wall Street Journal and the National Journal, among other media, have called him the “Father of Health Savings Accounts.” Dr. Goodman’s health policy blog is the premier right-of-center health care blog on the Internet. It is the only place where pro-free enterprise, private sector solutions tohealth care problems are routinely examined and debated by top health policy experts across the ideological specturm.