Lecture 5 - 2017.pdf

# Lecture 5 - 2017.pdf - Applied Health Economics Lecture 5...

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17/11/2017 1 Applied Health Economics Lecture 5: Adverse Selection II Christopher J Gerry Centre for Health Economics, Management and Policy 18 th November 2017 [email protected] The Rothschild-Stiglitz Model So far then we have looked separately at: Demand for insurance Risk aversion but no information asymmetry Akerlof’s market for lemons Information asymmetry but no risk aversion The Rothschild-Stiglitz Model (1976) puts these two together by introducing the I H -I S space.

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17/11/2017 2 I H -I S space Recall the income-utility space from lecture 4 Take H E and S E points and bundle them to one point E (endowment point) in I H -I S space Point E shows the income of an individual in both the healthy and the sick state I H I H -I S space Take H C and S C as points that represent a partial insurance contract Point C represents a partial insurance contract Horizontal shift = premium (r) and Vertical shift = payout if sick (q-r)
17/11/2017 3 I H -I S space Given C 1 , C 2 , C 3 , C 4 , and endowment point E we can make some assumptions: Individual prefers C 2 to C 1 Prefers C 1 to C 3 Cannot compare preference between C 1 to C 4 Cannot compare preferences to E Indifference curves in I H -I S space 1) Downward sloping Willing to give up income in one state if compensated for more income in the other state 2) Convex More downward-sloping at low levels of I H but flatter at high levels I S and I H are imperfect substitutes Result of risk aversion

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17/11/2017 4 The full insurance line The 45% line is the full- insurance line Why? Any point on this line represents a full insurance contract. State independence The zero-profit line Represents the set of contracts such that the premium is exactly the same as the expected payout (no profits for insurance company) Zero-profit line runs through endowment point E And has a slope that depends on the probability of sickness Also can be thought of as the actuarially-fair line
17/11/2017 5 The zero-profit line divides I H -I S space into profitable and unprofitable zones C 1 C 2 C 3 all have same healthy state income, so premiums same, pay-outs not C 1 lies below the zero-profit line and results in profits for insurance companies C 3 lies above the zero-profit line and results in a loss of money for companies No company will offer points above zero-

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