1. APPLICATION 15.2: Do HMO Patients
Need a Bill of Rights?
Because HMOs operate under
predetermined budget constraints, they
have an incentive to be sure that the care
they provide meets some sort of cost-
benefit standard.
They may therefore be reluctant to provide
care up to the amount that insured
consumers want to buy (Q’).
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2. APPLICATION 15.2: Do HMO Patients
Need a Bill of Rights?
These firms will tend to push the quantity of
care toward Q* -- a level of care for which
marginal benefit is equal to marginal cost.
Much of the consumer dissatisfaction with
HMOs may reflect the fact that established
spending patterns were already
exaggerated by the prevalence of insurance
in medical care markets.
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3. Methods of Reducing Risk:
Insurance
Figure 15.2 shows the motive for buying
insurance.
Assume that during the next year this person,
with a $10,000 current income, faces a 50
percent change of having $4,000 in
unexpected medical bills.
Without insurance, this person’s utility would
be U1, the utility of the average of $6000 and
$10,000.
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4. FIGURE 15.2: Insurance Reduces Risk
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U
U1
Income
(thousands
of dollars)
0 7.5 106
Utility
5. Fair Insurance
Fair insurance is insurance for which the
premium is equal to the expected value of the
loss.
– In Figure 15.2, fair insurance would cost $2,000
which is the expected value of what insurance
companies would have to pay each year in health
claims.
– This would guarantee income of $8,000 which
would yield utility of U2
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6. FIGURE 15.2: Insurance Reduces Risk
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UU2
U1
Income
(thousands
of dollars)
0 87.5 106
Utility
7. Unfair Insurance
Since insurance companies have costs
beyond paying benefits, they can not sell
insurance at actuarially fair premiums.
In Figure 15.2 the person would be willing to
pay up to $2,500 for health insurance since
$7,500 of risk-free income yields as much
utility (U1) as without any insurance.
A premium of $3,500, however, would reduce
utility to U0.
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8. FIGURE 15.2: Insurance Reduces Risk
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UU2
U1
U0
Income
(thousands
of dollars)
0 87.56.5 106
Utility
9. Uninsurable Risks
Some risks are so unique or difficult to
evaluate that insurers are unable to set
premium rates so that risks become
uninsurable.
– If events are so infrequent or unpredictable, such as
wars, etc. insurers have no basis for establishing
premiums.
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10. Uninsurable Risks
When buyers and sellers have different
information, market outcomes may exhibit
adverse selection--the quality of goods or
services traded will be biased toward market
participants with better information.
– Those who expect large losses will buy insurance
so the insurer will be paying out more in losses than
expected.
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11. Uninsurable Risks
Moral hazard is the effect that having
insurance has on the behavior of the insured.
– Having insurance may cause people to be more
likely to incur losses.
– For example, if people have insurance on the cash
they carry they are more likely to lose it through
carelessness.
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12. Methods of Reducing Risk:
Diversification
Diversification is the economic principle
underlying the adage, “Don’t put all your eggs
in one basket.”
Diversification is the spreading of risk among
several options rather than choosing only one.
– Suitably spreading risk around may increase utility
above that obtain by a single action.
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13. Diversification
Figure 15.3 shows the utility of income for an
individual with a current income of $10,000
who must invest $4,000 in risky assets.
Assume only two such assets, shares of stock
in company A or company B.
– The stock costs $1, but will increase to $2 if the
company does well during the next year.
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14. Diversification
– If the company does poorly, the stock will be
worthless.
– Each company has a 50-50 chance of doing well.
If the two companies’ prospects are unrelated
to one another, holding both stocks will reduce
the person’s risks.
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15. Diversification
Investing in 4,000 shares of company A yields
a 50 percent chance of having $14,000 and a
50 percent chance of having $6,000.
– This yields a utility level of U1.
If the person invests in 2,000 shares of each
company, there are four possible outcomes
which are shown in Table 15.1.
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17. TABLE 15.1: Possible Outcomes from
Investing in Two Companies
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Company B’s Performance
Poor Good
Poor $6,000 $10,000Company A’s
Performance Good 10,000 14,000
18. Diversification
Each of these four outcomes is equally likely,
with half the cases where the person ends up
with his or her original $10,000.
– The diversification strategy, while it still has an
expected value of $10,000, has less risk.
– In Figure 15.3, point C represent when B does
poorly and D represent when B does well.
– Point E, (the average of C and D) results from
diversification and yields utility U2 > U1.
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20. APPLICATION 15.3: Mutual Funds
Mutual funds pool money from many investors
to buy shares in several different companies.
For this service, investors pay annual
management fees of 1 to 1.5 percent of the
value of the money they have invested.
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