Economics of Public Sector II

Spring/Summer semester, 2023

July 3 (11/13)

1
Course contents
• April 10 Review of Economics of the Public Sector I
• April 17 Budget Analysis
• April 24 Cost-Benefit Analysis
• May 8 Political Economy (1)
• May 15 Political economy (2)
• May 22 Economics of Local Government (1)
• May 29 Economics of Local Government (2)

• June 12 Midterm Exam. & Review

• June 19 Education
• June 26 National Defense, and R. & D.
• Juｌｙ 3 Social Insurance
• July 10 Welfare Policy
• July 24 Final Exam.

2
SOCIAL INSURANCE
In the previous lectures, we have reviewed the role of
government spending on education, defense, and R&D.

Today, I will briefly explain social insurance, for which the

government has been playing an increasing role in recent
years.

Focus questions today.

 What market failures justify the provision of public social

insurance?

 Do individuals always need public social insurance?

 What is the moral hazard cost of social insurance, and why

is it economically important?
3
SOCIAL INSURANCE (cont.)
Facts:
Looking back the history of the U.S., the government’s
spending priorities have shifted dramatically away from
“national defense” toward promoting “the general welfare.”
Government Spending for the US, FY1960 Government Spending for the US, FY2020
Pensions, 9 Interest, 455.3 Balance, -0.5
Balance, -2.5
Interest, 8.6
Health Care, 5.2

Other
General Spending, Pensions,
Other Government, 353 1,218.30
General Spending, 1,492.80
Government, 3.7 16.3
Education, 19.4 Transportation,
403.7
Transportation, Health Care,
12.3 Protection, 322 2,024.20
Welfare, 1,307.90
Protection, 3.7
Welfare, Defense, 61.8
8.6
Education,
Defense, 1,299.80
1,012.10

By 2020, only 10￠of each dollar of US government spending

went to fund national defense, and 49￠was paid for Pensions,
Health Care, and Welfare.
4
SOCIAL INSURANCE (cont.)
Facts (cont.):

Health care spending are primarily on two program: the

Medicare program, which provides universal health insurance
coverage to the elderly, and the Medicaid program, which
provides free health insurance to many poor and disabled
people.

The programs that have grown over the past 50 years in the
U.S. are labeled collectively as social insurance programs,
government interventions to provide insurance against
adverse events.

5
SOCIAL INSURANCE (cont.)
The following social insurance programs are available in the
U.S.

 Social Security, which provides insurance against earning

loss due to death or retirement.
 Unemployment insurance, which provides insurance against
job loss.
 Disability insurance, which provides insurance against
career-ending disability.
 Medical insurance, which provides insurance against
medical expenditures.

In my lecture on "Economic Analysis of Social Security

Systems" in the following semester, we will study the
individual social security system one by one.
6
SOCIAL INSURANCE (cont.)
These social insurance programs have several common
features.

 Workers participate by “buying” insurance through payroll

taxes or through mandatory contributions that they or
their employers make.
 Program eligibility is conditioned only on making
contributions and on the occurrence of the adverse event.
 Eligibility is not means-tested; that is, eligibility does not
depend on the level of one’s current income or assets.

Instead of getting into particular social insurance programs,

we first try to understand the general economics of insurance
markets today.
7
SOCIAL INSURANCE (cont.)
WHAT IS INSURANCE AND WHY DO INDIVIDUALS VALUE IT?

We start our discussion of government insurance provision with an

understanding of what insurance is and why it is so valuable to
consumers.

What is Insurance?

Insurance has a common structure.

 Individuals, or those acting on their behalf, pay money to an

insurer, which can be a private firm or the government. These
payments are called insurance premiums.

 The insurer, in return, promises to make some payment to the

insured party, or to others providing services to the insured
party (such as physicians or auto repair shop). These payments
are conditioned on a particular event or series of events (a
doctor’s visit or an accident)..
8
SOCIAL INSURANCE (cont.)
WHAT IS INSURANCE AND WHY DO INDIVIDUALS VALUE IT? (cont.)
What is Insurance? (cont.)

This broad definition covers the wide variety of private

insurance products, including:

 Health insurance: Individuals pay premiums to insure

against health problems and the medical bills.
 Life insurance: Individuals pay premiums to provide income
to the heirs of those who die.
 Casualty and property insurance: Individuals pay premiums
to insure their homes, cars, and other properties against
fire, natural disasters, accidents, and theft.
9
SOCIAL INSURANCE (cont.)
WHAT IS INSURANCE AND WHY DO INDIVIDUALS VALUE IT? (cont.)
Why Do Individuals Value Insurance?

Insurance is valuable to individuals because of the principle of

diminishing marginal utility.

The principle means that, given the choice between (1) two years of
average consumption and (2) one year of excessive consumption
and one year of starvation, individuals would prefer the former.

Thus, individuals desire consumption smoothing: they want to

translate consumption from periods when it is high to period when
it is low.

When outcomes are uncertain, people want to smooth their

consumption over possible outcomes, or states of the world. In
other words, utility is maximized by having the same consumption
regardless of the outcome of some uncertain event.
10
SOCIAL INSURANCE (cont.)
Diminishing Marginal Utility & Consumption Smoothing

U U(0.5C1+0.5C2) > 0.5U(C1)+0.5U(C2)

U(C2)

U(0.5C1+0.5C2)

0.5U(C1)+0.5U(C2)

U(C1)

C1 CM C2 C
=0.5C1+0.5C2

11
SOCIAL INSURANCE (cont.)
WHAT IS INSURANCE AND WHY DO INDIVIDUALS VALUE IT? (cont.)
Why Do Individuals Value Insurance? (cont.)

Individuals choose across consumption in states of the world

by using some of their income today to buy insurance against
an adverse outcome tomorrow.

The fundamental result of basic insurance theory is that

individuals will demand full insurance in order to fully smooth
their consumption across states of the world.

Given diminishing marginal utility, the full insurance gives

individuals a higher level of utility than does allowing the
accidents to lower their consumption. 12
SOCIAL INSURANCE (cont.)
WHAT IS INSURANCE AND WHY DO INDIVIDUALS VALUE IT? (cont.)
Formalizing The Intuition: Expected Utility Model

The expected utility model helps you understand the

standard mechanism that economists use for modeling
choices under uncertainty.

Suppose that there is an uncertain outcome, with

some possibility p of an adverse event. Then expected
utility is written as

EU= (1-p)×U(consumption with no adverse event)

+ p ×U(consumption with adverse event)
13
SOCIAL INSURANCE (cont.)
WHAT IS INSURANCE AND WHY DO INDIVIDUALS VALUE IT? (cont.)
Formalizing The Intuition: Expected Utility Model (cont.)

We can use this model to examine an individual’s decision over

how much insurance coverage to buy.

An individual has a choice of insuring some, none, or all of

potential expenses, but this will cost him/her m¢ in insurance
premiums per dollar of expenditures covered.

If he/she buys an insurance policy that pays $b if he is in trouble,

his premium is $mb. So, if he buys the insurance,

 in the state where he doesn’t get involved in a trouble, he will be

$mb poorer than if he doesn’t buy the insurance.

 in the rare state where he does get involved in a trouble, he will

be $(b-mb) richer than if he hadn’t bought the insurance.
14
SOCIAL INSURANCE (cont.)
WHAT IS INSURANCE AND WHY DO INDIVIDUALS VALUE IT? (cont.)
Formalizing The Intuition: Expected Utility Model (cont.)

Thus, purchasing insurance is the way an individual can

effectively translate consumption from periods when
consumption is high and, therefore, has low marginal utility
to periods when consumption is low and has high marginal
utility.

An individual’s interest in translating consumption from the

no trouble state to the trouble state will depend on the price
that is charged for insurance.

We first assume that insurance companies charge an

actuarially fair premium, i.e., an insurance premium that is
set equal to the insurer’s expected payout.
15
SOCIAL INSURANCE (cont.)
WHAT IS INSURANCE AND WHY DO INDIVIDUALS VALUE IT? (cont.)
Formalizing The Intuition: Expected Utility Model
(cont.)
The central result of expected utility theory is that with
actuarially fair pricing, individuals will want to fully insure
themselves to equalize consumption in all states of the world.
In other words, full insurance is optimal.

This individual’s utility is higher if he/she buys the insurance, even though
he/she will almost certainly end up paying the premium for nothing.
16
SOCIAL INSURANCE (cont.)
WHAT IS INSURANCE AND WHY DO INDIVIDUALS VALUE IT? (cont.)
Formalizing The Intuition: Expected Utility Model (cont.)

With actuarially fair premiums, the efficient market outcome in the

insurance market is full insurance, and thus full consumption
smoothing.

Formal Expected Utility Model is described by the following

parameters:

1) An individual is hit by a car with some probability p.

2) His/her income is Y, regardless of whether he/she gets hit or not.
3) If he/she gets hit, he/she incur medical costs δ.
4) He can buy insurance, with premium m per dollar of insurance.
5) That insurance will pay him/her $b if he/she is hit by the car.

17
SOCIAL INSURANCE (cont.)
WHAT IS INSURANCE AND WHY DO INDIVIDUALS VALUE IT? (cont.)
Formalizing The Intuition: Expected Utility Model (cont.)
We can write the individual’s expected utility as

Since there are two unknowns, i.e., m and b, we need to add one
more condition to solve this problem. If the insurance is priced in
an actuarially fair manner, the zero expected profit condition for
the insurer holds.

This, in turn, implies that m=p. If we know the concreate form of

utility function, say , we can solve the expected utility
maximization problem as below.

18
SOCIAL INSURANCE (cont.)
WHAT IS INSURANCE AND WHY DO INDIVIDUALS VALUE IT? (cont.)
Formalizing The Intuition: Expected Utility Model (cont.)
The FOC (first order condition) of this maximization problem is given as

By solving the FOC for the optimal level of insurance benefits, we

obtain ∗ . This means that the individual should buy full insurance to
smooth their consumption across states.

By plugging ∗
into the utility function we can confirm that

which means that consumption is equalized at Y in both states of the

world.

So, facing actuarially fair insurance markets, individuals will want to

insure themselves fully against risk. 19
SOCIAL INSURANCE (cont.)
WHAT IS INSURANCE AND WHY DO INDIVIDUALS VALUE IT? (cont.)
The Role of Risk Aversion

Important difference across individuals is the extent to which they

are willing to bear risk, or their level of risk aversion.

Individuals who are very risk averse are those with a very rapidly
diminishing marginal utility of consumption.

Risk averse individuals are happy to sacrifice some consumption in

the good state to insure themselves from large reductions in
consumption in the bad state.

Individuals who are less risk averse are those with slowly
diminishing marginal utility of consumption. They are not willing to
sacrifice very much in the good sate to insure themselves against
the bad state.
20
SOCIAL INSURANCE (cont.)

WHAT IS INSURANCE AND WHY DO INDIVIDUALS VALUE IT? (cont.)

The Role of Risk Aversion (cont.)

Individuals with any degree of risk aversion will want to buy

insurance when it is priced actuarially fairly; so long as
marginal utility is diminishing.

When insurance premiums are not actuarially fair, those who

are very risk averse may be willing to buy insurance even if
those who are not very risk averse are unwilling to buy.

21
SOCIAL INSURANCE (cont.)
WHY HAVE SOCIAL INSURANCE? ASYMMETRIC INFORMATION AND
ADVERSE SELECTION

Here, we review some common motivations suggested by economists for

government intervention in insurance markets.

Asymmetric Information

Insurance markets are marked by information asymmetry, the difference

in information that is available to sellers and to purchasers in a market.

It can arise in insurance markets when individuals know more about their
underlying level of risk than do insurers. And the asymmetry causes the
failure of competitive markets.

The market failure caused by information asymmetry is best illustrated by

the market for used cars, or lemons, as it is documented in Akerlof (1970).
22
SOCIAL INSURANCE (cont.)
WHY HAVE SOCIAL INSURANCE? ASYMMETRIC INFORMATION
AND ADVERSE SELECTION (cont.)

Asymmetric Information (cont.)

Sellers of used cars know their vehicles’ problems, while potential

buyers may not.

Some individuals selling a car may be doing so because they have

a “lemon,” a car that has serious defects. Buyers of cars don’t know
whether they are getting a lemon, and they cannot necessarily trust
the information provided by the sellers because the sellers may
want to damp their lemons on unsuspecting buyers.

Therefore, buyers might avoid the used car market altogether.

As a result, overall demand in the used car market is low, and

sellers of used cars on average receive less of their cars than they
are worth. 23
SOCIAL INSURANCE (cont.)
WHY HAVE SOCIAL INSURANCE? ASYMMETRIC
INFORMATION AND ADVERSE SELECTION (cont.)

Asymmetric Information (cont.)

In insurance markets, the purchasers of insurance may know

more about their insurable risks than the seller (insurer) does.

In this case, the insurer will be reluctant to sell insurance.

e.g. Only the sick demand health insurance.

Only those about to lose their job will demand unemployment insurance.

As a result, insurers will charge higher than actuarially fair

premiums, or they may not sell insurance at all. 24
SOCIAL INSURANCE (cont.)
WHY HAVE SOCIAL INSURANCE? ASYMMETRIC INFORMATION AND ADVERSE SELECTION (cont.)
Asymmetric Information (cont.) Example with Full Information

Imagine that there are two groups, each with 100 persons.

 One group is absentminded and doesn’t pay attention when

crossing the street. As a result, members of this group have a 5%
chance of being hit by a car each year.

 The other group is careful and always looks both ways before
crossing the street. Members of this group have a 0.5% chance
of being hit by a car each year.

What effect would the existence of these two different types of

pedestrians have on the insurance market?

<= The effect depends on what we assume about the relative

information available to the individuals and to the insurance
company.
25
SOCIAL INSURANCE (cont.)
WHY HAVE SOCIAL INSURANCE? ASYMMETRIC INFORMATION AND ADVERSE SELECTION (cont.)

Asymmetric Information (cont.) Example with Full Information (cont.)

Consider the case that the insurance company and the street crossers
have full information about who is careful and who is not. In this case, the
insurance company would charge different actuarially fair prices to the
careless and careful groups.

The people in the careless group would each pay 5￠per dollar of
insurance coverage, while those in the careful group would each pay only
0.5￠per dollar of insurance coverage.

At these actuarially fair prices, individuals in both groups would choose to

be fully insured.

If an insurance policy pays $30,000 in the case of trouble, the careless

pays $30,000×0.05=$1,500 per year in premiums, and the careful pays
$150 per year in premiums. The insurance company would earn zero profit,
and society would achieve the optimal outcome. 26
 SOCIAL INSURANCE (cont.)
WHY HAVE SOCIAL INSURANCE? ASYMMETRIC INFORMATION AND ADVERSE SELECTION (cont.)

Asymmetric Information (cont.) Example with Asymmetric Information

Now suppose that the insurance company doesn’t know in

which category any given individual belongs.

(Total benefits paid out = $30,000×(0.05×100+0.005×100)=$165,000

for the first two rows above, and

Total benefits paid out =$30,000×0.05×100=$150,000 for the third row above.) 27
SOCIAL INSURANCE (cont.)
WHY HAVE SOCIAL INSURANCE? ASYMMETRIC INFORMATION AND ADVERSE SELECTION
(cont.)
Asymmetric Information (cont.)
Example with Asymmetric Information (cont.)

In the case of asymmetric information, the insurance

company could do one of the following two things.

i) The insurance company asks individuals if they are

careful or careless, and then offer insurance at separate
premium.

However, in this case, all consumers will say that they are
careful to buy insurance for $150 per year, resulting in the
loss of $135,000 per year for the insurance company.

Any companies will clearly not offer insurance under these

conditions, thus the market will fail.
28
SOCIAL INSURANCE (cont.)
WHY HAVE SOCIAL INSURANCE? ASYMMETRIC INFORMATION AND ADVERSE SELECTION
(cont.)

Asymmetric Information (cont.)

Example with Asymmetric Information (cont.)

ii) The insurance company could admit that it has no idea who is
careful and who is not, and then offer insurance at an average
cost.

However, the careful consumers would not buy insurance at all,

since $825>$150=$30,000×0.005, while all of the careless
consumers would buy insurance.

The insurance company ends up collecting $82,500 in premium

payments, but paying out $150,000 in benefits to those careless
customers. So the insurance company again loses money.

Once again, the market has failed to provide the optimal amount
of insurance to both types of consumers.
29
SOCIAL INSURANCE (cont.)
WHY HAVE SOCIAL INSURANCE? ASYMMETRIC INFORMATION AND ADVERSE SELECTION (cont.)

The Problem of Adverse Selection

Adverse selection is the fact that insured individuals know more

about their risk level than does the insurer might cause those
most likely to have the adverse outcome to select insurance,
leading insurers to lose money if they offer insurance.

If the insurance company knows that it will lose money when it

offers insurance, it won’t offer that insurance.

As a result, in this case no insurance will be available to

consumers of any type.

30
SOCIAL INSURANCE (cont.)
WHY HAVE SOCIAL INSURANCE? ASYMMETRIC INFORMATION AND ADVERSE SELECTION (cont.)

Does Asymmetric Information Necessarily Lead to Market Failure?

Are insurance companies destined to fail whenever there is

asymmetric information?

The answer is not necessarily.

Most individuals are fairly risk averse. Risk-averse

individuals so value being insured against bad outcomes
that they are willing to pay more than the actuarially fair
premium to buy insurance: they are willing to pay a risk
premium above the actuarially fair premium.

In our example, risk-averse careful individuals may buy

insurance even for $825.

This situation is technically called a pooling equilibrium, a

market equilibrium in which all types buy full insurance
even though it is not fairly priced to all individuals. 31
SOCIAL INSURANCE (cont.)
WHY HAVE SOCIAL INSURANCE? ASYMMETRIC INFORMATION AND ADVERSE SELECTION (cont.)

Does Asymmetric Information Necessarily Lead to Market Failure?

(cont.)

The pooling equilibrium is an efficient outcome (no market failures): both

types are fully insured, and the insurer is willing to provide insurance.

Even if there is no pooling equilibrium, the insurance company can address

adverse selection by offering separate products at separate prices.

Remember the source of our adverse selection problem: careless individuals

are pretending to be careful in order to get cheap insurance. Even if
individuals aren’t willing to voluntarily reveal their types, they might make
choices that involuntarily reveal their types.

Suppose that the insurance company offered two policies:

1) Full coverage for the $30,000 of medical costs associated with accidents
at $1,500.
2) Coverage of up to $10,000 of medical expenses at a price of $50.
32
SOCIAL INSURANCE (cont.)
WHY HAVE SOCIAL INSURANCE? ASYMMETRIC INFORMATION AND ADVERSE SELECTION (cont.)

Does Asymmetric Information Necessarily Lead to Market Failure?

(cont.)

If these two products are offered, it is possible that the careless would
purchase the more expensive coverage and the careful would purchase
the less expensive coverage.

This outcome occurs because the careless don’t want to bear the risk of
having only $10,000 of coverage, given their relatively high odds of
having an accident, while the careful can take that risk, because of their
very low odds of having an accident.

By offering different products at different prices, the insurance company

has caused consumers to reveal their true types. This market equilibrium
is called a separating equilibrium.

Unlike the pooling equilibrium, however, the separating equilibrium still

represents a market failure.

33
SOCIAL INSURANCE (cont.)
WHY HAVE SOCIAL INSURANCE? ASYMMETRIC INFORMATION AND ADVERSE SELECTION (cont.)
How Does the Government Address Adverse Selection?

There are many potential government interventions that can address

this problem of adverse selection.

Suppose that, in our careful/careless pedestrian example, the

government mandated that everyone buy full insurance at the average
price of $825 per year.

This plan would lead to the efficient outcome, with both types of
pedestrians having full insurance, though the plan would not be a very
attractive to careful consumers.

Careful consumers could view themselves as essentially being taxed in

order to support the market, by paying higher premiums than they
should base on their risk.

Many careful consumers would prefer to be uninsured rather than

being mandated to buy full insurance, so the government is making
them worse off.
34
SOCIAL INSURANCE (cont.)
WHY HAVE SOCIAL INSURANCE? ASYMMETRIC INFORMATION AND ADVERSE SELECTION
(cont.)
How Does the Government Address Adverse Selection? (cont.)
Another option is public provision: the government could just
provide full insurance to both types of consumers so that all
consumers have the optimal full insurance level.
Alternatively, the government could offer everyone subsidies
toward the private purchase of full insurance to try to induce
optimal full coverage.
However, these government interventions would have to be
financed. If they are financed by charging all consumers equally,
then the situation would be the same as that with the mandate.
To sum up, the government can address adverse selection, and
improve market efficiency in a number of ways, but they involve
redistribution from the healthy/careful to the sick/careless,
which could be quite unpopular.
35
SOCIAL INSURANCE (cont.)

A formal model of adverse selection

To understand the implications of adverse selection more

formally, consider two groups, the careful and the careless,
where the probability of accident for the careful is , and
the probability for the careless is

If there is full information, the insurance company charges

prices such that for the careless, and
for the careful.

This means that those who are more likely to have an

accident have to pay more for insurance, i.e., .

36
SOCIAL INSURANCE (cont.)
A formal model of adverse selection (cont.)

But if there isn’t full information, so that insurance companies know only
the proportions of types in the population, then there are two possible
pricing strategies.

First strategy is to assume that individuals are honest and charge them
according to their reported types.

However, this strategy is likely to lead all individuals to claim that they are
careful.

If it is the case, the profits earned on the careful are :

, and
the profits earned on the careless are:

implying that profits are negative overall and insurance is not offered.
37
SOCIAL INSURANCE (cont.)
A formal model of adverse selection (cont.)

The second strategy is to offer insurance at an average price, ,

which is based on the average of the accident probabilities

At this price, insurance is a good deal for the careless but a bad
deal for the careful, and may be bought only by the careless.

If so, the expected profits of the insurer are negative again as

below:
.

However, the careful still would buy full insurance (the pooling
equilibrium), if expected utility with insurance at the unfair price is
still higher than expected utility without insurance, i.e.,

38
SOCIAL INSURANCE (cont.)
A formal model of adverse selection (cont.)

Whether this inequality holds or not will depend on two things:

• the extent of risk aversion of the careful individuals, and
• the relationship between and .

If the careful individuals are more risk averse, they will be more
willing to buy insurance even at an unfair premium to guard
against the odds of being left with low consumption.

And the closer the average risk is to the risk faced by the careful, or
the closer the premium is to being actuarially fair, and the more
likely it is that the careful individuals will buy the insurance.
39
SOCIAL INSURANCE （cont.)
OTHER REASONS FOR GOVERNMENT INTERVENTION IN
INSURANCE MARKETS

Adverse selection is the most common but far from the only reason
offered for government intervention in insurance markets.

Externalities

A classic case for government intervention in insurance markets is

the negative externalities imposed on others through
underinsurance.

When we make our insurance decision, we don’t consider the total

social value. We consider the value to ourselves only.

40
SOCIAL INSURANCE （cont.)
OTHER REASONS FOR GOVERNMENT INTERVENTION IN
INSURANCE MARKETS (cont.) Externalities (cont.)

E.g. You may value the insurance at less than its cost when
you don’t mind getting flu.

But society values the insurance at more than its cost

because the cost of flu epidemic could be large.

The government can intervene to solve externalities in

insurance markets by subsidizing, providing, or mandating
insurance coverage.

41
SOCIAL INSURANCE （cont.)
OTHER REASONS FOR GOVERNMENT INTERVENTION IN INSURANCE
MARKETS (cont.)
Administrative Costs

So far, we have ignored the presence of the administrative costs. However,

we cannot always ignore the administrative costs in the real world.

If the insurance company has administrative expenses of 15% of

premiums, the company has to raise the charges by that amount in order
to break even.

E.g. Returning to the case of perfect information, where the insurance

company can price insurance appropriately for the careless and careful
consumers. The company have to charge $172.50 (=$150×1.15) to the
careful consumers and $1,725 (=$1,500×1.15) to the careless
customers.

At those higher (actuarially unfair) prices, some not-very-risk-averse

consumers may decide against buying insurance. In this way,
administrative costs can lead to market failure, as not all people will be
fully insured. 42
SOCIAL INSURANCE （cont.)
OTHER REASONS FOR GOVERNMENT INTERVENTION IN
INSURANCE MARKETS (cont.)
Redistribution

The optimal outcome without government interventions may not

be very satisfactory to many societies from a distributional point of
view.

E.g. Genetic testing may ultimately allow insurers to remove many

problems of asymmetric information via the testing of
individuals to predict their health costs accurately. However, will
modern societies tolerate an insurance market that charges
many times more for insurance to individuals who happen to
have been born with the wrong genes?

Governments may want to intervene in insurance markets, by

taxing the low-risk individuals and using the revenues to subsidize
the premiums paid by high-risk individuals, thereby achieving a
more even distribution of insurance costs. 43
SOCIAL INSURANCE （cont.)
OTHER REASONS FOR GOVERNMENT INTERVENTION IN
INSURANCE MARKETS (cont.)

Paternalism

Governments may simply feel that individuals will not appropriately

insure themselves against risks if the government does not force
them to do so.

(This motivation for intervention has nothing to do with market

failures. Instead, it has to do with the failure of individuals to
maximize their own utility.)

44
Summary today (cont.)
• The major motivation for government-provided social
insurance is the failure in private insurance markets
caused by adverse selection.

• Adverse selection causes insurance markets to fail

because imperfect information leads insurers to be
unable to offer full insurance to different type of
consumers.

• Other motivations for social insurance include

externalities, administrative inefficiencies in the private
insurance market, the desire for redistribution, and
paternalism.

45
Summary today
• The fastest-growing function of the government is the
provision of social insurance against adverse events such
as retirement, unemployment, injury, or illness.

• Social insurance programs are mandatory, contribution-

based systems that tie the payout of benefits to the
occurrence of a measurable event.

• Insurance is demanded because it allows individuals to

smooth their consumption across various states of the
world.

• With actuarially fair premiums, the optimal outcome is

for individuals to insure themselves fully against adverse
event.
46
Exercise Question
Q. There are two types of drivers on the road today. Speed Racers
have a 5% chance of causing an accident per year, while Low
Riders have a 1% chance of causing an accident per year. There
are twice as many Speed Racers as there are Low Riders. The cost
of an accident is $12,000.

a. Suppose an insurance company knows with certainty each

driver’s type. What premium would the insurance company
charge each type of driver?

The insurance company expects to pay out $12,000 in claims to

5% of the Speed Racers it covers, so it must collect at least
0.05($12,000) = $600 from each one.

Similarly, it must collect at least 0.01($12,000) = $120 from each

Low Rider.

47
Exercise Question (cont.)
Q. (cont.)
b. Now suppose that there is asymmetric information so that the
insurance company does not know with certainty the driver’s
type. Would insurance be sold if:

i. Drivers self-reported their types to the insurance company?

Every individual would claim to be a Low Rider, but if the insurance

company sold insurance to everyone for $120, it would lose money
because of the presence of Speed Racers in the population. The
insurance company would quickly increase premiums, but if it increased
them by too much the Low Riders would leave the market. It cannot be
determined here exactly how much more than $120 the Low Riders
would tolerate, as their risk aversion is not specified. As more Low
Riders chose not to purchase insurance, the pool of covered drivers
would include a higher and higher proportion of Speed Racers,
requiring the insurance company to increase premiums again to cover
the claims.
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Exercise Question (cont.)
Q. (cont.) b. (cont.)

ii. No information at all is known about individual driver’s types?

The insurance company could offer a premium that

averages the expected claims. In a population of half Low
Riders and half Speed Racers, the pooling premium would
be ($600 + $120)/2 = $360. The Low Riders would have to
be extremely risk averse to be willing to pay $360 to cover
an expected loss of $120. If the Low Riders opted out of the
market, the insurance company would be back to the
adverse selection problem discussed above—an insured
pool containing a high proportion of (or exclusively) Speed
Racers.
49