Chapter 8, 10, 11
The supply and demand for health insurance and the functioning
of health insurance markets

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)

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

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?

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

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)

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)

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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- Fall '17