Topics in Economic Analysis 1 (TEA1)

Problem Set 1 - SKETCH of Answers

1. (a) Owing an uninsured car leads to uncertain wealth. Gregs expected utility in the
absence of insurance when parked in the street is
EU
street
uninsured
= 0.2
_
90, 000 50, 000 + 0.8
_
90, 000 = 280
Gregs expected utility when uninsured and parked in a garage:
EU
garage
uninsured
= 0.1
_
90, 000 50, 000 599 + 0.9
_
90, 000 599 = 288.95
> 280 = EU
street
uninsured
Thus, in the absence of insurance, Greg will park in the garage.
(b) Full insurance leads to certain wealth. Gregs utility when fully insured and
parked in a garage:
EU
garage
full
=
_
90, 000 5, 000 599 = 290.52
and his utility when fully insured and parked in the street:
EU
street
full
=
_
90, 000 5, 000 = 291.5
Thus, with full insurance Greg will park in the street.
Once Greg parks in the street which leads to the chance of loss being 0.2, while
being fully insured at 0.1 per unit of coverage, the insurer makes losses of (0.1
0.2)50, 000 = 5, 000.
(c) This is a moral hazard problem (hidden action is present).
2. (a) With the partial coverage, Gregs utility of this coverage with garage parking is:
EU
garage
partial
= 0.9
_
90, 000 599 0.1X + 0.1
_
90, 000 599 0.1X 50, 000 +X =
= 0.9
_
89, 401 0.1X + 0.1
_
39, 401 + 0.9X
His utility of this coverage with street parking is:
EU
street
partial
= 0.8
_
90, 000 0.1X + 0.2
_
90, 000 0.1X 50, 000 +X =
= 0.8
_
90, 000 0.1X + 0.2
_
40, 000 + 0.9X
We are looking for the partial coverage X that would make Greg indierent be-
tween garage and street parking, i.e. EU
garage
partial
= EU
street
partial
. Thus, one needs to
1
solve this equation for X. This is a formidable task, and you are not expected to
solve it. (One can solve this equation numerically, for example, using Mathemat-
ica software, or graphical calculator, or even playing around with Excel.) Thus,
for this course, it is sucient to write the above equation and substitute in it the
value X equal to $44,083.5:
EU
garage
partial
= 0.9
_
89, 401 0.1 44, 083.5 + 0.1
_
39, 401 + 0.9 44, 083.5 = 290.502
EU
street
partial
= 0.8
_
90, 000 0.1 44, 083.5 + 0.2
_
40, 000 + 0.9 44, 083.5 = 290.502
We always assume in this type of problems that, when indierent, a risk-averse
individual will take the action because this would reduce risk. Thus the insurer
will make zero prot here as probability of loss when the action is taken equals
to the per-unit premium 0.1.
To see that the condition EU
garage
partial
= EU
street
partial
) indeed determines the maximum
coverage, let us consider two alternatives. First, suppose instead that the insurer
oers a higher partial coverage of X
1
> X, at the premium per unit of 0.1.
Consider, for example, X
1
= 44, 100. It is easy to show that in this case Greg
would buy the partial coverage and park in the street, as EU
garage
partial
< EU
street
partial
,
so that the insurer incurs losses. Now consider instead that the insurer oers a
lower partial coverage of X
2
< X, at the premium per unit of 0.1. Consider, for
example, X
2
= 44, 000. It is easy to show that in this case Greg would buy the
partial coverage and park in the street, as EU
garage
partial
> EU
street
partial
- just what the
insurer wanted, as parking in the garage would lead to zero expected prots. But
given the free entry into insurance market, another insurer could come over and
oer Greg a slightly higher partial coverage of X
3
, at the premium per unit of
0.1, such that X
2
< X
3
< X. Consider, for example, X
3
= 44, 050. One can show
that Greg would prefer partial coverage X
3
to partial coverage X
2
, so that Greg
would sign insurance contract with the new entrant, rather than with our original
insurer.
Thus, the only way an insurer can make business with Greg and not to lose money
is to oer him a partial contract such that Greg is indierent between parking in
the street and in the garage.
(b) Since the partial coverage is $44,083.5, the co-insurance value =
44,083.5
50,000
100% =
88.17%.
3. (a) The actuarially fair on average insurance premium is
Premium = (.8 .5 +.2 .5) = 0.5
so that the total premium is 0.51, 000 = 500. Note that the actuarially fair on
average premium, in eect, involves subsidization of rock-lovers by jazz-lovers.
(b) For either type, if fully insured then:
EU
full,0.5
= ln(10, 000 0.5 1, 000) = 9.1590
2
The rock lovers will buy full coverage insurance at this premium because:
EU
rock
uninsured
= .8 ln(10, 000 1, 000) +.2 ln 10, 000 = 9.1261 < 9.1590 = EU
full,0.5
But the jazz lovers will be better o without insurance:
EU
jazz
uninsured
= .2 ln(10, 0001, 000) +.8 ln 10, 000 = 9.18927 > 9.1590 = EU
full,0.5
(c) Since only the rock lovers buy insurance, the insurance companys expected prot
per unit of coverage is:
E = 0.2 0.5 + 0.8(0.5 1) = 0.1 0.4 = 0.3
Since the actual total premium per average contract is .8 1, 000 = 800 > 500,
so the company is losing money.
(d) To make sure that the company is not loosing money, the premium should be
closer to the probability of loss by the rock-lovers. Recommend the company
instead to oer the insurance at a premium per unit of coverage of 0.8 at a total
premium of $800.
If there is only one type of insurance contract oering full coverage at 0.8 per unit
of coverage, the rock lovers still fully insure - even though this is more expensive
insurance:
EU
rock
full,0.8
= ln(10, 000 0.8 1, 000) = 9.1269 > EU
rock
uninsured
= 9.1261
But the jazz lovers still opt for no insurance as
EU
jazz
full,0.8
= ln(10, 000 0.8 1, 000) = 9.1269 < EU
jazz
uninsured
= 9.18927
Yet the company will break even, as this is an actuarially fair policy for the rock
lovers.
(e) This is an adverse selection problem (hidden characteristics are present).
4. If the company can not see the music taste, then the company should oer two dierent
policies: one oering full coverage at $800, and the other oering partial coverage of
X at total premium 0.2X, where X is such that the rock-lovers are indierent between
full and partial coverage, and the jazz-lovers are better o buying the partial coverage.
EU
rock
partial
= .8 ln(10, 000 1, 000 +X 0.2X) +.2 ln(10, 000 0.2X) =
= .8 ln(9, 000 + 0.8X) +.2 ln(10, 000 0.2X) = EU
rock
full
= 9.1269
This is a dicult equation to solve (so just writing the above equation would be su-
cient). If one solves the above numerically, the solutions are $12.644 and $49,942.64.
Obviously, the second value is too high for the company to oer. As usual for this
3
type of problems, we assume that the rock lovers will take the full insurance when
indierent, so that the insurer will make zero prots on their contracts.
Check that the value of $12.644 also works for the jazz lovers:
EU
jazz
partial
= .2 ln(9, 000 + 0.8 12.644) +.8 ln(10, 000 0.2 12.644) = 9.18929
which is just a bit better than being uninsured.
Again, to understand why we use the condition EU
rock
partial
= EU
rock
full
, let us consider two
alternatives. First, suppose instead that the insurer oers a higher partial coverage of
X
1
> X, at the premium per unit of 0.2. Consider, for example, X
1
= 13. It is easy to
show that in this case rock lovers would buy the partial coverage as EU
rock
partial
> EU
rock
full
,
so that the insurer incurs losses. Now consider instead that the insurer oers a lower
partial coverage of X
2
< X, at the premium per unit of 0.2. Consider, for example,
X
2
= 12. It is easy to show that in this case rock lovers would buy the full coverage, as
EU
rock
partial
< EU
rock
full
- just what the insurer wanted, as buying full coverage at premium
of 0.8 by rock lovers would lead to zero expected prots. But given the free entry into
insurance market, another insurer could come over and oer a slightly higher partial
coverage of X
3
, at the premium per unit of 0.2, such that X
2
< X
3
< X. Consider, for
example, X
3
= 12.6. But that would attract jazz lovers as EU
jazz
partial,X
3
> EU
jazz
partial,X
2
,
so that jazz lovers would sign insurance contract with the new entrant, rather than
with our original insurer.
Thus, the only way an insurer can make business with both jazz and rock lovers
and not to lose money is to oer one full insurance designed for rock lovers and one
partial insurance designed to make the rock lovers to be indierent, and which is more
attractive than no insurance by the jazz lovers.
5. * This problem is based on the material of Topic 2a Moral Hazard in the Insurance
Market: Continuous Case.
(a) For any given level of care e, Barbaras total expected utility is:
EU(e) =
_
1
1
e
_

L +
1
e

0 0.5e
2
=
_
1
1
e
_

L 0.5e
2
First-order condition:

L
e
2
e = 0 e
3
NI
=

L
Thus, Barbaras optimal choice in the absence of insurance is e
NI
= L
1/6
=
2.92402.
(b) If the level of care was observable, and if an insurer oered an actuarially fair full
coverage based on the level of care, Barbaras utility is:
EU(e) =
_
1
1
e
_
_
L
_
1
1
e
_
+
1
e
_
0 +L
_
1
1
e
_
0.5e
2
=
_
L
_
1
1
e
_
0.5e
2
4
First-order condition:

L
2e
2
_
1
1
e
e = 0 2e
3
FI
_
1
1
e
FI
=

L
Thus, the implicit equation for e
FI
is
4e
6
FI
4e
5
FI
L = 0 4 2.52434
6
4 2.52434
5
625 0
(c) To show that e
FI
< e
NI
, note that
e
3
NI
=

L and 2e
3
FI
_
1
1
e
FI
=

L
so that
e
3
NI
= 2e
3
FI
_
1
1
e
FI

_
e
NI
e
FI
_
3
= 2
_
1
1
e
FI
But since e [2, 3], we have that, for any e
1.41 < 2
_
1
1
e
< 1.63
Thus,
_
e
NI
e
FI
_
3
> 1 e
NI
> e
FI
An alternative way involves using the general method presented in Topic 2a.
Notice that our functional forms satisfy the requirements that v

> 0, v

< 0,
d

> 0, d

> 0, p

< 0, p

> 0, as well as that Lv

(L(1 p(e
min
)) < v(L). Equate
the two rst-order conditions (as both are equal to zero):
p

(e
NI
)v(L) d

(e
NI
) = Lp

(e
FI
)v

(1 p(e
FI
) d

(e
FI
)
Rearrange:
d

(e
NI
) d

(e
FI
) = Lp

(e
FI
)v

(1 p(e
FI
) p

(e
NI
)v(L) (1)
Since e
FI
> e
min
, we have that 1 e
FI
< 1 e
min
, and since p

< 0, we have that

p(1 e
FI
) > p(1 e
min
), i.e.
e
FI
> e
min
1 e
FI
< 1 e
min
p(1 e
FI
) > p(1 e
min
)
Now recall that v

< 0. That means that v

is a decreasing function. Thus since

p(1 e
FI
) > p(1 e
min
) we have that v

(p(1 e
FI
)) < v

(p(1 e
min
)), i.e.
p(1 e
FI
) > p(1 e
min
) v

(p(1 e
FI
)) < v

(p(1 e
min
))
Lv

(p(1 e
FI
)) < Lv

(p(1 e
min
))
5
That leads us to
Lv

(p(1 e
FI
)) < Lv

(p(1 e
min
)) (2)
Now the technical condition Lv

(L(1p(e
min
)) < v(L) means that the right-hand-
side of (2) is less than v(L). In turn, that means that the left-hand-side, also is
less than v(L). In other words:
Lv

(p(1 e
FI
)) < Lv

(p(1 e
min
)) < v(L)
Lv

(p(1 e
FI
)) < v(L)
Now because p

< 0, we have that

p

(e
FI
)Lv

(1 p(e
FI
)) > p

(e
FI
)v(L)
We can now use the above to evaluate the right-hand-side of the equation (1):
p

(e
FI
)Lv

(1 p(e
FI
)) p

(e
NI
)v(L) > p

(e
FI
)v(L) p

(e
NI
)v(L) = v(L)(p

(e
FI
) p

(e
NI
))
Combining this with the left-hand-side of the equation (1):
d

(e
NI
) d

(e
FI
) > v(L)(p

(e
FI
) p

(e
NI
)) (3)
This is our main inequality. We need to consider three cases:
Case 1: e
FI
= e
NI
. This cannot be the case as rather than inequality (3) we
would have equality:
d

(e
NI
) d

(e
FI
) = v(L)(p

(e
FI
) p

(e
NI
))
Case 2: e
FI
< e
NI
. Since d

> 0 we have than d

(e
FI
) > d

(e
NI
) so that the
left-hand side is negative. Since p

> 0 we have than p

(e
FI
) > p

(e
NI
) so
that the right-hand side is positive:
d

(e
NI
) d

(e
FI
)
. .
<0
< v(L)(p

(e
FI
) p

(e
NI
))
. .
>0
so that instead of inequality (3) we got the opposite inequality. Thus, we
cannot have e
FI
< e
NI
.
Case 3: e
FI
> e
NI
. Since d

> 0 we have than d

(e
FI
) < d

(e
NI
) so that the
left-hand side is positive. Since p

> 0 we have than p

(e
FI
) < p

(e
NI
) so that
the right-hand side is negative:
d

(e
NI
) d

(e
FI
)
. .
>0
> v(L)(p

(e
FI
) p

(e
NI
))
. .
<0
so that we got inequality (3). Thus, the only case we can have is e
FI
> e
NI
.
6
(d) Notice that with any full coverage, the monetary utility is the same, but the
disutility of care is increasing in care e. Thus, with unobservable care, Barbara
should choose the lowest possible level, e = 2, which leads to losses for the insurer:
E = L(p(e
FI
) p(e
min
)) = L
_
1
e
FI

1
e
min
_
= L
e
min
e
FI
e
min
e
FI
< 0
which is always negative because e
FI
> e
min
. To calculate prot numerically, get:
E = 625
_
1
2.52434

1
2
_
= 64.91
7