ECON361 Chapter Notes - Chapter 8: Pareto Efficiency, Adverse Selection, Moral Hazard

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8 Aug 2016
Purpose: To develop option price as the conceptually correct measure of WTP in circumstances
in which individuals face uncertainty. The expected social surplus measure is usually different
from the option price measure of benefits.
Consensus among economists is that the conceptually correct way to value the benefits of a policy
in circumstances involving risk is to sum the ex-ante amounts people affected by a policy would
be willing to pay to obtain it. Option price is the maximum amount an individual would pay for a
policy prior to knowing which contingency will occur (if the probability of each contingency is
known). The sum of the option price of all individuals equals the aggregate benefit of the policy.
Relation of Option Price to Expected Surplus (ES) and Option Value (OV)
Option value is the difference between option price and expected surplus: the maximum amount
beyond expected benefits that individuals are willing to pay to reduce risk. ES can either
overestimate or underestimate OP, so that OV can be positive or negative.
Contingent surplus diagrams:
Certainty line - payment amounts along it are the same regardless of which contingency
Fair bet line - every point along it has the same expected value. Its slope equals the negative
of the ratio of the probability of contingencies.
OP - point on certainty line representing the maximum ex ante payment an individual is willing
to make.
WTP locus - all combinations of contingent payments that give the same expected utility. If
the cost of a project does not depend on which contingency occurs, then it is also on the
certainty line. If the OP lies further to the northeast along the certainty line than cost, then the
project would increase welfare.
Option price generally does not equal expected surplus in circumstances of risk. Is OP the correct
measure? If complete and actuarially fair insurance is unavailable against the relevant risks, then
the larger of OP and ES is the conceptually correct measure of benefits. Insurance is complete if
a person can buy enough insurance to eliminate all risk. It is actuarially fair if the price depends
only on the true probabilities of the relevant contingencies. Availability of actuarially fair
insurance means individuals could move from the initial point in contingent claims space along the
fair bet line through the purchase of insurance. The availability of complete insurance allows
individuals to move all the way to the certainty line.
Problems with Insurance
Moral hazard (changes in behavior induced by insurance coverage) and adverse selection
Boardman, Greenberg, Vining, Weimer / Cost-Benefit Analysis, 4th Edition
Instructor's Manual 8-1
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