2 - I. Insurance: why it is interesting: o A. Because one...

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I. Insurance: why it is interesting: o 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 such problems? 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 insurance, etc. o B. All of these involve the same set of issues, as we will see. o C. Starting with straightforward private insurance, which provides the simplest introduction to the analysis. II. Why insure? o 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, advertising, . ..). o 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. o 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? 4. Why? o 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: o 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 solution to interpersonal comparisons that we used in defining efficiency--compare value measured in dollars--but this time in an intrapersonal context. o B. Where revealed preference solves the problem of how to measure the difference o C. And people buy insurance--
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1. precisely because a dollar in the future where their house burns down is worth more to them 2. than a dollar in the alternative future where it doesn't. o D. This argument implies that you will insure against large risks but not against small risks, since the difference in value to you between the goods you would buy with an extra dollar if your income was $49,990 and the goods you would buy with an extra dollar if your income was $50,010 is small. IV. Von Neumann and Morgenstern formalized this argument in the form of Von Neumann utility--which is defined in such a way that individuals, in choosing among alternative gambles, maximize expected utility, rather than expected income. In other words, "utility" already has built into it the fact that dollars are worth more to you in some situations (when you don't have very
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This note was uploaded on 04/05/2012 for the course ECON 395 taught by Professor Beckett during the Fall '11 term at Rutgers.

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2 - I. Insurance: why it is interesting: o A. Because one...

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