CHAPTER 7 DEMAND FOR INSURANCE
CHAPTER 7 DEMAND FOR INSURANCE
Why buy insurance? Demand for insurance driven by the fear of the unknown Hedge against risk--the possibility of bad outcomes Purchasing insurance means forfeiting income in good times to get money in bad times If bad times avoided,then money lost Ex:The individual who buys health insurance but never visits the hospital might have been better off spending that income elsewhere. Bhattacharya,Hyde and Tu-HealthEconomics
Bhattacharya, Hyde and Tu – Health Economics Why buy insurance? Demand for insurance driven by the fear of the unknown Hedge against risk -- the possibility of bad outcomes Purchasing insurance means forfeiting income in good times to get money in bad times If bad times avoided, then money lost Ex: The individual who buys health insurance but never visits the hospital might have been better off spending that income elsewhere
Risk aversion Hence,risk aversion drives demand for insurance We can model risk aversion through utility from income U(I) Utility increases with income:U'(1)>o Marginal utility for income is declining:U"(1)<o Bhattacharya,Hyde and Tu-HealthEconomics
Bhattacharya, Hyde and Tu – Health Economics Risk aversion Hence, risk aversion drives demand for insurance We can model risk aversion through utility from income U(I) Utility increases with income: U(I) > 0 Marginal utility for income is declining: U(I) < 0
Income and utility Graphically, Utility increasing with income U'(l)>o Marginal utility decreasing U"(1)>o U() → Bhattacharya,Hyde and Tu-HealthEconomics
Bhattacharya, Hyde and Tu – Health Economics Income and utility Graphically, Utility increasing with income U’(I) > 0 Marginal utility decreasing U’’(I) > 0
Adding uncertainty to the model An individual does not know whether she will become sick,but she knows the probability of sickness is p between o and 1 Probability of sickness is p Probability of staying healthy is 1-p If she gets sick,medical bills and missed work will reduce her income Is=income if she does get sick IH>Is=income if she remains healthy Bhattacharya,Hyde and Tu-HealthEconomics
Bhattacharya, Hyde and Tu – Health Economics Adding uncertainty to the model An individual does not know whether she will become sick, but she knows the probability of sickness is p between 0 and 1 Probability of sickness is p Probability of staying healthy is 1 - p If she gets sick, medical bills and missed work will reduce her income IS = income if she does get sick IH > IS = income if she remains healthy