Slide 1Important Social Insurance ProgramsSlide 3Common features of Social Insurance programsUnderstanding the economics of insurance marketsKey termsWhy insuranceWhy do individuals value insurance?Why individuals value insurance?Insurance, contd.Slide 11Expected Utility ModelAnalyzing an individual’s demand for insuranceExpected utility modelExpected (Utility)Slide 16Result implicationsRole of risk aversionWhy have social insurance?Asymmetric Information Ex.Slide 21Adverse Selection ProblemWill asymmetric information lead to Market Failure?Asymmetric informationHow does government address adverse selection problem?Other reasons for government interventionOther ways to smooth consumptionSlide 28Example: Unemployment InsuranceSlide 30Slide 31Slide 32Slide 33Lessons for Consumption-Smoothing Role of Social InsuranceTHE PROBLEM WITH INSURANCE: MORAL HAZARDSlide 36Slide 37What Determines Moral Hazard?Slide 39Moral Hazard Is MultidimensionalPUTTING IT ALL TOGETHER: OPTIMAL SOCIAL INSURANCESlide 42Recap of Social Insurance: The New Function of Government12.5 The Problem with Insurance: Moral HazardSocial Insurance: The New Function of Government12.3 Other Reasons for Government Intervention in Insurance Markets12.2 Why Have Social Insurance? Asymmetric Information and Adverse Selection12.1 What Is Insurance andWhy Do Individuals Value It?Chapter 1212.4 Social Insurance VersusSelf-Insurance: How MuchConsumption Smoothing?12.6 Putting It All Together:Optimal Social Insurance12.7 ConclusionIn the preamble to the United States Constitution, the framers wrote that they were uniting the states in order to “provide for the common defense, promote the general welfare, and secure the blessings of liberty to ourselves and our posterity.”For most of the country’s history “common defense,” was the federal government’s clear spending priority.Since then, the government’s spending priorities shifted dramatically, away from “common defense” and toward promoting “the general welfare.”Important Social Insurance ProgramsSocial SecurityUnemployment insuranceDisability InsuranceWorkers CompensationMedicarePublic Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers3 of 29C H A P T E R 1 2 ■ S O C I A L I N S U R A N C E : T H E N E W F U N C T I O N O F G O V E R N M E N TCommon features of Social Insurance programsContributions are mandatoryA measurable, enabling eventBenefits are not related to one’s income or assets (not means tested)Understanding the economics of insurance marketsWhy individuals value insuranceWhy insurance markets may failAdverse selectionMoral hazardWhat tradeoffs in designing social insuranceKey termsAdverse selection—the insured individual knows more about their own risk level than does the insurerMoral hazard---when you insure against adverse events, you can encourage adverse behavior.Why insuranceInsurance premium---paid to insurerIn return, insurer promises payment to individual if adverse event happensExamples: Health, car, property, farm crops,Why do individuals value insurance?Individuals value because of Diminishing marginal utilityIe. They choose 2 years of smooth income over 1 year of high consumption and 1 year of starving--because excessive consumption does not raise utility as much as starvation lowers it.They prefer to smooth out consumptionWhy individuals value insurance?When outcomes are uncertain, individuals wish to smooth their consumption over possible states of the worldExamples:State1: get hit by a carState2: not getting hitGoal is to make choice today that determines consumption in future for each of these statesInsurance, contd.Consumers smooth by using some of today’s income to insure against adverse outcome tomorrow.Basic insurance theory suggests that individuals will demand full insurance to smooth their consumption across states of the world.Same consumption possible whether accident occurs or not12.1What Is Insurance and Why Do Individuals Value It?Formalizing This Intuition: Expected Utility Modelexpected utility model The weighted sum of utilities across states of the world, where the weights are the probabilities of each state occurring.Expected utility is written as:actuarially fair premium Insurance premium that is set equal to the insurer’s expected payout.Expected Utility ModelEU = (1-p) U(C0) + pU(C1)Where •p stands for the probability of an adverse event•C0 and C1 stand for consumption in the good and bad states of the worldAnalyzing an individual’s demand for insuranceAssume, a 1% chance for and accident with $30,000 of damagesSam can insure some, none, or all of these medical expensesPolicy cost: m cents per $1 of coverageA policy pays $b for an accidentHis premium is $mbFull insurance: m x $30,000State 0: $mb poorerState 1: $b-$mb richer than if he doesn’t buy insuranceExpected utility modelSam’s desire to buy depends on price of insuranceAn actuarially fair premium sets the price charged equal to the expected payout$30,000 x .01 = $300 (act. fair prem.)Expected (Utility)Decision to buy insurance also affected by risk preferenceAssume a utility function U= √C. (risk averse)C0= 30,000Without insurance: .99√30,000+.01 √0 =171.5With actuarially fair insurance:.99√29,700 + .01√29,700 = 172.3Utility is higher with insurancePartial insurance is lower utilityTable 1The expected utility modelIf Sam … And Sam is …ConsumptionUtility √CExpected utilityDoesn’t buy insuranceNot hit by a car (D=99%)$30,000173.20.99x173.2 + 0.01x0 = 171.5Hit by a car (D=1%) 00Buys full insurance(for $300)Not hit by a car (D=99%)$29,700172.30.99x172.3 + 0.01x172.3 = 172.3Hit by a car (D=1%)$29,700172.3Buys partial insurance(for $150)Not hit by a car (D=99%)$29,850172.80.99x172.8 + 0.01x121.8 = 172.2Hit by a car (D=1%)$14,850121.8Result implicationsEven if insurance is expensive, if premium is actuarially fair, individuals will want to insure against adverse events.Implication: The efficient market outcome is full insurance and thus full consumption smoothingRole of risk aversionRisk aversion: extent to which an individual is willing to bear riskRisk averse individuals have a rapidly diminishing marginal utility of consumptionIndividuals with any