The complete summary of the course welfare state economics. In-class discussions are included, to provide an as complete as possible summary to prepare you for your examination.
Welfare State Economics lecture summary
Welfare State Economics lecture 2: Insurance Theory
- Demand for insurance
o Why interested?
- Supply of insurance
o 4 conditions
o 2 problems: moral hazard and adverse selection
- Empirical analyses of the two problems
Demand for insurance: may be beneficial for individuals if uncertainty causes disutility →
risk aversion.
This means there are two conditions for insurance demand:
- Uncertainty about utility outcomes.
- Decreasing marginal utility of income.
Insurance provides certainty … Slide 3
Suppose U(y) denotes the utility U as a function of income/wage y.
When you want insurance:
U(y)>0 : utility is positive
U’(y)>0 : utility increases with income
U’’(y)<0 : increase in utility smaller for higher income
Definitions/assumptions:
- Suppose there are two possible outcomes:
o With probability p, you receive income y1
o With probability 1-p, you receive income y2
o
o There is a utility loss because of uncertainty. In a world without uncertainty
you can follow the green line, with
o Willingness to pay for insurance is determined by the distance between:
▪ Utility of expected income
▪ Expected utility of income
, o Example:
▪ U(y) = wortel van y -> concave slope
▪ Income of 225 with probality 0.8 and 25 with probability 0.2
▪ Expected amount (E(y)): 185 = 225*0,8 + 25*0,2
▪ 0,8 wortel225 + 0,2*wortel25 = 12+1=13 expected utility
▪ Certainty equivalent of this utility level
• y2=169
• difference between straight line vs concave
▪ willingness to pay for insurance?
▪ Fair premium 225-185=40
▪ Plus willing to pay for certainty: 185-169=16
• So 56 willingness
▪ Characteristics for utility:
• Positive
• Going up
• Decreasing
o
o
-
Supply side of insurance:
- Insurers essentially pool risks to reduce risks for individuals. The average risks of
individuals decreases.
- The four conditions to step into this market:
o 1. Risk probabilities are independent: individual risks, not common shocks.
The law of large numbers doesn’t work anymore, diversifications needed.
Unemployment risk correlated with business cycle, which applies to large
groups of workers
o 2. Probabilities less than one. Risk, not certainty. Medical insurance for the
elderly.
o 3. Known probabilities. Risk not uncertainty. Rare events: natural disasters.
Complexity of problem: insurance for pension indexing against future
inflation? Long term contracts: in the long term, risks may become unknown,
like long term care due to medical advances.
o 4. No asymmetric information. There has to be a plain field.
▪ Hidden actions (to increase your risks) causes moral hazard.
, ▪Hidden knowledge causes adverse selection: individuals with high risks
are contracted, rather than low risks
▪ Moral hazard: this behaviour wouldn’t have been there because of the
insurance.
o Outcome is over-insurance.
▪ Deadweight loss due to elastic demand (due to moral hazard) P*xQ**-
Q*=DWL
▪ Endogeneity (individuals can change risks) is a necessary but not
sufficient condition for moral hazard
• Four cases of endogenous risks:
o 1.
o 2. Low psychic costs of moral hazard (ignore being sick)
o 3. High gains of moral hazard: insured event is
deliberate act, you exploit it. (childbirth, hair transplant)
o Not risk but costs are endogenous (supply side; third
party problem)
▪ No incentive to prevent high costs
▪ Another way to classify:
• Reduced precaution (car
• Increased odds of staying in the adverse state (unemployment
• Increased costs when in adverse state (third party)
▪ How can we fight moral hazard?
• Regulation/inspection: getting more information that causes
moral hazard
• Less insurance: taking away the incentive. Providing less
insurance.
o Experience rating: determined by past behaviour.
o Deductibles: fixed amount of the costs
o Co-payments: proportional amount of the costs
o Stricter eligibility conditions: where is the problem of
moral hazard the biggest?
▪ Adverse selection:
• Individuals have private information on certain risks and this
information is not available for the insurer
• → consequence: there can be no market, or incomplete market
(with underinsurance)
• One drastic solution: one single pooling contract with
compulsory participation.
• Examples:
o 2nd hand cars
o Medical insurance
o Car insurance (drives like a madman)
▪ Voluntary pension contracts
o Model of adverse selection:
▪ Two types of risks, high and low
▪ Individuals types are unknown, but the distribution of risks is observed.
▪ A is income when working
The benefits of buying summaries with Stuvia:
Guaranteed quality through customer reviews
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through credit card or Stuvia-credit for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying these notes from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller wesselnagelgast89. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy these notes for $8.29. You're not tied to anything after your purchase.
