From Integrated Questions

Is Health Care A Place For Free Markets?

Below is an essay (and I use that term loosely, reports with headings do not an essay make) I recently wrote for Public Finance III. I present it here in a largely unedited format.

Apologies for any problems with the tables. I seem to be having some rather embarrassing difficulties coding them properly.

Edit: Looks like the tables work fine, just didn’t display nicely in the preview. (Also, fixed an extra line break in Table 2).
Second Edit: Fixed the nbsp in Table 2.
Third Edit: Did the same thing for Table 1.
Fourth Edit: Added labels. Here’s hoping that’s all that needs updating.

Daniel O’Brien.


Health care provision is a complex and multifaceted subject with numerous different approaches to its provision. The role of the public and private sectors in financing and delivering health care differs greatly across nations and the impact these have on health outcomes are complicated to measure. Health care ranks in the top three expenditures in both GDP and tax spending in the majority of OECD nations. This government intervention is predicated on the argument that it can provide superior equity and efficiency to private markets.

I -Efficiency of Health Care

Besley and Gouveia state that ‘in an idealised economy, health insurance would be provided competitively. … The markets in which individuals purchased medical care would also be perfectly competitive. The resulting allocation of resources would be efficient’ (Besley and Gouveia, 1994). For perfect competition to be viable an insurance market needs to meet five conditions (Barr, 2004).

The first condition is that the probability of an individual needing treatment must be independent across all individuals. This is a reasonable assumption except during major epidemics. The second condition requires that the probability of an individual needing treatment be less than one. Though this condition is met for the great majority of illnesses, it is not met for significant categories, notably pre-existing chronic diseases and congenital illness. This leads to significant gaps in coverage in the private health care market. The third condition requires that the probability of an individual needing treatment be known or estimable. Though this is generally true, difficulties arise with policies that provide long-term benefits such total permanent disability cover. (Barr, 2004)

More substantial difficulties are found with the fourth and fifth conditions. The fourth requires that there be no significant adverse selection problems. Adverse selection is prevalent within health care insurance. As premiums rise, those who are less likely to need treatment will purchase less insurance. Thus the likelihood of treatment being required within the insured population will increase and the insurance company will be required to make a greater proportion of payouts, this will put further upwards pressure on the premium and lead to further adverse selection problems. This results in significant difficulties in acquiring insurance in high risk groups, notably the elderly population. (Barr, 2004)
The fifth condition requires that there be no significant moral hazard problems. Moral hazard is a major problem within many health care insurance markets and arises in three ways. Individuals with health insurance may be less likely to take precautions with their health. More substantially, some health care is choice-driven, notably pregnancy and doctor-consultations for seemingly minor conditions. This leads to either an increase in the consumption of health care or to gaps in coverage. The most substantial moral hazard issue is the third-party payment problem. This arises as a result of the arrangement of agents within the health care insurance market. Effectively, the primary cost-bearing agent, the insurance company, is divorced from the decision making of the doctor and the patient and thus has little direct impact on the level of consumption. Furthermore, neither the doctor nor the patient face the full social cost of health care and will thus over-consume. In the extreme case, where insurance companies cover all costs, the doctor and patient face zero private costs and will consume all health care that provides a positive private benefit, resulting in serious over-consumption. (Barr, 2004)
This can be further exacerbated where the doctor is paid on a fee-for-service basis and thus will have a positive private benefit for all health care consumption.

The failure to meet these conditions causes the health care market to fail to operate in a perfectly competitive manner and thus there is an inefficient allocation of health care goods. Government intervention, through public financing or delivery, may be useful to provide a more efficient allocation.

II – Equity of Health Care

Barr discusses two concepts of equity within health care. The first is that of horizontal equity, which calls for perfect information and equal power. Both of these are often absent within health care.

Patients face great difficulties in assessing their health care needs. Medical knowledge is very technical. Patients are generally ignorant as to the quantity of health care that they need and the quality that they are receiving. They are ignorant of various treatment options and of likely outcomes. Even previous personal experience in consuming health care is rarely of assistance, as many medical services are only used once in a life-time by any given individual.
This lack of information is exacerbated by the costliness of a mistaken choice, the high likelihood of the irreversibility of medical procedures and the high emotional involvement of the consumer. This can be exacerbated further by the potential for urgency issues (such as following a motor vehicle accident) and for patients to be incapable of making rational decisions (such as if they are unconscious or mentally impaired by their illness).
Unequal power is a result of patients lacking knowledge as described above, though expanded to include their rights in respect to the relevant health care system and their confidence and ability to articulate their legitimate grievances. Barr writes that it is implausible to imagine that this is the state of affairs for all consumers, though in the final analysis the issue is empirical (Barr, 2004).

The second concept is vertical equity – the redistribution of health care from rich to poor. This redistribution has become the norm in modern western economies. There are several reasons why such redistribution may be considered desirable. Firstly, the rich people may benefit directly from the altruism of helping others. Secondly, unhealthy people are likely to be less productive and may in fact foster further illness. In this case, providing health care to the poor may have a direct impact on the consumption level and general well-being of the rich. For example, more workers available will lead to lower wages which lowers costs for firms and thus lowers the price of goods consumed by the rich. Additionally, health care measures such as vaccinations are most effective when substantial portions of the population are treated. The rich gain direct health benefits from the vaccination of the poor and it may thus be in their best interest to provide such health care.

III – Arguments For and Against Government Intervention in Health Care

In markets facing externalities or other substantial failures, government intervention may be able to foster a more efficient outcome. Governments are also the principal mechanism for the redistribution of wealth for equity purposes.

Though many have argued for less government intervention in the health care sector, it is generally agreed that private health care markets suffer from significant failures as discussed above. Thus in most instances, the arguments for and against government intervention in health care markets are actually arguments about whether such intervention induces a more or less efficient outcome. For government intervention to be desirable on an efficiency basis the gains from an increase in efficiency must offset any deadweight loss incurred.

Governments face a myriad of options for intervention. These range from simple regulation, to public financing of private health care, to full public delivery in place of a private market. Simple regulations such as mandating minimum qualifications to become a doctor can help address some, but by no means all, of the incomplete information problems. Alternatively, governments can provide public financing of health care with or without public delivery.

In the case of public financing without delivery, health care services are provided by private firms. There are two general ways in which this financing could be structured. The first is through private finance for ‘easy’ cases in the form of regulated insurance markets, with state financing covering residual (i.e. largely uninsurable) conditions and for those unable to afford basic coverage. Regulations take the form of minimum standards of coverage and compulsory insurance for all citizens.
The second method is state finance. In this the state pays all medical bills, using either a social insurance system or tax revenue. As social insurance systems are not strictly actuarial, they avoid most of the gaps in coverage problems that arise in purely private markets. (Barr, 2004)

Alternatively, the government can both finance and provide health care. Such systems can overcome many of the failures inherent in private markets. Barr argues that public delivery systems such as the UK’s NHS can provide more efficient outcomes. He argues that doctors deciding treatment addresses the problems of consumer ignorance and that the system avoids many gaps in coverage by abandoning the insurance principle and providing tax-financed health care that is free at the point of use. The minimal use of fee for service arrangements limits the third party payment problem. Administrative rationing of health care provides a restriction to the quantity consumed, this helps prevent over-consumption of health care arising from the null cost to the consumer.

The issue of vertical equity is a normative one, that is to say it is values based and depends on the beliefs of individuals. Libertarians often support redistributions for the utility-boosting reasons described above, but believe that this should be on a voluntary basis rather than through enforced taxation. They often believe that the current level of redistribution is larger than the optimal level. Socialists support redistributions for their own sake, arguing that they increase equity and that the current level of redistribution is likely suboptimal.

IV – Role of the Public and Private Sectors in Australian Health Care

Australia’s health care system features a significant portion of both public and private involvement.
The federal, state and territory governments all play a role in the funding and delivery of health care. Medicare, the national health insurance scheme, is administered and funded by the Commonwealth Government. The state and territory governments administer the public hospital system, which is jointly funded by the state/territory and Commonwealth governments.
The private sector is composed of a mix of both not-for-profit and for-profit organisations and accounts for approximately one-third of health expenditure in Australia (Australian Bureau of Statistics, 2007). The private sector plays a strong role in the delivery of health care services, accounting for 55.8% of operating room use in 2004-05 (Australian Bureau of Statistics, 2007). 41.2% of hospitals in Australia are private, accounting for 32.4% of hospital beds (Australian Bureau of Statistics, 2007).

V – Differences between the Australian Approach to Financing and Delivery and the United Kingdom Approach

Within the United Kingdom the private sector plays a significantly smaller role than it does within Australia. Private insurance covers only 11% of the population as compared to approximately one-third within Australia (Ross et al, 1999). There are also fewer co-payments required in the United Kingdom, with payments required only for pharmaceuticals, eyesight tests and up to 80% of dental costs (Ross et al, 1999). Funding is overwhelmingly through general taxation.
Health care delivery within the United Kingdom is also predominantly provided by the government rather than the private sector. All hospital staff are salaried employees of the state, whilst general practitioners are self-employed individuals who contract their services to the state. Though similar conditions exists within Australia for general practitioners, hospital staff, especially doctors, within Australia undertake substantial quantities of private work, often within the hospital system. The Australian system also features a far greater proportion of fee-for-service arrangements than the United Kingdom system does.

VI – Differences between the Australian Approach to Financing and Delivery and the United States Approach

The United States health care system is substantially different from the Australian system. Financing within the United States is predominantly through private means, with 61% of the population in employment-related health cover, underwritten by tax concessions (Ross et al, 1999). The Federal Government finances free basic cover for the elderly and disabled, along with a safety net for the poor. However, there are no assurances of universal coverage and some 14% of the population is not covered by insurance or safety nets. This contrasts strongly with Australia which provides often free cover to all citizens and a number of non-means tested safety nets (alongside stronger safety nets for low income earners).
The majority of health care within the United States is provided by private, for-profit organisations (Ross et al, 1999). Again, this contrasts strongly with Australia where nearly two-thirds of hospital beds are within public hospitals (Australian Bureau of Statistics, 2007).

VII – Comparisons between the Australian, United Kingdom, and United States Health Care System Costs

Health care costs can vary quite significantly across countries. There are a number of ways to measure health care expenditure. Traditional methods include measuring the proportion of GDP spent on health care and comparing per capita PPP.
There are some potential difficulties in using the proportion of GDP as a measure of health care expenditure. In recessions when much of the economy is contracting, health care expenditure stays relatively constant (even more so in countries with a large public health sector). Thus the proportion of GDP spent on health care will rise in a recession and decrease in an expansion without underlying changes in actual health expenditure (Ross et al, 1999).
Per capita purchasing power parity avoids this difficulty. However, it does introduce problems concerning the use of a given basket of health care goods. This becomes particularly problematic when one considers that many basic health care goods differ substantially across nations. An example is the prevalent use of aspirin in the United States as compared with the use of paracetamol in Australia. Though direct costs of these two drugs are comparable, this may not be the case with preferred surgical procedures or powerful new drugs, especially chemotherapeutics. Furthermore, PPP is not adjustable for inflation and can thus not be compared across time (Ross et al, 1999)
Therefore, it is best to look at the data in conjunction with one another. That is, to compare both PPP and the proportion of GDP, along with other measures as available. Table 1 shows the expenditures in both PPP and the proportion of GDP for Australia, the United Kingdom, and the United States. It is quite evident that the United States spends far more per capita than either Australia or the United Kingdom. Indeed, it spends nearly twice the United Kingdom as a proportion of GDP and more than double in terms of PPP.

Table 1 – 2004 Health Expenditures in Australia, the UK, and the US
&nbsp GDP (2004) Per capita US$ PPP
Australia 9.5 3128
United Kingdom 8.1 2560
United States 15.2 6037

All data are 2004 figures
Source: OECD, 2007

It can also be important to look at differences in public expenditure across countries. The most frequently used method is to describe public expenditure as a proportion of total health expenditure. In 2004, the United Kingdom’s public expenditure was 86.3% of total expenditure, nearly twice that of the United States’ 44.7% and one-third higher than Australia’s 67.5% (OECD, 2007). It is interesting to note that across these three nations there seems to be a negative association between total health care expenditure and public health expenditure. This is perhaps empirical evidence that a public health system is more adept at avoiding the problems that contribute to the over-consumption of health care than a private system is.

VIII – Comparisons between the Australian, United Kingdom, and United States Health Care System Outcomes

It is not sufficient to compare health care costs across nations. If higher costs are associated with superior health care outcomes system may be preferable to the low-cost, low-outcome system. As such it is important to consider the health outcomes across the three nations. Unfortunately, health is a difficult concept to precisely define and there are thus extreme difficulties in measuring outcomes. Commonly used health indicators include infant mortality and life expectancy at varying ages. There may be some discrepancies in these data caused by changes in health care. For example, there is some evidence that infant mortality can rise slightly in the presence of greater reproductive services. This is because the availability of fertility treatment to women who previously could not become pregnant results in a greater number of high risk pregnancies. There are also associations between greater health and general welfare and delaying the age of first pregnancy. As age of first pregnancy is a significant factor in the risk of pregnancy, this too can have a negative impact on infant mortality. However, it is likely that these impacts are relatively minor and, as such, infant mortality and life expectancy are the most widely used health indicators.
Table 2 shows three health indicators for Australia, the United Kingdom, and the United States. Australia has the best results for each of the health indicators. The United States’ infant mortality is significantly high – only two OECD nations had higher rates (Mexico 19.7 and Turkey 24.6) (OECD, 2007). It should be noted that all three nations have infant mortality rates that are higher than the OECD average.

It is interesting to note that the country with the more mixed public-private system produces the best results of the three countries examined. However, the data set is far too small to provide any conclusive results.

Table 2 – 2004 Health Indicators for Australia, the United Kingdom, and the United States
&nbsp Infant Mortality Life Expectancy at Birth Life Expectancy at Age 65
Female Male
Australia 4.7 80.6 21.1 17.8
United Kingdom 5.0 78.9 19.1* 16.1*
United States 6.8 77.8 20.0 17.1

All data are 2004 figures except * – 2002 data
Source: OECD, 2007

IX – Conclusion

Government intervention in health care provision is an important and difficult topic. The clear failure of private markets to efficiently allocate health care services, and the superior health indicators in countries with stronger public involvement in health care clearly indicate the desirability of government intervention. The precise method of intervention is a far more contentious issue and it is strongly debateable which precise mix of public and private financing and delivery is optimal. Indeed, it is likely that there are a range of optimal solutions, varying with preferences, circumstances, and other factors.


Australian Bureau of Statistics 2007, ‘Health care delivery and financing’, Year Book Australia, no. 89, Cat. No. 3010, pp. 277-294.

Barr, Nicholas 2004, ‘Health and health care’, Economics of the Welfare State, 4th edition, Oxford University Press, Oxford.

Besley, Timothy, and Gouveia, Miguel 1994, ‘Alternative Systems of health care and provision’, Economic Policy, vol. 9, no. 19, pp 199-258.

OECD 2007, OECD Health Data 2007 – Frequently Requested Data, Last accessed: 01/10/2007

Ross, Bill, Nixon, Jen, Snasdell-Taylor, Jamie, and Delaney, Keir 1999, ‘International approaches to funding health care’ Occasional Papers: Health Financing Series, no. 2, Commonwealth Department of Health and Aged Care.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s