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Unformatted text preview: the probability that some event occurs as "taking care". When it sets the insurance rates the insurance company has to take into account the incentives that the consumers have to take an appropriate amount of care. If no insurance is available then consumers have an incentive to take the maximum possible amount of care. For example, if it were impossible to get bike insurance then all bike owners would use large, expensive, and secure locks. In this case, the individual bears the full cost of his actions and wants to "invest" in taking care until the marginal benefit of taking care just equals the marginal cost of doing so. However, if a consumer can buy bike insurance then the cost inflicted on the individual from having their bike stolen is much less. After all, if the bike is stolen then the person simply needs to report the theft to the insurance company and will receive insurance money to replace it. In the extreme case, where the insurance company completely reimburses the individual for the theft, the individual has no incentive to take care at all. This lack of incentive to take care is called moral hazard. Notice the trade-off involved in this scenario... 328 Too little insurance means that people bear a lot of risk, too much insurance means that people will bear too little risk and will not take appropriate care. If the amount of care taken were observable by the insurance company then there would be no problem. The insurance company could just base their rates on the amount of care taken by each individual. In reality, it is common for insurance companies to give different rates to businesses that have a fire sprinkler system in their building, or to give a better rate on home content insurance to homeowners that have a home security system. It is also quite common for smokers to pay a higher rate for life and health insurance than nonsmokers. Yet, in our example of the bike insurance we can't expect the insurance company to be able to obser...
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- Spring '10