2 Advantageous Selection Consider the market for life insurance with consumers w

Question

2 Advantageous Selection Consider the market for life insurance with consumers who purchase life insurance Suppose this insurance is basic, a consumer pays for life insurance and then if they die before say 65, their family gets paid a large sum of money. Thus, from the insurance companies point of view, the consumers that are the least likely to die are the ones that cost the least. Suppose th but consumers do vary in their type and their type is unobserved by the insurance company. Suppose consumers have different levels of risk aversion. So the amount of risk aversion a consumer has is their hidden type and the insurance company cannot observe this ere is no moral hazard (no hidden action), Recall, in the market for health insurance the least healthiest consumers, which are the most costly for the insurance company, are the ones who have a high demand for health insurance. In the market for life insurance, the consumers who are the most risk averse, which are the ones least likely to die, are the least costly. This leads to increasing MC and AC curves and this is known as advantageous selection. Suppose demand, marginal cost, and average cost are given by: P = 100-Q, MO-10-2Q, and AC 10 + Q

Explanation / Answer

5. The deadweight loss is marked below as the shades triangular area.

Here, Pm and Qm represent monopoly outcome obtained by setting MR = MC

Here, Pe and Qe represent efficient outcome obtained by setting P = MC

6. Yes, moral hazard or hidden actions do affect life insurance markets as consumers who tend to deviate from their expected behavior impose a risk of loss to their health and thus a cost or loss to the insurance companies.

For eg if a person is allergic to sugar goes on to consume sugar after taking health insurance, then he will detoriate his health and thus increase health checkup and treatment costs (which could otherwise have been avoided) and thus impose a loss to the insurance company who will have to pay for this expenditure.

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