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This chapter attempts to explain to physicians how economists think about physicians and medical care. Economists' mode of thinking has shaped health care policy and institutions and thus the environment in which physicians practice. As a result, it may be useful for physicians to understand some aspects of this way of thinking even if at times it may seem foreign or uncongenial.

Physicians see themselves as professionals and as healers, assisting their patients with their health care needs. When economists are patients, they probably see physicians the same way, but when they view doctors through the lens of economics as a discipline, they see them as economic agents. In other words, economists are interested in the degree to which physicians respond to various incentives, both those that they face and those facing their patients, in deciding how to deploy the resources they control. Examples include how much of their own time to devote to seeing a patient; which tests to order; what drugs, if any, to prescribe; whether to recommend a procedure; whether to refer a patient; and whether to admit a patient.

This interest stems from fundamental economic questions: What goods and services are produced and consumed? In particular, how much medical care is available, and how much of other goods and services? How is that medical care produced? For example, what mix of specific services is used to treat a particular episode of illness? Who receives particular treatments?

Physicians in all societies live and function in economic markets, although those markets differ greatly from the simple competitive markets depicted in introductory economic textbooks and also differ from country to country, depending on an individual country's institutions. Many of the differences between actual medical markets and textbook competitive markets cause what economists term market failure, a condition in which some individuals can be made better off without making anyone else worse off.

This chapter explains two features of health care financing that cause market failure: selection and moral hazard. A common response to market failure in medical care is what economists term administered prices, which is another concept this chapter describes. Administered prices also exact an economic cost, leading to what economists call regulatory failure. All developed societies seek a balance between market failure and regulatory failure, a topic addressed in this chapter's conclusion.


In the idealized competitive market found in economic textbooks, buyers and sellers know the same amount about the good or service they are buying and selling. When one party knows more—or when goods of different quality are being sold at the same price, which is analytically similar—markets can break down in the following sense: There may be a price at which an equally well informed buyer and seller could make a transaction that would make them both better off, but the transaction does not occur because one party knows more ...

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