ECO 2023 Week 7 - Day 1 Lecture Notes
ECO 2023 Week 7 - Day 1 Lecture Notes Eco 2023
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This 5 page Class Notes was uploaded by Erika Huber on Monday October 3, 2016. The Class Notes belongs to Eco 2023 at University of Florida taught by Mark Rush in Fall 2016. Since its upload, it has received 15 views. For similar materials see Principles of Economics: Microeconomics in Economics at University of Florida.
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Date Created: 10/03/16
10/3/16 ECO 2023 Week 7 – Day 1 Lecture Notes Chapter 20: Risk & Insurance Risk and Insurance: Cardinal Utility We use the cardinal utility approach to study decisions under risk, especially the decision to buy insurance. Wealth (or income) Total Utility Marginal Utility (per $1,000) 0 0 - $1,000 150 150 $2,000 250 100 $3,000 300 50 $4,000 330 30 $5,000 350 20 Utility Wealth Curve Total Utility 300 200 This line shows all the different combinations of Expected Utility and Expected Wealth. 100 Wealth 1000 2000 3000 4000 5000 Expected Wealth and Expected Utility - Suppose there is a 50% chance of an accident and a 50% chance of no accident. o W = $1,000 with an accident; W = $5,000 with no accident o U = 150 with an accident; U = 350 with no accident - Consumers maximize their EXPECTED UTILITY o E(u) = Expected utility o E(w) = Expected wealth o E(u) = (150 * 0.5) + (350 * 0.5) = 250 (what you really need) o E(w) = ($1,000 * 0.5) + ($5,000 * 0.5) = $3,000 Insurance: Demand Will the person buy this insurance policy? - Premium = $2,000 - Pays $4,000 if there is an accident; pays $0 if there is no accident - Compare the expected utility with no insurance to the expected utility with insurance. - A person’s utility depends on their wealth. No Insurance I = $2,000 Accident (50%) o W = $1,000 o U = 150 No Accident (50%) o W = $5,000 o U = 350 E(U) = (150 * 0.5) + (350 * 0.5) = 250 Insurance I = $2,000 Accident (50%) W = $1,000 + $4,000 - $2,000 = $3,000 Looking at the chart, if your wealth is $3,000 then, U = 300 - ($1,000 = starting wealth = assume this) - ($4,000 = what insurance pays) - ($2,000 = price you have to pay to buy insurance / premium) No Accident (50%) W = $5,000 + $0 - $2,000 = $3,000 U = 300 E(U) = (300 * 0.5) + (300 * 0.5) = 150 + 150 = 300 E(U) = 300 The person will buy insurance because their expected utility with insurance is greater than their expected utility without insurance. Will the person buy this insurance policy? - Premium $4,000 - Pays $4,000 if there is an accident and pays $0 is there is no accident. - Again, compare the expected utility with insurance and without insurance. No Insurance Accident (50%) o W = $1,000 o U = 150 No Accident (50%) o W = $5,000 o U = 350 E(U) = (150 * 0.5) + (350 * 0.5) = 250 Insurance Accident (50%) o W = $1,000 + $4,000 - $4,000 = $1,000 o U = 150 No Accident (50%) o W = $5,000 + $0 - $4,000 = $1,000 o U = 150 E(U) = (150 * 0.5) + (150 * 0.5) = 150 The person will not buy insurance because their expected utility with insurance is less than their expected utility without insurance. Insurance: Supply With a premium of $3,000, will the company sell insurance? Probability of accident: 50% Cost: $4,000 Probability of no accident: 50% Cost: $0 Revenue Per Person $3,000 Expected Cost Per Person E(C) = ($4,000 * 0.5) + ($0 * 0.5) = $2,000 Expected Profit Per Person: $3,000 - $2,000 = $1,000 This is the average profit the insurance company will make on every policy. So yes, the insurance company is willing to sell insurance at a premium of $3,000, because the insurance company will get an average of a profit of $1,000 for every person they sell insurance to. Insurance: An Increase in Risk If the risk of an accident increases… The expected cost per person increases… So the premium increases, Probability of an accident: 80% Cost: $4,000 Probability of no accident: 20% Cost $0 Revenue Per Person $3,000 Expected Cost Per Person E(C) = ($4,000 * 0.8) + ($0 * 0.2) = $3,200 Expected Profit: $3,000 - $3,200 = -$200 No, the insurance company would not sell this insurance. To make a profit, the insurance company would have to increase the premium. Adverse Selection This comes about because people have private information Private information: information known to only one party to a transaction. Screening and Signaling Screening and signaling: The company wants to screen consumers into the appropriate risk group. They want to put riskier people into an insurance policy with a more expensive premium. o EX: teenage males And they want to put less risky people into an insurance policy with a less expensive premium. o EX: teenage females Low risk consumers want to signal their risk group. o EX: type of car you buy Two seater cars are riskier than 4 or more seats Why does the Affordable Care Act require everyone buy insurance? o If everyone buys it, then it makes the health insurance more affordable for everyone because the healthy people are helping make the health insurance cheaper. The healthy people subsidize the health insurance cost for the sick people. o But the healthy people tend to complain about this because they still have to pay more for this insurance than if it wasn’t required for everyone.
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