Question

Chimnesia has two equal-sized groups of people: smokers and nonsmokers. Both types of people have utility U = Ï W C, where C is the amount of consumption that people have in any period. So long as they are healthy, individuals will consume their entire income of $16,000. If they need medical attention (and have no insurance), they will have to spend $12,000 to get healthy again, leaving them with only $4,000 to consume. Smokers have a 10% chance of requiring major medical attention, while nonsmokers have a 2% chance.

Insurance companies in Chimnesia can sell two types of policies. The “low-deductible” (L−) policy covers all medical costs above $2,000, while the “high-deductible” (H−) policy covers only medical costs above $10,000.

1. What is the actuarially fair premium for each type of policy and for each group?
2. If insurance companies can tell who is a smoker and who is a nonsmoker and charge the actuarially fair premiums for each policy and group, show that both groups will purchase the L-policy.

   Suppose that smoking status represents asymmetric information: each individual knows whether or not they are a smoker, but the insurance company does not.

3. Explain why it is impossible, at any price, for both groups to purchase L-policies in this setting. Which groups, if any, do you expect to buy L-policies, and at what price?
4. Show that it is possible for both groups to purchase insurance, with one group buying L-policies and one group buying H-policies.

Answer 1