Healthcare And ‘Market Failure’ – Analysis


By Marc Fouradoulas*

In the face of illness and suffering, private markets for healthcare services allegedly fail. Since the 1960s, neoclassical economists have legitimized the regulation and collectivization of this sector under the term “market failure.” This assumption forms the foundation of the discipline of health economics and its attempt to replace the failed market using econometrics. In addition to widespread ethical principles such as equality of access and solidarity, health economics legitimizes collectivist state intervention for the development, maintenance, and regulation of national healthcare systems. The threat of government failure is to be averted by health policy interventions, and health economic models and research (health services research, econometric cost-benefit studies, etc.) are supposed to inform these interventions. Health economists — so-called social engineers — in line with politicians, aim at technocratic management of healthcare systems and the associated political discourse. The consequences are far-reaching: compulsory insurance, price controls, and third-party financing of all services ultimately transform the entire sector into a bureaucratic form of economy.

Characteristics of the Healthcare Sector

Healthcare systems are mass-scale. Their development is unpredictable and their complexity unmanageable. The abandonment of market mechanisms of price formation inevitably leads to misguided incentives, rigid structures, and bureaucratization. Instead of the spontaneous order of the market, a chaotic web of unclear claims and quid pro quos emerges. Collectivist funding entails moral hazard and escalating costs, followed by centralist attempts at control, such as increasing regulation and arbitrary rationing. Health economic research aims at healthcare policy (i.e., politicians) and leaves a wide scope for special interest groups. The attempts at political control inevitably take on planned economic characteristics. Depending on the system, the role of the market is maintained in the residual form of so-called regulated competition. However, regulated competition is not based on the willingness of patients to pay, but on diagnoses (diagnosis-related groups) and price-controlled fees, which must be financed by third-party financiers (i.e., by the collective). As the number of providers increases, an expansion of volume and a focus on lucrative service fees inevitably result from this distorted competition.

The discourse on system rescue conducted by stakeholder groups generally ends unproductively. Neither doctors, insurers, nor the general public have any interest in voluntarily deviating from their entitlements. The scope of “healthcare services” unfortunately remains unclear. The concept of illness itself is rarely defined. Also, academic medicine with its biopsychosocial understanding of illness contributes little to this clarification, since it remains vague about application and does not incorporate an economic dimension. Nevertheless, political discussions are based on a sharp distinction between health and illness, which is convenient. If a diagnosis is present, a so-called effective, expedient, and economic treatment is legitimized. The discussion is thereby shaped by an all-or-nothing thinking, with diagnosis as the clear signpost. Economists prefer to cite examples of simple reparative interventions such as elective operations (hysterectomy, cataract surgery), rare diseases (“orphan disease”), and excessively high drug prices. Public health experts refer to rough metric data such as mortality and satisfaction surveys to measure and legitimize the mass system. Unfortunately, the view of the actual problems is lost: an entitlement attitude to something that remains vague, coupled with the problem that medicine as such is not an exact science.

What Are “Healthcare Services”?

Healthcare services are heterogeneous goods and services that are available in different quantities, qualities, and combinations. They are not homogeneous, and nobody consumes health services per se. On the other hand, there is an equally large variety of providers, whose only common feature is a certificate from a university and a professional medical association, both monopoly organizations. Doctors are anything but uniform. One only needs to look at the growing range of specialist disciplines, subdisciplines, and special-interest certificates. What constitutes a “doctor” is not the result of market processes but a matter of academic and professional certification, usually by licensing monopolies. Furthermore, medical jargon and a guild-like organization (“organized medicine”) obscure the actual background and conditions of these services. Since healthcare services are already in the hand of organized medicine, the market is prone to fail.

Instead of dealing with regulation and the right of equal access to this construct as a whole, one would do better to focus should on specific services and needs themselves. Do services as diverse as ear rinsing, kidney transplantation, and psychotherapy actually have something in common that requires collective regulation and funding? Are they connected at all, despite their appropriation by organized medicine? A generalisation of these highly diverse services under the guise of “market failure” is hardly helpful. After all, the term “healthcare service” remains vague and refers to a variety of completely different services and products that depend upon different types of knowledge and degrees of skill.

The Doctrine of “Market Failure”

The American economist Kenneth Arrow first described market failure in relation to medical care in 1963.1 Arrow himself was a representative and cofounder of the so-called welfare economics and equilibrium theory. Equilibrium theory is based on the model of an ideal market, which can function optimally and efficiently only if certain conditions exist. The requisite conditions include the existence of perfect decision-relevant information (quality and price), homogeneous goods, consumer sovereignty, lack of externalities, and free market access. If these conditions are met, the market will be completely competitive, with supply and demand reaching a competitive equilibrium. It is a model that is based on mathematical derivations and leaves no room for the dynamic, uncertain, and ultimately entrepreneurial market process. If these conditions are not present, there is a “market failure,” and this supposedly legitimizes the state intervention.

According to Arrow and current health economic theory, the conditions of the ideal market for health services and health insurance are not given. Uncertainties, information asymmetries, and supply-side regulation are too great. Some of the specific sources of these characteristics are listed here for better understanding.

Uncertainty regarding:

  • onset of disease (coincidence) and efficacy of therapy
  • quality of diagnosis
  • necessity of medical services; patients can’t know what they need
  • extent of costs
  • consequences of illness, including impairment of the personal integrity of the affected, and the potential loss of his decision-making sovereignty and income opportunities

Information asymmetry:

  • the doctor’s advantage in knowledge and experience

Expected behavior of the physician is affected by:

  • principal-agent relationship: the physician advises the patient and thus influences demand
  • deviation from self-interest and profit motive towards collective orientation
  • treatment on the basis of objective parameters
  • trust and relationship element; no pretest of performance is possible

Supply-side regulation:

  • licensing by universities and professional medical associations

An Austrian Response: From Model to Reality

Models are always abstract simplifications of reality. Scientifically this may be legitimate. The benefit for the real world is the more relevant question, however. The equilibrium model is based on mathematical equations and does not take into account the complexities of human behaviour and environmental constraints. Similarly, the entrepreneur as an actor in overcoming these obstacles is dismissed.

In reality, markets are never perfect, but are in a process of striving for an optimum. Equilibrium is a state, but the market a process. The question, then, is rather: is the absence of a market, i.e., a state-organised healthcare system, better than a market with uncertainties? An all-or-nothing answer regarding the marketability of all healthcare services is hardly helpful. Further, to question marketability in a state of high supply-side regulation is comprehensible, but the latter is a consequence of previous intervention rather than a cause of market failure.

Uncertainty and Information Asymmetry

Uncertainties and information asymmetries are givens in markets. Lawyers, financial advisors, and career advisors all operate with uncertainties and information asymmetries. The client turns to them for lack of knowledge and experience. In the case of perfect information and certainty, such advisors — as well as the doctor — would be needless. In order to prevent the abuse of power by the gradient in competence, private markets allow for mediation through the obtention of second opinions, the availability of information from consumer protection organizations and rating agencies, or through guarantees. In trust-dependent professions, reputation continues to play a central role. Uncertainties only become a problem when they entail high, so-called catastrophic costs. Such catastrophes cannot be predicted for the individual, but in a large pool, they can be statistically predicted, which forms the basis of insurance.

Shopping for medical services with uncertainty and information asymmetry is frowned upon. The patient is supposed to be incompetent to decision-making in that state. Still, doctors use comparable standardized approaches to diagnose and treat illness. Hence, the costs somewhat comparable. What a patient needs is to some degree subject to a learning process similar to those that occur with the other purchases. Consumer sovereignty takes experience. On the other hand, a doctor who abuses his competence might risk his reputation. With widespread information available nowadays, it has become possible to compare diagnostic and therapy costs for moderate cases of illness. Is it unthinkable to privatize treatments such as iron deficiency, wound treatment, asthma, or colds? Especially with recurring conditions, it’s hard to frown upon a responsible approach to private diagnostic services. The embedding of all healthcare services in a third-party financed healthcare system with exclusive handling by highly specialized MDs  — the medical training takes at least twelve years in Switzerland — enforces a quality standard which is probably more luxurious than what a cost-conscious consumer would opt for voluntarily.

Arrow aptly described key elements of applied medicine but, as with the idea of a perfect market, the rationale he uses tends towards all-or-nothing thinking: for every form of medical consultation there is such a gradient of knowledge, skill, and vulnerability that the patient always seems at the mercy of the doctor. The patient is therefore always incapable, never able to judge, and always at risk due to illness. He is apparently not in a position to acquire knowledge and experience and learn to make independent decisions. On the other hand, the physician is attributed a standardized medical competence. But in reality there is no constant in that, either. Apart from acute and distinct situations, treatment styles can vary a lot. The variety of medical special-interest certificates is proof of this. Likewise the abandonment of the profit motive is an ideal-typical conception, which is not durable in reality.

Also, diseases are not always coincidental. A large part of chronic diseases can be traced to unfavourable behaviour. Around 80 percent of direct healthcare costs in Switzerland are caused by non-communicable diseases (NCDs, cardiovascular diseases, diabetics, cancer, and respiratory and musculoskeletal diseases). Estimates suggest that more than half of NCDs could be avoided or at least delayed with a healthy lifestyle. Chronically ill people therefore contribute in part to their diseases. They are not just victims of chance. Hence, the trade-off in these cases is always individual, (e.g., lifestyle change or insurance-funded drug?). In addition, healthcare may cause illness opportunism or “morbid gain,” in which people identify with illness and avoid responsibilities. In such cases treatments even have an illness-promoting effect.

Would patients rather seek empowerment when they are biased by insurance-related moral hazard or in a free market? Health literacy is the choice of the individual. After all, he is the expert on his perception and behaviour, and in this regard exhibits asymmetric information vis-à-vis the doctor.

The characteristics of unambiguously limited decision-making apply predominantly in acute illnesses and severe mental illnesses with a high degree of urgency. Unfortunately, health economic theory utilizes these rather extreme cases and extrapolates them to analyze all healthcare services. Patients thus get the impression that they cannot become masters of their health. This is tragic, since they have a lifetime to learn and shop for the best options instead of becoming subjects of learned helplessness, guided by the welfare state and organized medicine.

The Behavior of the Doctor

The problem of uncertainty regarding the onset of disease and the effectiveness of therapies is a reality. Limited decision-making sovereignty and personal vulnerability characterize the patient. Dealing with this is characteristic of the medical profession. Thus the physician advises the patient in his interest (“principal-agent” relationship) and adheres to a profession-specific medical ethic in his own interest. This is precisely what distinguishes him from a salesman and is intended to prevent abuse of power.

However, state licensing of the medical profession has made such a distinction needless. Trust no longer arises from ethical and thus economically appropriate action, but from the passed state examination and subsequent professional certification. The state-subsidized certificate thus stands in for reputation. The excessive length of training prescribed by the state and professional associations creates the impression of unattainable competence in the eyes of the patient.

The elimination of price differentiation through widespread price controls decouples quality from pricing. Detached from the willingness of patients to pay, prices will always yield to highest quality, e.g., specialist and academic, certification. Thus competition happens only on a quality level and inevitably moves towards higher specialization. The more proof of certification, the higher the quality. The gap between doctor and patient thus continues to widen. For the patient, however, the significance of certificates is unclear and the certification system itself remains opaque, as it does to many a doctor.

Since the physician as a person of trust is concerned about his reputation, he has hardly any incentives to abuse his power. But if he is insulated from the patient’s willingness to pay and becomes a monopolist through high barriers to entry (such as compulsory licensing) or insurance contracts, the patient is truly at his mercy. If the doctor mainly performs technical services financed by health insurance, such as radiologists do, the patient and society are at his mercy. The abuse of power is perfected.

State examination has thus become a unique entry barrier to medical monopoly and prestige. The temptation of medical prestige, a monopoly position, and income guarantee is reflected in the constantly increasing number of doctors. It is no longer the merit to the patient that counts. No. By price and service regulation medicine was detached from merciful achievement. Only the right to preserve vested rights remains. Although technical progress has reduced uncertainties, e.g., in the form of more precise diagnostic techniques, technical examinations have remained in the hands of doctors. The extent to which a doctor who only carries out technical examinations continues to be a doctor has never been questioned. Consequently, since technical procedures are not property of organized medicine, they may undergo a process of commodification leading to higher productivity and lower prices. E.g., allergy testing is not a medical service but a technical procedure separate from the consultation of an MD.


The idea of market failure originates in a highly abstract economic model. The discrepancy between the model and the real world is too great to allow markets to work. The assumptions it contains end up denying the marketability of all healthcare services in practice. But isn’t this discrepancy more a problem of the model than the real world?

Looking closer at the specific assumptions of market-failure theory, we find errors such as all-or-nothing thinking, overgeneralization, vagueness, and the confounding of cause and effect, as in supply side-regulation. Looking further at socialized medicine, we find that the neoclassical market model is not very helpful in real life, since bureaucratization of all healthcare services leads to a sluggish, rigid, mass-scale system, which cannot adapt to the needs of the patient and becomes subject to abuse by special interest groups. Furthermore, the adherence to state-subsidized licensing monopolies and the guild-like structure of organized medicine cements patient dependencies and capitalizes on them in an unfavorable way.

Omitting market-failure doctrine and the preservation of vested rights leads us to the question of which services are marketable and how and where social welfare is appropriate. The patient’s maturity and ability to judge and take responsibility will play a greater role. Ultimately, this assessment is a central task for physicians. E.g., a psychotic patient certainly can’t choose what’s best for him. A final answer to the question of marketability is therefore not possible. From a praxeological point of view, health is a desirable goal and a constant learning process. The challenge, therefore, is always how to empower the patient and conceptualise medicine outside the structure of organized medicine.

*About the author: Marc Fouradoulas practices medicine in Switzerland. He is a board-certified internist with a subspecialty in psychosomatic medicine. He holds a Master’s degree of advanced studies in managed health care.

Source: This article was published by the MISES Institute

  • 1.Kenneth Arrow, “Uncertainty and the Welfare Economics of Medical Care,” American Economic Review 54, no. (December 1963): 941–73,


The Mises Institute, founded in 1982, teaches the scholarship of Austrian economics, freedom, and peace. The liberal intellectual tradition of Ludwig von Mises (1881-1973) and Murray N. Rothbard (1926-1995) guides us. Accordingly, the Mises Institute seeks a profound and radical shift in the intellectual climate: away from statism and toward a private property order. The Mises Institute encourages critical historical research, and stands against political correctness.

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