How Does Insurance Help People Smooth Consumption
Chapter 12
2. What is consumption smoothing? How does insurance help people smooth consumption?
When consumption goes from a period of high consumption to a period of low consumption. For example, if a person does not save money at all while they work in order to live a high maintenance lifestyle then they suddenly get laid off, they must greatly reduce their consumption because they can no longer support their lifestyle. Insurance helps people smooth consumption because it helps them defend against unexpected events. If a person did not have insurance and broke all four of their limbs but did not have sufficient funds to pay for their medical bills, they would have to lower their consumption until they paid their medical bills. A person with …show more content…
insurance would have the medical costs (or at least some of it) covered and could maintain their lifestyle.
10. Describe the dimensions along which moral hazard can exist. Can you think of ways in which the government can reduce the prevalence of moral hazard along each dimension?
Moral hazard can exist in a few different ways.
First is people with insurance are less careful with their behavior because they know they are covered by insurance so they will not have to cover the entirety of costs of the consequences. To combat this, a more restrictive policy when accepting claims should be used. The fact that not all claims will be automatically accepted would provide as an incentive to be more careful.
Next, people who are insured to not take into consider cost effective strategies because they are not paying for the repairs. To combat this, the provider should have fixed prices for specific situations in a tiered system and not cover anything and everything.
Lastly, whoever is contracted with fixing whatever issue the insuree has is not concerned with price because they know the insuree is not having to pay for it all. This makes it easy to add premium and excessive services to drive up the price and have the insurance pay for the additional and unnecessary service.
12. There are two types of drivers on the road today. Speed Racers have a 5% chance of causing an accident per year, while Low Riders have a 1% chance of causing an accident per year. There is the same number of Speed Racers as there are Low Riders. The cost of an accident is
$12,000.
a. Suppose an insurance company knows with certainty each driver’s type. What premium would the insurance company charge each type of driver?
Speed Racers: 0.05 x $12,000 = $600
Low Riders: 0.01 x $12,000 = $120
b. Now suppose that there is asymmetric information so that the insurance company does not know with certainty the driver’s type. Would insurance be sold if
i. drivers self-reported their types to the insurance company?
Yes, insurance would be sold if drivers self-reported their types to insurance companies. The problem with this is that everyone would claim to be a low rider and as the speed racers got into more and more accidents, premiums would increase for everyone and leave the entire market paying more.
ii. ii. no information at all is known about individual driver’s types?
If no information is known about the driver types, the insurer would have to offer insurance that would cover the high costs incurred by speed racers but not make it too high so that low riders still opt into having coverage. The problem with this is it is difficult to determine the low rider’s willingness to pay and as a result, if it is too high, they leave the market and the insurer has to have higher premiums because of the smaller pool of cash for the insured. If it is too low, the insurer loses money and cannot stay in business. There is a chance insurance is not sold in this model but I think after adjusting the premium a few times, the insurance company would find the happy balance right in between the WTP for the low riders and still not lose money on speed racers.
Chapter 13
1. The government of Weaseltown has just reformed its social security system. This reform changed two aspects of the system: (1) It abolished its actuarial reduction for early retirement, and (2) it reduced the payroll tax by half for workers who continued to work beyond the early retirement age. Would the average retirement age for Weaseltownian workers increase or decrease in response to these two changes, or can you tell? Explain your answer.
The average retirement age in Weaseltown would depend on the overall health of the population and how much they value their time over money. If the population is relatively healthy and values money, they might opt in to working past the previous retirement age because the return on working later is much better and they expect to reap the benefits once they are finally ready to retire. If their health isn’t great and they don’t expect to live very long, the average retirement age would decrease to whatever the new limit was at.
2. When you called her last night, your grandmother confided that she is afraid to sell her home because doing so will affect her Social Security benefits. You told her that you’d call her back as soon as you read Chapter 13. Now that you’ve read it, what will you say to her about how her benefits will change when she sells her house?
Her benefits would stay the same whether or not she sold the house because social security is calculated based in income only. Asset value is not at all taken into account when calculating social security benefits.
13. Does Social Security provide much benefit in terms of consumption smoothing over the retirement decision? Contrast Social Security with a different social insurance program, unemployment insurance, which provides income support for half a year to individuals who have lost their jobs. Do you think that unemployment insurance is likely to provide more or less consumption smoothing than Social Security?
Unemployment insurance provides more consumption smoothing than Social Security. Unemployment is a percentage of a person’s previous income and is only for a fixed amount of time, so the payout is much greater and makes it so a person does not have to drastically reduce their consumption because of unemployment. It is meant to be temporary so the consumption smoothing is less drastic because the individual is expected to resume their normal consumption once they are again employed.
Social security on the other hand is not intended to make it so that a person maintains their consumption level from when they were working. Social security is intended to give seniors enough to survive on once they cease working. Seniors typically save for retirement because social security alone is not enough to keep them at the level of consumption they are used to.
2. What is consumption smoothing? How does insurance help people smooth consumption?
When consumption goes from a period of high consumption to a period of low consumption. For example, if a person does not save money at all while they work in order to live a high maintenance lifestyle then they suddenly get laid off, they must greatly reduce their consumption because they can no longer support their lifestyle. Insurance helps people smooth consumption because it helps them defend against unexpected events. If a person did not have insurance and broke all four of their limbs but did not have sufficient funds to pay for their medical bills, they would have to lower their consumption until they paid their medical bills. A person with …show more content…
insurance would have the medical costs (or at least some of it) covered and could maintain their lifestyle.
10. Describe the dimensions along which moral hazard can exist. Can you think of ways in which the government can reduce the prevalence of moral hazard along each dimension?
Moral hazard can exist in a few different ways.
First is people with insurance are less careful with their behavior because they know they are covered by insurance so they will not have to cover the entirety of costs of the consequences. To combat this, a more restrictive policy when accepting claims should be used. The fact that not all claims will be automatically accepted would provide as an incentive to be more careful.
Next, people who are insured to not take into consider cost effective strategies because they are not paying for the repairs. To combat this, the provider should have fixed prices for specific situations in a tiered system and not cover anything and everything.
Lastly, whoever is contracted with fixing whatever issue the insuree has is not concerned with price because they know the insuree is not having to pay for it all. This makes it easy to add premium and excessive services to drive up the price and have the insurance pay for the additional and unnecessary service.
12. There are two types of drivers on the road today. Speed Racers have a 5% chance of causing an accident per year, while Low Riders have a 1% chance of causing an accident per year. There is the same number of Speed Racers as there are Low Riders. The cost of an accident is
$12,000.
a. Suppose an insurance company knows with certainty each driver’s type. What premium would the insurance company charge each type of driver?
Speed Racers: 0.05 x $12,000 = $600
Low Riders: 0.01 x $12,000 = $120
b. Now suppose that there is asymmetric information so that the insurance company does not know with certainty the driver’s type. Would insurance be sold if
i. drivers self-reported their types to the insurance company?
Yes, insurance would be sold if drivers self-reported their types to insurance companies. The problem with this is that everyone would claim to be a low rider and as the speed racers got into more and more accidents, premiums would increase for everyone and leave the entire market paying more.
ii. ii. no information at all is known about individual driver’s types?
If no information is known about the driver types, the insurer would have to offer insurance that would cover the high costs incurred by speed racers but not make it too high so that low riders still opt into having coverage. The problem with this is it is difficult to determine the low rider’s willingness to pay and as a result, if it is too high, they leave the market and the insurer has to have higher premiums because of the smaller pool of cash for the insured. If it is too low, the insurer loses money and cannot stay in business. There is a chance insurance is not sold in this model but I think after adjusting the premium a few times, the insurance company would find the happy balance right in between the WTP for the low riders and still not lose money on speed racers.
Chapter 13
1. The government of Weaseltown has just reformed its social security system. This reform changed two aspects of the system: (1) It abolished its actuarial reduction for early retirement, and (2) it reduced the payroll tax by half for workers who continued to work beyond the early retirement age. Would the average retirement age for Weaseltownian workers increase or decrease in response to these two changes, or can you tell? Explain your answer.
The average retirement age in Weaseltown would depend on the overall health of the population and how much they value their time over money. If the population is relatively healthy and values money, they might opt in to working past the previous retirement age because the return on working later is much better and they expect to reap the benefits once they are finally ready to retire. If their health isn’t great and they don’t expect to live very long, the average retirement age would decrease to whatever the new limit was at.
2. When you called her last night, your grandmother confided that she is afraid to sell her home because doing so will affect her Social Security benefits. You told her that you’d call her back as soon as you read Chapter 13. Now that you’ve read it, what will you say to her about how her benefits will change when she sells her house?
Her benefits would stay the same whether or not she sold the house because social security is calculated based in income only. Asset value is not at all taken into account when calculating social security benefits.
13. Does Social Security provide much benefit in terms of consumption smoothing over the retirement decision? Contrast Social Security with a different social insurance program, unemployment insurance, which provides income support for half a year to individuals who have lost their jobs. Do you think that unemployment insurance is likely to provide more or less consumption smoothing than Social Security?
Unemployment insurance provides more consumption smoothing than Social Security. Unemployment is a percentage of a person’s previous income and is only for a fixed amount of time, so the payout is much greater and makes it so a person does not have to drastically reduce their consumption because of unemployment. It is meant to be temporary so the consumption smoothing is less drastic because the individual is expected to resume their normal consumption once they are again employed.
Social security on the other hand is not intended to make it so that a person maintains their consumption level from when they were working. Social security is intended to give seniors enough to survive on once they cease working. Seniors typically save for retirement because social security alone is not enough to keep them at the level of consumption they are used to.