Question

Amanda, a homeowner, discovers that the crime rate in her neighbourhood is increasing. In fact, it is so bad, the local insurance industry will not sell property insurance with theft coverage to her.

1. Draw a diagram showing the marginal benefit of crime prevention Amanda applies against the marginal cost she incurs. Explain the significance of equilibrium in this model.
2. Draw a diagram showing the impact of increased police surveillance in Amanda’s neighbourhood on Amanda's marginal benefit and marginal cost curves. Explain why equilibrium changes.
3. Show what happens to Amanda's marginal benefit and marginal cost curves in the diagram if she could buy theft insurance. What does this do to her standard of care to prevent theft? Why does the graph shift in the direction it does? Explain what phenomena is at work in the shift. How would a market of such homeowners effect the costs of insurance companies?
4. If the insurer introduces a deductible for theft loss or a loss splitting term into the insurance contract, what effect will this have on the marginal benefit curve of the homeowner? What other contractual terms might be added to minimize the cost of theft to the homeowner? The insurance company? To society?

Answer 1

a. As amanda takes precautionary measures, her marginal cost increases and her marginal benefits decreases because adding a guard dog and incurring the cost would not provide much deterrence if the house already has an electric fence.

equilibrium occurs when MC=MB, ie the cost of applying another precaution is equal to the benefits that the new precaution provides. in this case net benefit is zero.

b. with increased police surviellance, MB curve shifts upwards and the quantity of private precautionary measures against theft increases.

c. if she could buy theft insurance then she would not undertake any private precautionary measures. This is called moral hazard.

Given this, insurance companies would increase the price of insurance to provide cushion for their potential losses, as a result the market size of the insurance company would shrink

d. introducing a deductible in the theft loss would make buyer of insurance more careful as he also has to bear the burden of the loss, so his MB curve would become flatter now.