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Lecture 8

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Wilfrid Laurier University

Economics

EC248

Logan Mc Leod

Winter

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EC 248 Lesson 8 – The Demand for Health Care Insurance
The Demand for Health Care Insurance
- Most illness and injury is unpredictable, making health expenditures difficult to budget for
- Mechanisms (such as insurance) reduce the financial risk associated with illness and injury can
increase welfare
Definition of Risk
- Risk is present when we are uncertain whether an event will happen
- The amount of risk a person faces is determined by the probability of an event occurring and
the potential size of the loss/gain associated with the event
- For example, a person faces two lotteries:
1) 95% chance of winning $10,000, 5% chance of winning $0
2) 50% chance of winning $10,000, 50% chance of winning $0
- The greater risk is in the second lottery
Risk Pooling
- Occurs when each member of a large group contributes a small amount (money/effort) to the
“pool” in return for the promise that if a risky event happens to one of the members, money
from the pool will be used to compensate the individual for the loss experienced
- Risk pooling does not only share risks, but reduces total risk borne by the group
- Not all risks can be pooled, only those that can be traded mon individuals, (ex. Pooling their
financial risk, health (illness, injury, etc.) cannot be traded or pooled
- How effective a risk pooling is, depends on three factors:
1) Size of the risk pool
A larger risk pool is preferred, optimal size depends on nature of underlying risks
(probability of loss and size of the loss)
2) Independence of risks across members and risk pool
Important for illness/injury for one person in the risk pool not to materially affect the
probability of illness/injury for another person in the pool
3) Independence between having insurance and size of loss
Important the health care a person receives when ill is the same whether or no they have
insurance, if the presence of insurance affects size of loss it is called Moral hazard which can
potentially bankrupt the risk pool
Why Risk Pooling Through Insurance Can Improve People’s Welfare Activity
In your study notes describe and explain how and why risk pooling through
insurance can improve people’s welfare.
Demand for Insurance
- The economic model of the demand for insurance assumes: people know all possible outcomes,
probability of a specific outcome, and the monetary loss/gain with the outcome
- Meaning, a person knows the financial cost associated with a bad health outcome known as
monetary equivalent of the loss
The Standard Insurance Model
- In this model, we assume individuals only care about their absolute level of wealth, and that the
expected value of a gamble and proceed to make choices that maximize their utility
- The expected value of a gamble is the sum of the probability of event i (denoted by p) multiplied i
by the value (in monetary terms) of the event i (denoted by V ): i
- Similarly, the individual’s expected utility is the sum of the probability of event i (again, denoted
by p)imultiplied by the utility of the event (denoted by U): i
- Example: Assume for a given lottery, a person has a 60% chance of winning $30,000 (

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