This is a highly stylized example of an insurance market. Suppose there are just two risk types, A and B, and their probabilities of different levels of medical spending are as shown in the table below (similar to Table 7.1 on page 89 of Reinhardt’s book). In this example, we will not be concerned about moral hazard; probabilities and medical spending levels are the same whether or not one has insurance.
Table 1. Probabilities of Different Levels of Medical Spending
Size of Medical bill
Fraction of TypeA Fraction of Type B
Expected to Incur Expected to Incur
Bill Such a Bill Such a Bill
$0 0.851 0.5295
$5,000 0.12 0.34
$25,000 0.02 0.09
$100,000 0.009 0.0405
Use this additional information for your answer:
4.Now suppose that insurers can tell who is TypeA and who is Type B (perhaps because they require a physical exam of anyone applying for coverage). Thus premiums can be different for each type. What would you expect premiums to be at equilibrium and who would buy insurance? Is anyone better or worse off than they were in Part 3?
5.Now suppose that we require insurers to “community rate” their premiums, that is, charge the same premium to everyone, but also require anyone who does not buy insurance to pay a penalty of $1,500. Now, what will equilibrium look like? Will anyone feel better off or worse off than they did in Part 4? **Note only need help with 5, 4 is for your reference**
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