Demand for Insurance
o :# - risk because there is a fear of the unknown
- forfeiting income in good times to get money in bad times
Risk Aversion
o :# U'(1)>0, utility increases with income
U''(1)<0, marginal utility for income is declining
Uncertainty
o :# - probability of sickness= P...
EC248 Final Questions and Answers
Demand for Insurance
o :# - risk because there is a fear of the unknown
- forfeiting income in good times to get money in bad times
Risk Aversion
o :# U'(1)>0, utility increases with income
U''(1)<0, marginal utility for income is declining
Uncertainty
o :# - probability of sickness= P (between 0 and 1)
- probability healthy= 1-p
- Is= income if sick
- IH>Is= income if healthy
E(I)= PIs + (1-P)U(IH)
Probability of Sickness
o :# - P=1
- E(U)= U(Is)= Is
- P=0
- E(U)=U(IH)= IH
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SEE GRAPH
Health Insurance Contract
o :# - customer pays up front fee
- r= insurance premium
- if ill customer gets q- insurance pay out
- sick: IH+q-r
- healthy: Is+0-r
- optimal: Is'=IH', full insurance with no uncertainty
Actuarially Fair Insurance
o :# - means that insurance is fair
- r=pq, q=IH-Is
- Sub in values to previous equations
Insurer Profits
o :# r= premium q= payout E(pi)= profit
E(pi(p,q,r))= (1-p)r + p(r-q)= r-pq
Fair and Unfair Insurance
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o :# - perfectly competitive: E(pi)=0, r=pq
- unfair: E(pi)>0, r>pq
Full Insurance
o :# Is'=IH'
q= IH-Is
Partial Insurance
o :# - doesn't achieve state independence
Is'<IH'
q<IH-Is
Comparing Contracts
o :# See Graphs
Chapter 8
o :#
Asymmetric Info
o :# - incomplete information about the quality of a good
Lemons Problem
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o :# - asymmetric info
- can't tell quality of good, 1 price
- adverse selection, only low quality goods remain in the market therefore don't buy,
market failure
Akerlof Model
o :# - Buyers value cars 50% more than sellers
- M= utility from other goods, X= quality of car
Us= Xj+M, Ub= 3/2 Xj+M
- car quality uniform distribution
- will put car on market if P>Xj, buyers buy if 3/2E(Xj)>P this is not possible therefore
no cars sell
- assumptions: buyers don't know true quality of car, buyers know sellers utility and
distribution of cars, buyers know sellers withdraw highest quality cars
Pareto Improving Transaction
o :# - transaction that leaves all parties at least no worse off
Adverse Selection
o :# - over supply of low quality goods, products or contracts that results
Lemons Problem and Insurance
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