I. Insurance: why it is interesting:
A. Because one recurring legal issue is who will bear the costs if
something goes wrong--i.e. who is insuring whom. For example:
1. Contracts. Something changes, so either I don't want to produce what I
agreed to or you don't want to buy it. Who bears the costs resulting from
2. Auto accidents: Who pays for them?
3. Product defects and the associated costs. When a coke bottle explodes,
injuring someone, is Coca Cola liable for the resulting medical costs?
4. Wider political issues of welfare, unemployment insurance, health
B. All of these involve the same set of issues, as we will see.
C. Starting with straightforward private insurance, which provides the
simplest introduction to the analysis.
II. Why insure?
A. In expected value terms, insurance is a losing deal for the customers--
on average, they pay out more in premiums than they collect in claims. If
that were not true, insurance companies would go broke, since they not
only have to pay claims but also other expenses (salaries, rent,
B. But a dollar as not a dollar is not a dollar. Insurance may be a bad deal
if you are calculating in dollars paid out and collected on average, but a
good deal in terms of what those dollars buy.
C. Consider two futures:
1. 50/50 chance of $10,000/year or $90,000/year
2. or a Certainty of $50,000/year
3. Which do you choose?
D. Consider the goods you would buy in each case. The goods you
would give up if your income dropped from $50,000 to $10,000 are
probably a lot more important to you than the extra goods you would
buy if it rose from $50,000 to $90,000.
III. The economics of risk aversion:
A. On average, an additional dollar is worth less to you, in terms of the
importance to you of what you use it for, the more dollars you have. This
is the same reason we were not entirely happy with the
interpersonal comparisons that we used in defining efficiency--compare
value measured in dollars--but this time in an intrapersonal context.
B. Where revealed preference solves the problem of how to measure the
C. And people buy insurance--