The Free Market in Healthcare – Another Fantasy

This is a departure from my normal political topics. In the past few days I have described why the free market does not work with the healthcare system in the United States at least two times. Because both were sort of ad hoc, I decided to write one that is a little more complete. Neither of my readers will mind a change in subject and I get to review interesting stuff.

This article is based on classical economic theory. The Austrian school of economics will argue that some of the assumptions below, notably perfect knowledge, are not valid. The Heritage Foundation has published a refutation of the original argument at I’ll come back to these later. Note that I am not a practicing economist so there will be valid disagreements with some of the items below. However, taken as a whole and observing the healthcare market, I believe the argument to be valid. Free markets, like all principles in economics, depend on certain conditions being present. In reality, there are very few markets where all the principles apply but in many cases, enough are true to get close to the “invisible hand”.

A market is an opportunity for buyers and sellers to come together to exchange goods and services for some medium of exchange, generally money. A “free market” is one where the laws of supply and demand operate “free” of influences outside the market itself.

You can find market assumptions in many places. The particular list I chose comes from a course at Swarthmore college (

Perfect Competition:

For a market to be free, the producers must have the same products to sell and the sellers have the same needs. Every doctor, nurse, lab, hospital or clinic must be indistinguishable. Given the flap over “you can keep your doctor”, I’d guess Americans don’t see doctors as interchangeable. Since we never know the cost in advance, you can’t argue that they get to choose the best price for value. The presence of insurance companies in the mix also makes it more difficult for either the buyer or seller to actually know in advance what the cost to the buyer will be. If you are having a stroke, you are not going to price shop Emergency Rooms in any event. It is also not at all clear that competition in US healthcare brings costs down except in very limited conditions.

Perfect information:

Buyers and sellers should have all the relevant information on the product and its pricing. Tough to do! It isn’t even clear what the product is. Is it a visit to the doctor’s office? A specific procedure the doctor performs? A series of treatments for a disease or chronic condition? Is it your health in general? Is it health insurance?

The medical community, even with WebMD and other health web sites, will know so much more than any consumer that they hold all the cards. A well-educated consumer can narrow the gap and should. But she will still be not be able to compete.  Moreover, since the buyer in most cases (employer-provided insurance) is not the consumer of the product, the consumer had little choice either in what was purchased or what kind of coverage is included.  Likewise, the provider of the product (doctor, lab) is negotiating with the buyer’s intermediary through his own intermediary (e.g., clinic or hospital group).  The chance to have common information on pricing is worse than on the product itself.

Perfect mobility of resources:

This deals with barriers to entry like regulation of hospitals or licensing of nurses and training of doctors. Medical schools set the number of US graduates that will be able to practice. Thirty-five states have laws (Certificate of Need) limiting the concentration of hospitals and certain kinds of devices.  They came about out of fear that too much availability would cause prices to rise to ensure that the equipment was profitable.  That is exactly the opposite of the way a free market is supposed to work but apparently there was evidence as far back as the ’60s that it was not working for health care.  Regardless of the reason for the laws, it is certainly a restriction of capital mobility.

Medical care is complex and no one wants unqualified people in those positions. The training and certification of the growing number of types of medical practitioners restricts the mobility of labor.

No externalities:

An externality is something external to the theory.  It is often considered to be the inclusion of any third party other than the buyer or seller. Other types of externalities would include the cost of disposal of medical and radioactive wastes, costs of administration, etc.  Many of the third parties are mentioned under “Perfect Information”.  Externalities interfere with the free dealings of buyers and sellers to obtain the optimum price for a given service.

Another factor in health care of course is that it is regulated.  Each state regulates the insurance companies and HMOs that operate there as well as doctors, hospitals and labs.  Government influence via regulation is a classic externality and adds to the cost.

No Public Goods:

Publicly provided goods are non-competitive. If Healthcare were all provided by a government, that public good would destroy the private market. In our world, only about half of healthcare (Medicare and Medicaid) is provided by the government but that is more than enough to disrupt a free market. Uninsured emergency room visits are also a public good since the law requires ERs to treat anyone who appears.

No Interdependence:

This refers to collusion between buyers and sellers. In healthcare, we see decisions made by the seller (medical provider) that can influence the amount of goods sold. For example, a doctor whose practice also owns a lab is more likely to prescribe tests that lab can conduct.  There is a temptation to  use the lab as long as it’s already there.  Also, since the doctor knows so much more the buyer can’t know if he is being oversold.

No economies of scale:

In a truly free market, no producer should be able to gain an advantage via economies of scale. In healthcare, large hospital groups, large insurers, large buyers (big, self-insured companies), large pharmaceutical companies and others all clearly have economies of scale and sometimes close to monopoly pricing power. Only state regulators get in the way.

Low transaction costs:

These are any costs paid by the consumer that don’t end up with the provider who delivers a treatment. They effectively increase the price of the service for the buyer without delivering anything to the seller and create another market distortion in the process.  In healthcare, this is a very complex analysis and includes everything from transportation to the provider, to the office costs of the providers, including their liability costs, cost of insurance overhead, etc. It has been estimated that transaction costs in US healthcare are around 25% of the amount spent on insurance. ( , footnote 29)


All this says that free market conditions do not exist for the healthcare market. It does not define a solution for delivering healthcare except to say that the solution is not a pure free market system. There are perhaps parts of it that meet enough of the conditions that they could be delivered in a free market. Other parts may need various kinds of intervention. The Heritage article mentioned earlier argues that the failure of market solutions does not mean a government-run system is necessary. That’s a straw man argument. The alternative is not necessarily a government-run system. The industrialized world is full of examples, all different and ranging from almost all government provided to largely private but regulated. But, in all cases, everyone or close to everyone has access to healthcare.  Except in the US!  The problem in all cases is that the system today is incoherent, disjointed, unpredictable for the consumer and not competitive.

There are other definitions of free market economies that tend to deal with a nation’s approach to the economy. These include individual rights, property rights, equal justice etc. In fact, all the items in those definitions are good descriptors of a free market economic system but do not deal with specific product markets within that economy.

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