Econ 590 chapter 8.pptx - Chapter 8 10 11 The supply and demand for health insurance and the functioning of health insurance markets Announcements Last

Econ 590 chapter 8.pptx - Chapter 8 10 11 The supply and...

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Chapter 8, 10, 11 The supply and demand for health insurance and the functioning of health insurance markets
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Announcements: Last problem set goes live on Friday Policy brief topic due Nov. 13 Literature review due Dec. 1(?) Next few lectures: Government programs Prescription drugs Physicians practice (if time)
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Supply and Demand for insurance The insurance market brings together two sides: On the demand side, we have people who generally prefer to have some certainty about their expenditure (that is, they are risk averse ) So they prefer to pay an annual premium rather than be subject to the unpredictable nature of health care costs On the supply side insurers can rely on the law of large numbers As the group they insure gets bigger, the amount they will have to pay out in any given year will approach the mean (average) expenditure, which they can predict given the characteristics of their population So you want to have a lot of people in the “pool” The market will then determine the equilibrium price and quantity
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Expected value Suppose you start a new job and you are offered two contracts In one, you are offered $15,000 a year In the other, you are offered a 50% chance of earning $20,000 And a 50% change of earning $10,000 Which do you choose?
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Expected utility Earlier, we talked about the expected value of a number which is We can also talk about expected utility Consider two states: 1. you’re ill, and your utility is low (feel bad; earn less, etc.) You’re ill with probability P I 2. you’re healthy, and have a higher utility (feel good, work and earn more, etc) You’re healthy, with probability P H Your expected utility is E(u) = P I *U I + P H *U H Notice that this is not the same as the utility of the expected value
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First let’s look at why people buy insurance People buy insurance because they are willing to make some sacrifices during “good” times to protect themselves during bad These people are risk averse In economics we model this through a concept called “ expected utility Recall that utility is the amount of “satisfaction” we get from consuming a good As we consume more, we get more utility But as we consume more, the amount of extra utility we get decreases (decreasing expected utility)
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The demand for insurance: why do we buy insurance Recall that we have decreasing marginal utility So the total utility diagram, as a function of wealth, is increasing, but tapers off (p. 189)
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People with this kind of utility are risk averse , that is, they prefer certainty to uncertainty This leads them to want to hedge their bets Pt A is our utility when we’re ill Pt B is our utility when we’re healthy The line in between A and is all the weighted averages of U A and U B These weights correspond to the possible probabilities of the two events For example, at point C’, the two events are equally likely
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