Question

1. Consider two alternative reforms to the Disability Insurance (DI) system in the United States.

• Pay different DI benefits for different types of disabilities (e.g., you get 30% of benefits if you have an injured back and 50% of benefits if are paralyzed).
• Amplify the stigma associated with receipt of social insurance, by enforcing a requirement that individuals receiving DI have a sign that declares “Mooch on Society” planted on the recipient’s lawn.

1. Explain the rationale behind each proposal using the concepts of consumption smoothing and moral hazard.
2. Explain the downside of each proposal.

Answer 1

The first proposal uses the concept of consumption smoothing, i.e. trying to have relatively similar consumption in all states of the world, so as to avoid the case of a bounty in one and penury in the other. If someone has an injured back, the negative effect on consumption is low. So a small part of the insurance should be used. When a more serious ailment happens, like a paralysis, to have the same level of consumption, more benefits are required.

Moral hazard refers to when, due to the availability of insurance, the insured becomes less careful and takes less care of the asset as he knows that he will be compensated for any damages. To prevent people from doing this, if stigma is attached to using insurance, people will use it only when absolutely necessary and will take steps to make sure they don't have to rely on insurance, thus eliminating moral hazard.

The downside of proposal A is that it can lead to moral hazard. As people are more likely to receive higher benefits for more serious disabilities, they will tend to be less and less careful. Also, smoothing is not a desirable thing always. Someone might want more if he is paralytic than when he has an injured back

The downside of proposal B is that it can have serious social ramifications. Since relying on insurance will be stigmatized, people might not use it even when required. It might also make disability looked down upon, weakening society's social fabric.