Problem Set 2

Health Economics

Spring 2014

An individual with the concave utility function u(y) has a gross income of Y . In case of illness, treatment costs are L. The probability of illness is 0 , but by spending V units on prevention, the individual can lower it to 1 . All insurance contracts are fair. (a) Assume that prevention activity is observable and that there are two types of insurance contracts available. If the individual exerts prevention effort, it pays the premium P1 (I1 ) = 1 I1 where I1 is the chosen coverage. If the individual does not engage in prevention, the premium is P0 (I0 ) = 0 I0 where I0 is the chosen coverage. (i) Write down the expected utility (as a function of coverage I) with and without prevention. With prevention: EU1 (I ) = (1 1 )u(Y 1 I V ) + 1 u(Y 1 I V L + I ) Without prevention: EU0 (I ) = (1 0 )u(Y 0 I ) + 0 u(Y 0 I L + I ) (ii) Show that the individual will choose full coverage (i.e., I = L) with and without prevention. Take rst-order condition with respect to I . With prevention: EU1 (I ) =(1 1 )u (Y 1 I V )(1 ) + 1 u (Y 1 I V L + I )(1 1 ) = 0 I u (Y 1 I V ) = u (Y 1 I V L + I ) Y 1 I V = Y 1 I V L + I 0 = L + I
I1 = L.

Similarly without prevention: EU0 (I ) =(1 0 )u (Y 0 I )(0 ) + 0 u(Y 0 I L + I )(1 0 ) = 0 I Y 0 I = Y 0 I L + I 0 = L + I

I0 = L.

(iii) Under which condition will the individual exert prevention effort in equilibrium? Utility with prevention:
EU1 (I1 = L) =(1 1 )u(Y 1 L V ) + 1 u(Y 1 L V L + L)

=u(Y 1 L V ) 1

Problem Set 2

Health Economics

Spring 2014

Utility without prevention:

EU0 (I0 = L) =(1 0 )u(Y 0 L) + 0 u(Y 0 L L + L)

=u(Y 0 L) The individual will exert prevention effort if

EU1 (I1 = L) = u(Y 1 L V ) > u(Y 0 L) = EU0 (I0 = L)

or Y 1 L V > Y 0 L (iv) Interpret this condition. Gain from prevention (drop in probability of being sick times loss when sick) has to be larger than cost of prevention. (b) Assume now that prevention activity is not observable. We want to implement the secondbest contract with (partial) coverage I at a premium P = 1 I where the individual voluntarily engages in prevention activity. (i) Write down the expected utility (as a function of coverage I) with and without prevention. With prevention: EU1 (I ) = (1 1 )u(Y 1 I V ) + 1 u(Y 1 I V L + I ) Without prevention: EU0 (I ) = (1 0 )u(Y 1 I ) + 0 u(Y 1 I L + I ) Use the following parameter values: Y = 10, L = 7, 0 = 0.4, 1 = 0.2 and V = 1. For simplicity, assume now linear utility: u(y) = y. under which the individual voluntarily engages in (ii) Derive the maximum coverage I prevention effort. Expected utility with prevention: EU1 (I ) =0.8(10 0.2I 1) + 0.2(10 0.2I 1 7 + I ) =7.2 0.16I + 0.4 0.04I + 0.2I = 7.6 (0 1 )L > V

Problem Set 2

Health Economics

Spring 2014

Expected utility without prevention: EU0 (I ) =0.6(10 0.2I ) + 0.4(10 0.2I 7 + I ) =6 0.12I + 1.2 0.08I + 0.4I = 7.2 + 0.2I under which the individual voluntarily engages in prevention Maximum coverage I EU1 (I ) = 7.6 7.2 + 0.2I = EU0 (I ) I2 = 2 I

(iii) Show that this contract is preferred to a contract with full coverage and no preven: tion. Utility under a contract with prevention and coverage I ) = 7.6 EU1 (I Utility under a contract with no prevention and full coverage EU0 (L) = u(Y 0 L) = 10 0.4 7 = 7.2