Mises puts the consumer at the heart of the market process. He notes that, while entrepreneurs take the helm, the consumers are the captains of the ship and exercise consumer sovereignty over the market (Mises [1949] 2007,

269).1 Successful entrepreneurs are those who fulfill the wants and desires of consumers. If an entrepreneur brings to market a product that is anathema to consumer preferences, that entrepreneur’s business career is not long for this world.

As many other market process theorists, including Hayek (1948) and Kirzner (1973, 1997), have noted (with varying degrees of emphasis), producers’ success is a derivative of their ability to satisfy consumer demand. If a producer does not satisfy consumers’ desires for a low enough price, consumers are free to buy from another purveyor of goods and services, conditional on that other producer being in the market. The combination of free entry in the market for producers and the consumers’ ability to buy from any producer should satisfy consumer preferences with profits tending toward zero. In Kirzner’s view, this process is driven by the entrepreneurial role of both producers and consumers (Kirzner 1973). The entrepreneurial role of the producer is to be alert to profit opportunities afforded by gaps in supply that either lower the cost of an existing product or fulfill the desires of consumers with a new product. The entrepreneurial role of the consumer is to be alert to price differences among producers and to new products that fulfill their desires better than older products.

This process toward equilibrium may, however, be impeded if consumers are unable to effectively shop based on price or quality. This could be due to several factors: cognitive limitations of consumers, high search costs, high cost of switching from one producer to another, consumers not bearing the full marginal cost of buying the product, and so on. All these factors reduce the relative benefit a consumer gains from being alert. If a consumer is considering switching doctors, the consumer may not have access to information about quality, and if the consumer has access to quality measures, those measures may be incomplete and fail to address doctor characteristics like bedside manner. As noted by Mises (2007, 270), only a few sellers of goods and services directly interact with consumers, but the buying decisions of consumers trickle all the way up the supply chain to determine the prices of the most minute input. When consumers face impediments to shopping, this relay of information becomes distorted. I will describe how each of the factors listed above can limit the equilibrating effects of market competition. Because all those factors are present in the health care market, this exercise will provide a general way of viewing the market process in the health care market.

In general, the medical market is characterized by asymmetric information. This is a situation in which one party to an exchange has more information than the other about the product being sold. I will focus mostly on the issue of moral hazard. This is characterized by one party’s action being hidden from the other. An example from the medical context is the service that a doctor provides. A patient may visit a doctor and present certain symptoms. Because the patient is not a medical expert, she is not sure whether the condition is serious or mild and does not know what action should be taken to treat the condition. The doctor may choose the treatment that maximizes his benefit rather than the patient’s. Take the example of a stomachache and assume that the doctor knows the condition will resolve itself with no action on his part. In the extreme case, the doctor could recommend the removal of the appendix, and the patient would not know that this was a completely unnecessary procedure.2 This type of information asymmetry makes service quality hard to ascertain.

When consumers face cognitive or informational limitations3 in understanding the product for sale, the role of consumer alertness is necessarily dulled and, therefore, ex ante profit opportunities that benefit the consumer are reduced. If consumers do not understand a product, such as health insurance,4 the alertness consumers exercise may only reveal false profit opportunities, since the consumers may choose a cost-increasing option without realizing their mistake. Given the cognitive and informational limitations of consumers, it may then not be in the producers’ best interest to introduce a product that provides the consumer with a lower-cost option. This is often the case with consuming doctors’ services, in which case the provider has much more information than the consumer, but if this is the case, we should ask why it may be difficult to get a second opinion.

High search costs and high switching costs are often blamed to some extent for why the health care market is different from other markets. On the one hand, thinking on these two particular topics tends to be plagued by the nirvana fallacy in the form of assuming that these costs should not exist and that the government should regulate these costs away.5

On the other hand, it can sometimes be a beneficial exercise to consider a market in which things are not as they currently are; in this case, a market with lower search and switching costs. The important thing to remember is that we must understand why those costs are present, and if we think a world in which those costs are lower is possible, the next issue to consider is what is impeding the reduction of those costs through competition. If there are rules that impede entrepreneurs from providing cost-reducing services to consumers, then we can fruitfully analyze the implications of removing those impediments. If the issue is search cost, then we must ask why an information aggregator has not emerged to provide consumers with the relevant information (more on this topic below). If the issue is switching cost, we should ask why there may not be enough doctors in an area to make switching relatively easier. It may be that there are restrictions on entry into the health care market, and restrictions on market entry or on certain uses of price and quality of information forestall entrepreneurial activity on the supplier side.

Lastly, most of the marginal cost of health care is not borne by the consumer of health care due to current payment models, which tend to be fee-for-service arrangements in which the provider is paid for each service rendered. These payment models not only allow consumers to face a lower marginal cost at the point of care through a system of premiums, co-pays, and coinsurances, but most of these payment models also separate the financing decisions from treatment decisions. Taking these in turn, if consumers do not bear the full marginal cost of care, then the relative profit from their alertness decreases, thus reducing consumers’ incentives to be aware of lower-cost alternatives. Because of the separation of financing and treatment decisions, doctors have less of an incentive to control costs than if they were also in charge of financing the care.6 With this fee-for-service payment, the doctor faces no incentive to provide a particular quality of care at the lowest cost and has an incentive to overtreat the patient because she benefits with each procedure performed. With capitation payment (fee per patient), the doctor has an incentive to undertreat the patient given that the payment is the same independent of quality. As in the cases above, these payment structures only impede the market process if there is some restriction on alternative payment methods.7

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