It has for long been widely argued that free-markets do not provide the most efficient, and, certainly not, the fairest outcomes in areas like health care and education. Markets in these sectors are characterized by asymmetric information problems like adverse selection and moral hazard. The recent work of behavioural economists have added weight to such arguements.
Two interesting working papers illuminates the possibility of market failures in the market for health care and education.
It is argued that health care quality report cards (public disclosures of patient health outcomes at the level of the individual physician and/or hospital) help to allocate the sickest patients to the highest quality providers. However, using US national data on health care quality report cards of Medicare patients, researchers Dranove, Kessler, McClellan, and Satterthwaite found that on the contrary, it gives providers the incentive to totally decline to treat sick patients in order to improve their quality ranking.
They found that data of patients at risk for cardiac surgery was used by health care providers to filter patients and prefer/select more healthy patients for surgery. In other words, as the authors write, "Existing cardiac surgery report cards decrease patient and social welfare on net" and more needy patients end up with under-provision of services.
In a more recent working paper, W.Bentley MacLeod and Miguel Urquiola, find similar market failures and inefficient outcomes with respect to school reputation (measured by the achievements of its graduates) and the market for education. It had for long been argued that a free market in which schools compete based upon their reputation would lead to an efficient supply of educational services. However, research based on the economics of tipping point based segregation, have claimed that such competition invariably leads to inefficient and unfair outcomes.
The authors agree that if schools cannot select students based on their ability, then a free market is indeed efficient and raises school performance and student outcomes. However, if there is a possibility for them to select students based on innate ability by leveraging their reputation, then "competition leads to stratification by parental income, increased transmission of income inequality, and reduced student effort (all students face weaker incentives for academic effort) - in some cases lowering the accumulation of skill - and lower incomes for students who do not gain admission to selective schools".
In other words, in a selective school system, there is an "anti-lemon effect" - entry by relatively small schools that serve students within a specific ability range. In contrast, in a non-selective school system (where the distribution of student innate ability is the same at every school), competition leads to efficient outcomes - both student academic effort and improvements in school value addition are incentivized.
Further, if an educational system has poor measures of individual performance, then the market will set wages using other observable characteristics, such as the identity of the school or the district a student attended. In such cases, superior students from under-performing schools have no way to signal their skill, and will therefore rationally divert effort toward non-academic activities. The superior students in the good schools, firmly assured of attractive labor market placements, have an incentive to not stretch themselves to their limits and ride with the group. Even the not-so-good students in the high-reputation schools are likely to get attractive offers in the labor market by default.
The authors also claim that selective school systems are likely to be resistant to reform since parents with children at schools with good reputations will rationally resist efforts to make schools less selective. This makes it difficult to enhance school performance by reducing selectivity. They therefore propose the enhancement of individual incentives by the introduction of more rigorous standardized national testing, that would provide an alternate way to enhance performance.
They also claim that selective school systems "may help explain why it is so difficult to enhance school performance in urban areas where competition for admission into selective schools leaves many students behind in schools with adversely selected populations". Therefore, expecting a lower return from academic study, these students will rationally allocate their time to non-academic activities such as sports, part time jobs, crime, and parenthood.
Paul Krugman points to Kenneth Arrow's paper on why health care cannot be market like any other good and explains "why health care cannot be cured by the free market system".