Lecture 10 Insurance

# Lecture 10 Insurance - Lecture 10 Insurance Readings Todaro...

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Unformatted text preview: Lecture 10: Insurance Readings: Todaro, Chapter 8 Ray, Chapter 15 Insurance Problem: human beings are risk-averse They prefer one average income to a widely-varying income Numerical example: harvest: 2000\$ with prob ½ 1000\$ with prob ½ For now, exogenous reasons: bad weather… Farmer prefers 1500\$ for sure to (1000\$, 2000\$) Graph Graph: U(1500)> ½*U(1000)+1/2*U(2000) U concave Money Utility 1000 1500 2000 U(1500) ½*U(1000)+1/2*U(2000) Risk-aversion Math: U: utility function H: high payoff with prob p L low payoff with prob (1-p) Here U [pH+(1-p)L] > p*U (H) + (1-p)*U (L) Empirical evidence: Binswanger (1980): 330 Poor farmers in semi-arid rural India Lotteries (50-50), same payoff or differing payoffs When stakes increase (up to monthly income), choices of lotteries became safer Holt, Laury(2002): 175 undergraduate students Slightly different instrument, but still based on lotteries with different probabilities and payoffs Subjects display a very risk-averse behaviour (prefer lotteries with lower expected payoff but safer) Questions 1. What are the ways to obtain U [pH+(1-p)L], rather then p*U (H) + (1-p)*U (L)? Self-insurance Mutual insurance Credit (borrow when poor, lend when rich) 1. Problems with provision of insurance 2. Empirical evidence of informal risk pooling Self-insurance Individuals (with the wealth to do it) protect themselves against exogenous uncertainties Example: Cash Savings Stocks of food grain (but less durable than money) Durable goods (jewellery, animals…) Bullocks India: Rosenzweig, Wolpin (1993): No land markets No financial services Stocks of food grain useful to smooth consumption inside the year, but not across years Observations: Biggest share of non-land wealth (50%): bullocks No short-term rental markets: each farmer should own 1 or 2 bullocks, and keep them But: 86% of households were involved in at least one bullock transaction over a 10 years window Moreover: prob to keep a bullock ↑ when wealth ↑ Bullock price is constant = a good self-insurance mechanism Mutual insurance A and B are farmers Harvest can be 1000\$ or 2000\$ (by an exogenous shock (weather) 4 possibilities: 1. A: 2000, B: 2000 2. A: 1000, B: 1000 3. A: 2000, B: 1000 4. A: 1000, B: 2000 Insurance? Mutual insurance A and B are farmers Harvest can be 1000\$ or 2000\$ (by an exogenous shock) 4 possibilities: 1. A: 2000, B: 2000 2. A: 1000, B: 1000 3. A: 2000, B: 1000 4. A: 1000, B: 2000 A and B prefer insurance to no insurance, because promise of 1500 if the other gets 2000 Mechanism: the lucky one gives 500\$ to the unlucky one No insurance possible Insurance A gives 500 to B B gives 500 to A Notes And start again after this one-shot game: A may contribute indefinitely if he always gets a positive shock Insurance ≠ credit (when one remembers the past)...
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Lecture 10 Insurance - Lecture 10 Insurance Readings Todaro...

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