Health Care Economics 7th Edition

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Chapter 7: The Demand for Health Insurance

MULTIPLE CHOICE

1. Which of the following types of reimbursement would hospitals support?

a. Indemnity benefit c. Both a and b

b. Service-benefit d. Neither a nor b

ANS: B
Hospitals would prefer service-benefits because insurance companies would reimburse hospitals
directly for the cost of treatment. Indemnity benefits reimburse only the patients and up to a fixed
amount, causing patients to actively seek to minimize cost.

PTS: 1

2. When an insurer promises to pay 30% of treatment costs, this amount is known as a

a. Deductible c. Stop-loss

b. Co-insurance d. Lifetime maximum

ANS: C
This is an example of a co-insurance rate where the insurance company pays 30% of the cost and the
patient pays 70% of the cost.

PTS: 1

3. It is flu season, and you are trying to decide if you should get a flu shot. When you are healthy, you
earn $144 a day, but if you become ill, you will only earn $100 a day. There is a 25% chance you will
get the flu without a flu shot. If you do receive the flu shot, then you definitely will not get the flu.
What is the actuarially fair price for the flu shot given this information?

a. $44 c. $22

b. $33 d. $11

ANS: D
The actuarially fair price is equal to your expected loss, which is (144 - 100)(0.25) = $11. Answer is
(d)

PTS: 1

4. It is flu season. When you are healthy, you will earn $144 a day, but if you become ill, you will only
earn $100 a day. There is a 25% chance you will get the flu. If your utility function is equal to
where W is equal to wealth, then what is your expected utility of catching the
flu?

a. $133 c. $11.5

b. $111 d. $10.5
 ANS: C
We need to find the expected utility. Therefore, we use the following formula: Prob(well)U(wealth
when well) + Prob(ill)U(wealth when ill) = (.75)(12) + (.25)(10) = 11.5.

PTS: 1

5. Insurance coverage is sold at

a. The actuarially fair price

b. The pure premium

c. The loading fee

d. The actuarially fair price + the loading fee

ANS: D
Insurance is sold at the actuarially fair price plus the loading fee. The actuarially fair price will cover
the expected cost of treatment, and the loading fee covers administrative cost for providing the
insurance.

PTS: 1

6. For a risk-averse consumer

a. The expected utility of wealth is greater than the utility of expected wealth

b. The expected utility of wealth is equal to the utility of expected wealth

c. The expected utility of wealth is less than the utility of expected wealth

d. There is no relationship between the expected utility of wealth and the utility of expected
wealth

ANS: C
Only a risk-averse agent buys insurance. For a risk-averse agent, the expected utility of wealth is less
than the utility of expected wealth. For this reason, a risk averse agent is willing to pay a certain loss
rather than face the risk of an uncertain loss with the same expected value as the certain loss.

PTS: 1

7. Calculate the expected return (or expected winnings) in a game where a person wins $1 with the
probability of , $5 with the probability of , and $0 with the probability of .

a. 0 c. $2 1 / 6

b. $1 1 / 6 d. $3

ANS: B
E(win) = ($1)(1/3) + ($5)(1/6) + ($0)(1/2) = 1/3 + 5/6 = $1 1/6.

PTS: 1

8. Use the following figure for questions 8 through 10

 Suppose that Q0 = 10 office visits, Q1 = 20 office visits, P0 = 10, and P1 = 2. The increased
expenditures due to insurance are:

a. $50 c. $200

b. $100 d. $300

ANS: B
The total expenditure before insurance was Q0*P0 = $100. By only paying 20% of the cost, the patient
sees the $10 cost as a $2 cost and increases their quantity to 20 office visits, but the total cost is really
at the old price of $10, which would imply a total cost of (10)(20) = 200. Therefore, the increase in
expenditures is $100.

PTS: 1

9.
 In the figure above, the change in insurance coverage causes a consumer’s private benefits to increase
(area under the demand curve) by:

a. 120 c. 60

b. 90 d. 30

ANS: C PTS: 1

10.

In the figure, the change in insurance coverage causes a social welfare loss equal to:

a. 100 c. 40

b. 60 d. 20

ANS: C PTS: 1

11. As it applies to health insurance, the adverse selection problem is the tendency for:

a. Those most likely to collect on insurance, i.e., sick people, to buy it.

b. Those who buy insurance to take less precaution in avoiding illness.

c. Sellers to price-discriminate.

d. Sellers to restrict output and charge high prices.

ANS: A
Healthy individuals with insurance are essentially subsidizing unhealthy people with insurance.
Further, healthy people realized that purchasing health insurance is more expensive than insuring
themselves by saving the expected cost of care. Thus, only sick people buy insurance.

PTS: 1
12. Lucy Ramirez has $22,500 in income. After a recent trip to Cuba, she discovers that there is a 25%
chance of acquiring Cubanitis. The disease is 100% curable but requires the Fidelonomy procedure (at
a cost of $12,500). The Kuba-Kuba Insurance Company offers a policy that will cover the
Fidelonomy. The premium they charge is $4,000. Of this premium, the pure premium is __________
and the loading fee is _______.

a. $4,000; $0 c. $875; $3125

b. $3,125; $875 d. Not enough information to answer.

ANS: B
The pure premium is the actuarially fair price (or expected cost), which is equal to $12,500*(0.25) =
$3,125. The loading fee is the difference between the full premium and the pure premium, $4,000 -
$3,125 = $875.

PTS: 1

13. Which of the following policies limits the extent of moral hazard in the health insurance market?

a. Stop loss

b. Large deductibles

c. Varying co-insurance rates

d. All of the above

e. None of the above

ANS: D
A stop loss places a lifetime cap on health care expenditures, causing patients to become more price
sensitive. Large deductibles place the cost of health care on the patient initially, causing patients to be
more sensitive about prices. Varying or increasing co-insurance rates can be used so that patients bear
a portion of the cost.

PTS: 1

14. A public option in the health insurance market has been proposed as a remedy to the increasing cost of
health care. Critics state that a public option requiring all citizens to purchase health insurance would
decrease health insurance premiums on average by mitigating

a. The adverse selection problem c. A failure of the market for externalities

b. The moral hazard problem d. The existence of spillover benefits

ANS: A
Forcing all citizens to purchase health insurance prevents a lemons’ market for health insurance by
removing adverse selection.

PTS: 1

15. Purchasing additional medical services because you are covered by health insurance is an
illustration of
 a. The adverse selection problem c. A failure of the market for externalities

b. The moral hazard problem d. The existence of spillover benefits

ANS: B
A failure of the market for externalities is an example of moral hazard. People know they will not have
to face the loss if a disaster is to arise because the government will cover them and thus they do not see
the benefit of insurance.

PTS: 1

SHORT ANSWER

1. Suppose the inverse demand for physician office visits is P = 1000 - 20Q. Now suppose an insurance
policy provides a co-insurance rate of 50%. Graph the new demand function with health insurance.

ANS:

PTS: 1

2. In the figure below: By how much do expenditures increase with insurance? What is the deadweight
loss to society for insurance?
 ANS:
Originally, expenditures are equal to (80)(100) = $8,000. After insurance, the new equilibrium
expenditure is (100)(120) = $12,000 or a difference of $4,000. The deadweight is the additional
amount of expenditure made above the additional benefit for receiving more services. This is equal to
the triangle shaded in below. Therefore, the answer is (100 - 20)(20) / 2 = $800.

PTS: 1

3. Suppose there are two types of people in an insurance market: high and low risks. The high-risk person
is sick 10% of the time and the low-risk person is sick 5% of the time. The probability that any
individual is high risk is 40%. Upon getting sick, an individual loses $10,000 in medical expenses.
What are the actuarially fair premiums for the types?

ANS:
The actuarially fair premiums are equivalent to each individual’s expected loss. For a high premium,
(high) = $10,000(Pr[ sick | high ]) = $10,000(.10) = $1,000. For a low premium (low) = $10,000*(Pr[
sick | low ]) = $10,000(.05) = $500.

PTS: 1

4. Suppose there are two types of people in an insurance market: high and low risks. The high-risk person
is sick 10% of the time and the low-risk person is sick 5% of the time. The probability of any
individual being high risk is 40%. Upon getting sick, an individual loses $10,000 in medical expenses.
If the insurer cannot distinguish between the two types, but the two individuals know their types, what
will be the equilibrium premium?

ANS:
This is an example of the lemons. If the insurer sets premiums equal to the actuarially fair premium for
the low type, then both types of consumers will enter the market. The low type is just indifferent and
the high type has surplus. But, the insurer is going to have to except negative profits.

E(profit) = $500 - $10,000(Pr[ sick | high ]*Pr[ high ] + Pr[ sick | low ]Pr[ low ])
 = $500 - $10,000[(.10)(.4) + (.05)(.6)]

= $500 - $10,000[.04 + .03] = $500 - $700 = -$200

Now, let the insurer pick the expected premium.

Premium(low)*Pr(low)+Premium(high)*Pr(high) = (.6)(500)+(.4)(1000)=$700

The low type won’t buy at this price, but the high type will. Again, the expected profits will be
negative.

E[profit]=$700*Pr(high) - $10,000[Pr(sick|high)*Pr(high)]

=Pr(high)[$700 - $10,000*(.1)]=Pr(high)*[$700-$1,000]=-$300*Pr(high) < 0

Therefore, the insurer will charge a premium of $1000. Only the high type will purchase insurance and
the insurer will earn zero profit.

PTS: 1

5. Suppose there are two types of people in an insurance market: high and low risks. The high-risk person
is sick 10% of the time and the low-risk person is sick 5% of the time. The probability of any
individual being high risk is 40%. Upon getting sick, an individual loses $10,000 in medical expenses.
What if the individuals do not know their type?

ANS:
If neither the insurer nor the patients know their type, then the prevailing premium is the expected
premium. We found this above, and it is equal to $700. At this value, the insurer should expect zero
profits, and each patient has zero surplus.

PTS: 1