(a) Assuming a competitive insurance market, and that insurers are able to observe fully each individual customer’s volitional choice of ai, provide a diagrammatic analysis with accompanying discussion of how the value of ai affects the equilibrium. (25%)
(b) Again assuming a competitive insurance market, and full observability of each individual’s expenditure on care, depict and discuss the equilibrium that would arise when the
government compels individuals to spend a specific amount aˆ on care, such that the individual’s expected utility is lower in equilibrium, in spite of any insurance cover purchase, than it would have been had the individual not been compelled to spend aˆ on care. Describe and explain also how the representation of the equilibrium would differ if the government’s requirement that aˆ be spent on care were to lead to the individual’s expected utility in equilibrium being higher than when there is no such requirement. (25%)
(c) Assuming once again that the individual is free to choose their level of care (ai), which must now take either one of two values, a0 (low) or a1 (high), where 0 ≤ a0 < a1, analyse with appropriate diagrams the competitive equilibrium when insurers cannot observe each individual’s choice of ai. Your accompanying discussion should explain, inter alia, the optimal design of the insurance contract and the welfare implications of the non- observability of actions. Proceed to discuss, explain and depict the potential welfare impact in this situation of a policy consisting of both a lump-sum tax and a subsidy. (50%)

 

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