ECP4530 ECP5536 Sherron Test 2 Study Guide Demand for Private Health Insurance Chapter 4 o Expected value of an outcome EV outcome probability of that outcome value of that outcome Ex Coin flip If the coin lands on tails I pay you 100 If the coin lands on heads you pay me 50 EV outcome probability of landing on tails winnings if land on tails probability of landing on heads winnings if land on heads EV to me 0 5 100 0 5 50 25 EV to you 0 5 100 0 5 50 25 Would you play take the bet Yes risk loving or risk neutral No risk averse or risk neutral o Actuarially fair price of insurance Actuarially fair price of insurance the expected value of the insurance pay out A F premium expected value of loss probability of loss size of loss Insurance premium actuarially fair premium loading fee Loading fee includes marketing claims processing and capital costs Ex An insurer expects to pay 250 if an individual contracts the flu with a probability of 0 15 of contracting it EV pay out 250 0 15 37 50 Graph C If risk loss is small you tend to exhibit risk loving behavior especially true for low income individuals Positive and increasing marginal utility o Risk loving o Risk averse o Risk neutral Graph A Positive and increasing marginal utility Graph B Positive and diminishing marginal utility Graph A risk averse graph B risk neutral graph C risk loving General illustration of a RISK AVERSE utility function Notations for RISK AVERSE ONLY utility function graph A if the individual is sick W wealth of the individual if he she is sick U Ws utility of the individual is he she is sick B if the individual is healthy Wh wealth of the individual if he she is healthy U Wh utility of the individual if he she is healthy C expected value of the individual Ww expected wealth of the individual U Ww expected utility of the individual D individual is insured for the actuarially fair price Ww wealth when insured for actuarially fair price U Ww utility when insured for actuarially fair price E insured for maximum willingness to pay W w wealth when insured for maximum willingness to pay U Ww utility when insured for maximum willingness to pay EL expected loss maximum loading fee Points A B and C involve risk Points D and E involve no risk Any point on the chord involves risk and is a weighted average Utility gains for RISK AVERSE ONLY individuals from actuarially fair insurance Measured by o Distance between the expected value of utility and the utility if insured o Vertical distance between the chord and the utility function U Ww U Ww Willingness to pay for insurance by RISK AVERSE ONLY individuals Increases with degree of risk aversion Related to probability of loss o Highest with the probability of loss is midrange o Lowest when probability is known 0 0 or 1 0 Increases as size of loss increases Example for RISK AVERSE individual Need to know Utility function U W2 Wealth A Loss if injured B Probability of risk C Probability of being well 1 C a Wealth if healthy injury free A Utility if healthy U W2 U A2 a Wealth if injured sick W A B Utility if injured sick U A B 2 b Expected value of wealth E W 1 C A C A B c Expected value of utility probability of being well income if well probability of being sick income if sick probability of being well utility if well probability of being sick utility if sick E U 1 C A2 C A B 2 d Actuarially fair price of full coverage insurance expected value of loss probability of loss size of loss E L C B to check your math take wealth if healthy and subtract expected value of wealth e Wealth if risk adverse individual purchases full coverage insurance at actuarially fair price Sick income if healthy expected value of loss actuarially fair price of insurance loss if injured loss if injured expected value of wealth Well income if healthy expected value of loss actuarially fair price of insurance expected value of wealth f Utility if risk adverse individual purchases full coverage insurance at actuarially fair price U wealth if insured for actuarially fair price expected value of wealth 2 g Will this risk adverse individual buy insurance at the actuarially fair price Yes if the individual gains more utility Compare utility with risk and with no risk h What is the most this individual is willing to pay for full coverage insurance In other words what premium price of insurance leaves this individual with his her expected value of utility U W2 1 C A2 C A B 2 W2 find the square root of both sides W subtract this W from income if well A to find premium REMEMBER Whether or not a person is worse or better off is based on utility NOT income wealth FDA o History 1938 FDA created in response to deaths caused by drugs Before selling a drug the manufacturer had to file a new drug application The FDA had 180 to block the drug FDA checked labeling for safe use 1951 FDA distinguished between over the counter and prescription drugs 1962 Kefauver amendments Drugs need approval Manufacturers most prove safety and efficacy and must submit testing plans which the FDA had the discretion to change 1962 1992 huge technological advancements 1992 Prescription Drug User Fee Act Pay fees to guarantee review time FDA reviews testing plan an deems a drug non approval approvable or approved Standard or priority status processing Novelty drugs are considered priority unmet needs for small fraction of a population FDA must review 90 of all priority status drugs in 6 months and 90 of all standard status drugs in 10 months o Dug development process 1 Preclinical toxicology FDA is not involved yet a 1 6 years and doesn t test on people 2 Clinical trials on humans FDA approval a Phase 1 through 3 could take anywhere from 6 to 11 years b Phase 1 Tests safety any weird side effects on at least 50 healthy volunteers c Phase 2 Tests safety efficacy and dosing on at least 100 sick volunteers d Phase 3 Tests safety and efficacy on more than 1 000 sick volunteers e Phase 4 i Could take anywhere from 11 to 14 years ii After a drug is approved it is available for sale on the market but still regulated by the FDA iii Manufacturers conduct more studies and report negative impacts iv FDA can remove approval v 8 probability of success to market from preclinical trials New Drug Application is submitted with results from phase 1 2 and 3 0 6 2 years Application is either rejected approved or needs more testing If approved a label is made Label lists clinical summaries side effects and diseases the drug is approved to treat Doctors can