Upload
jordan-richards
View
221
Download
7
Tags:
Embed Size (px)
Citation preview
Key IDEA
• Risk = We don’t KNOW if something will happen.
• Many (most?) of us DO NOT LIKE risk.
• We will PAY to avoid the consequences of risk.
What is insurance?
• Consider a club• 100 members• About the same age, about the same lifestyles• About once a year one of the members gets sick and
incurs expenses of $1,000. • Club collects $10 from each member each year. • Invests it somewhere to maintain or increase its
value.• Pays it out to members who file claims.
What has happened?
• Insured pay $10 per year, guaranteed, to avoid the possibility of having to pay $1,000.
• Although outlays for an individual may be highly variable,
• Outlays for a group are generally rather predictable.• The “Law of Large Numbers” suggests that as group
size increases, the distribution of the average rate of illness will collapse around the “true” probability of the illness.
What does LoLL say about Michigan Lottery?
• Play it StraightWhen the number the Lottery draws matches the number you picked in exactly the same order, you win $500 on a $1 bet or $250 on a $.50 bet.Odds of winning: 1 in 1000
https://www.michiganlottery.com/daily_3_info#how_to_play
Insurance Terms
• Premium - $X premium for $Y of coverage.• Coinsurance and Copayment - The insured person
must pay the loss. – % paid is the coinsurance rate (varies from 0 to 100%).– amount paid is the copayment.
• Deductible - Some amount may be deducted from the payment to the insured person, irrespective of coinsurance.
• Why coinsurance and deductibles? Discuss.
Risk and Insurance
What is “expected value?”What’s the expected value of a coin flip that pays $1 for heads and 0 for tails.A> (Prob. of heads) * $1 + (Prob. of tails) * 0.E = (0.5 * 1) + (0.5 * $0) = $0.5
How much would you pay to play this kind of game?Why do we care?A> Because insurance is based on expected losses!
What does LoLL say about Michigan Lottery?
• Play it StraightWhen the number the Lottery draws matches the number you picked in exactly the same order, you win $500 on a $1 bet or $250 on a $.50 bet.Odds of winning: 1 in 1000
E = (Prob. of winning) * $500 + (Prob. of losing) * 0.
E = (0.001 * 500) + (0.999 * $0) = $0.50
• Is it a good bet?
https://www.michiganlottery.com/daily_3_info#how_to_play
Cardinality
• We don’t HAVE to measure “utils”
• BUT, we have to think about what the utility function looks like.
• MORE than just ordinal utility.
Marginal Utility of Wealth and Risk Aversion
• Would you bet $50 on a coin flip that would give you either 0 or $100.
• Would you bet $5000 on a coin flip that would give you either 0 or $10000?
• Why?• Consider a utility function
with wealth. Wealth
Util
ity
5 10 15 20
Marginal Utility of Wealth and Risk Aversion
• Suppose wealth is 10 (thousand). It gives him U = 140
Wealth
Util
ity
5 10 15 20
140
• Suppose wealth is 20 (thousand). It gives him U = 200
200
Cardinal Utility
• Just about everywhere else in microeconomics we use “ordinal utility”.
• Here we use “cardinal utility.”
• Why?
Expected wealth is due to risk
Wealth
Util
ity
5 10 15 20
140
200E (U) = (Prob. Healthy * Utility of Wealth if Healthy) + (Prob. Ill * Utility of Wealth if Ill)
E (U) = Prob. Healthy * Utility of 20 + Prob. Ill * Utility of 10
We’re on the maroon line rather than the blue curve BECAUSE of RISK
Expected wealth is due to risk
Wealth
Util
ity
5 10 15 20
140
200We see that total utility is increasing, but what about marginal utility
We see that it is decreasing. Why?
In this example, losses bother us more than gains help us, so we lose utility due to risk.
Wealth
Mgl
. Util
ity
Deal or No Deal?
• Biggest Fail Ending (Not my term).
• www.youtube.com/watch?v=H9CQscwXBt0
• What does utility function look like?
1 1M500T
E(W)
Util
ity
Deal or No Deal?
• They offer him 412T and he refuses. Is he risk loving?
• Maybe not.• What could utility
function look like?
1 1M500T
E(W)
412T
U(412)
U[E(500)]
Util
ity
What if risk neutral?
Insurance puts us on the Blue LineWe are certain
Wealth
Util
ity
5 10 15 20
140
200
Suppose the probability of illness is 0.05.
E (U) = Prob. Healthy * Utility of 20 + Prob. Ill * Utility of 10
E (U) = (0.95 * 200) + (0.05 * 140).
E (U) = 197.
BUT, without risk, Utility would be 199.
Wealth
Mgl
. Util
ity
Insurance risk (you end up at wealth = 19.5 and U=199 whether you’re sick or not).
19.5
Insurance puts us on the Blue Line
Wealth
Util
ity
5 10 15 20
140
200Suppose the probability of illness is 0.05.
E (U) = Prob. Healthy * Utility of 20 + Prob. Ill * Utility of 10
E (U) = (0.95 * 200) + (0.05 * 140).
E (U) = 197.
BUT, without risk, Utility would be 199.
Wealth
Mgl
. Util
ity
Insurance risk (you end up at wealth = 19.5 and U=199 whether you’re sick or not).
19.5
If you don’t like risk
You BUY Insurance !!!
Does everyone buy insurance?
• Depends on marginal utility of wealth.
• Some people “love” risk.
• How would we draw this?
Wealth
Util
ity
5 10 15 20
140
200
Wealth
Mgl
. Util
ity• How would we draw
curves for someone who was “risk neutral.”
RiskLocus
How much insurance?
E (U) = (Prob. Ill * Utility of Wealth if Ill) + (Prob. Healthy * Utility of Wealth if Well) (8.3)
If insured,
new wealth = Wealth - insurance premium
new wealth = W - aq
q is the value of the insurance purchased
a is the fraction paid, called the premium
Wealth if ill = [(W - L) + q] - aq = W - L + (1-a)q
Wealth if well = W - aq
How much insurance?
E (U) = (Prob. Ill * Utility of Wealth if Ill) + (Prob. Healthy * Utility of Wealth if Well) (8.3)
Wealth if ill = [(W - L) + q] - aq = W - L + (1-a)q
Wealth if well = W - aq
So we put the maroon stuff into the blue equation to get.
E (U) = [Prob. Ill * Utility (W - L + (1-a)q] +
[Prob. Healthy * Utility (W - aq)]
[1]
[2]
How much insurance?
E (U) = [Prob. Ill * Utility (W - L + (1-a)q] +
[Prob. Healthy * Utility (W - aq)]
[1]
[2]
A purchase of 1 extra dollar of insurance increases utility in [1].
When he is ill, it will increase wealth by (1-a). The extra utility is (1-a) * MU (wealth when ill) * p. (Since wealth is lower, this is a relatively large marginal benefit).
When he is healthy, it will decrease wealth by a. “Loss” of utility is a * MU (wealth when well) * (1-p).
Amount of Insurance
A purchase of 1 extra dollar of insurance increases utility in [1].
When he is ill, it will increase wealth by (1-a). The extra utility is (1-a) * MU (wealth when ill) * p. (Since wealth is lower, this is a relatively large marginal benefit).
When he is healthy, it will decrease wealth by a. “Loss” of utility is a * MU (wealth when well) * (1-p).
Amount of insurance
Mgl. Benefits,Mgl. Costs MB
MC
Amount of Insurance
A purchase of 1 extra dollar of insurance increases utility in [1].
When he is ill, it will increase wealth by (1-a). The extra utility is (1-a) * MU (wealth when ill) * p. (Since wealth is lower, this is a relatively large marginal benefit).
When he is healthy, it will decrease wealth by a. “Loss” of utility is a * MU (wealth when well) * (1-p).
Amount of insurance
Mgl. Benefits,Mgl. Costs MB
MC
q*
Utility and Marginal Utility
0102030405060708090
100110120130140150160170180190200210220230240250260270
0 5 10 15 20 25 30
Wealth
Uti
lity
U
MU