ECON 236 -- Professor Atal 1

Demand for Insurance:

Expected Utility
Choice Under Uncertainty
 ECON 236 -- Professor Atal -- 2

Choice Under Uncertainty

• • Many choices consumers make involve
uncertainty, or weighing the probabilities
and payoffs of different potential outcomes

• Examples:

• Which class to take

• What major to choose
• Roulette
• Financial investments
• What health insurance plan to
choose!
 ECON 236 -- Professor Atal -- 3

Choice Under Uncertainty

Factors:
•
• Probability of outcomes
• Likely
• Not Likely

• Payoffs of outcomes:
• Very high
• Very low

• Empirical evidence from many contexts

shows that people prefer certainty to
uncertainty

• Examples?
• True
• Not true
 ECON 236 -- Professor Atal -- 4

Insurance
• Insurance is a product that reduces financial uncertainty

• Reduction in financial uncertainty means that insurance

takes away money from outcomes where you are well off,
and gives you money when you are poor.

• Examples of Insurance Markets:

• Car Insurance
• Health Insurance
• House Insurance
 ECON 236 -- Professor Atal -- 5

Why Buy Insurance? Risk Aversion

• We’ve talked about some cases where people prefer
more uncertainty, and cases where people want more
certainty

• When thinking about insurance, which reduces financial

uncertainty, we’ll assume consumers are risk averse

• Risk aversion, with respect to money, means that you

prefer a fixed dollar amount $S to a risky gamble that
pays off $S in expected value
 ECON 236 -- Professor Atal -- 6

Risk-aversion: Example
• Suppose your only source of income this year is one of the
following two options; a lottery and a certain payout.

• A: A lottery that gives you $50,000 with probability 0.5, and

$10,000 with probability 0.5
• B: A check for $30,000 with probability 1

• Which one of these options would you rather have?

 ECON 236 -- Professor Atal -- 7

Expected Value
• The expected value of a random variable X (e.g.
income), denoted E[X], is the sum of all possible
outcomes of X, weighted by each outcome’s probabilities

If outcomes are x1, x2, . . . , xn, and the probabilities for each
outcome are p1, p2, . . . , pn respectively, then:
E[X] = p1 x1 + p2 x2 + · · · + pn xn

• A and B have the same expected value:

E[A] =0.5 x 50,000 + 0.5 x 10,000 = 30,000

E[B] =1 x 30,000
 ECON 236 -- Professor Atal -- 8

Expected utility theory

• Studies for experiments / related real world scenarios

show that most people prefer certain payouts

• The standard way that economists model choice

behavior under uncertainty is called expected utility
theory.

• Under expected utility theory:

• Individuals compare expected utility and not expected values.
• Rationalizes why you prefer A over B, even if both have the
same expected value.
 ECON 236 -- Professor Atal -- 9

Expected Utility
• The expected utility from a random payout X E[U(X)] is
the sum of the utility from each of the possible
outcomes, weighted by each outcome’s probability.

• If the outcomes are x1, x2, . . . , xn, and the

probabilities for each outcome are p1, p2, . . . , pn
respectively, then:

E[U(X)] = p1 U(x1) + p2 U(x2) + · · · + pn U(xn)

 ECON 236 -- Professor Atal -- 10

Example: Expected Utility

E[U(B)] = U($30,000)

E[U(A)] = 0.5 x U($50,000) + 0.5 x U($10,000)

• A “typical” preference for the certain outcome B ($30,000) over

option A (lottery) implies that expected utility from B, is greater
than expected utility from A:

E[U(B)] ≥ E[U(A)]

U($30,000) ≥ 0.5 U($50,000) + 0.5 U($10,000)

• Even though the expected values of A and B are the same, a

typical person who prefers B over A acts in a risk-averse
manner
• Prefer certain outcomes to uncertain outcomes.
• Why?
 ECON 236 -- Professor Atal -- 11

(extreme) example of health insurance

• Individual with wage W = $ 50,000 (only source of
income)
• Probability of sickness p = 0.5
• If sick:
• Medical bills c = $ 40,000
• Can buy insurance for a “premium” (price) r = $ 20,000:
• Insurance pays medical bills “in full” (aka “full insurance”)
• Therefore, payout if sick q = $ 40,000
Income under different scenarios
No insurance Insurance
Sick (p=0.5) $ Is = W - c $ I’s = W – c – r + q
Healthy (p=0.5) $ IH = W $ I’H = W – r
 ECON 236 -- Professor Atal -- 12

Income and Utility

A : No Insurance B : Insurance
Sick (p=0.5) $ 10,000 $ 30,000
Healthy (p=0.5) $ 50,000 $ 30,000

• Expected utility, no insurance: E[U(A)] = 0.5*U($50 K) + 0.5*U($10 K)

• Expected utility, with insurance: E[U(B)] = U($30,000)

• To compare E[U(A)] and E[U(B)] we make assumptions on U(I)

• Utility increasing with income U’(I) > 0: “more is better…”
• Marginal utility decreasing U’’(I) < 0 : “…specially when I have little”

• How sensible are these assumptions to you?

 ECON 236 -- Professor Atal -- 13

Assumptions on U(I): concavity

 ECON 236 -- Professor Atal -- 14

Expected utility of lottery, E[U(A)]

Step 1: find U[IS] and U(IH)

U(IH)

U(IS)

IS = 10 IH = 50
 ECON 236 -- Professor Atal -- 15

Expected utility of lottery, E[U(A)]

Step 2: Draw line Draw a line connecting (IS,US)
and (IH,UH)

U(IH)

U(IS)

IS = 10 IH = 50
 ECON 236 -- Professor Atal -- 16

Expected utility of lottery, E[U(A)]

Step 3: Find E[I] = pIS+(1-p)IH

U(IH)

U(IS)

IS = 10 E[I] = pIS+(1-p)IH IH = 50
= 30
 ECON 236 -- Professor Atal -- 17

Expected utility of lottery, E[U(A)]

Step 4: Read y-axis value of line at E[I]

U(IH)

E[U(A)]=
U(IS)p+U(IH)(1-p)

U(IS)

IS = 10 E[I] = pIS+(1-p)IH IH = 50
= 30
 ECON 236 -- Professor Atal -- 18

Expected utility of lottery

why does this work?
Intuition: Linear projection of a linear combination

U H −U S
yp = US + (E[I ]− I S )
IH − IS
U H −U S
yp = US + ( pI S + (1− p)I H − I S )
IH − IS
U H −U S
yp = US + (1− p)(I H − I S )
IH − IS
y p = pU S + (1− p)U H
y p = E[U]
 ECON 236 -- Professor Atal -- 19

Expected utility with insurance, E[U(B)]

In our example (of full insurance), income = 30 regardless of the state

U(IH)
E[U(B)] = U(30)

U(IS)

IS = 10 I’H = I’S= 30 IH = 50
 ECON 236 -- Professor Atal -- 20

Risk aversion, and the value of insurance:

E[U(B)]>E[U(A)]

U(IH)
E[U(B)])

E[U(A)])

U(IS)

IS = 10 I’H = I’S= 30 IH = 50
 ECON 236 -- Professor Atal -- 21

Definitions of Risk Aversion

Synonymous definitions of risk aversion:

1. Prefer certain outcomes to uncertain ones with the

same expected income

2. Prefer utility from expected income U(E[I]) to

expected utility E[U(I)]

3. Increasing and concave utility function U(I)

Question: What are things you can be risk averse

about besides income?
 ECON 236 -- Professor Atal -- 22

Certainty equivalent, ICE

U(IH)
E[U(B)])

E[U(A)])

U(IS)

IS = 10 ICE I’ = I’ = 30 IH = 50
H S
 ECON 236 -- Professor Atal -- 23

Certainty equivalent, ICE

What is your ICE for a lottery?

When you are indifferent between

• A: The lottery (example: Lottery A which gives you

$50,000 with probability 0.5, and $10,000 with
probability 0.5)

• B’: A check for $ICE with probability 1

 ECON 236 -- Professor Atal -- 24

Certainty equivalent, ICE

What is your ICE for a lottery?

When you are indifferent between

• A: The lottery (example: Lottery A which gives you

$50,000 with probability 0.5, and $10,000 with
probability 0.5)

• B’: A check for $ICE with probability 1

• Mine is around $ 25,000

• What determines $ICE?

 ECON 236 -- Professor Atal -- 25

Risk aversion, and ICE Risk aversion +

Curvature of U +
U(I)
ICE -

U3

U2
U1 (linear or “risk neutral”)

IS ICE,3 ICE,2 ICE,1=E[I] I

IH
 ECON 236 -- Professor Atal -- 26

A closer look to the Insurance Contract

 ECON 236 -- Professor Atal -- 27

Basic Health Insurance Contract

• Customer pays up front fee $r know as insurance
premium

• If customer becomes sick, gets insurance payout $q

• If customer is healthy, customer gets nothing back

• Either way, customer loses up front premium $r

• Final Income with insurance:

• Sick: IS + q – r = IS’
• Healthy: IH – r = IH’
 ECON 236 -- Professor Atal -- 28

Insurance categorization
Depending on the values of the premium and payouts
relative to expected claims, we will categorize insurance
contracts along two dimensions:

1. “Fullness”

Full v/s Partial Contracts

2. “Fairness”

Actuarially Fair v/s Actuarially Unfair

 ECON 236 -- Professor Atal -- 29

Definition: Full Insurance

• Remember that a risk averse consumer wants to avoid

uncertainty, so, optimally, get full insurance contract
where income is the same when healthy or sick

IS’ = IH’

• Under full insurance income is state independent

 ECON 236 -- Professor Atal -- 30

What is Payout in Full Insurance?

• We already know IS’ = IH’ under full insurance

• So:

IH – r = IS + q – r
IH = IS + q
q = IH – IS

• The payout q from full insurance equals difference

between income outcomes in each state without
insurance
 Full insurance contract: an insurance contract that achieves state indepen-
dence; income in all states is equal.
ECON
0 2360 -- Professor Atal -- 31
IS = IH

Partial Insurance
Partial insurance contract: an (as opposed
insurance toisfull
contract that state-dependent; in-
come in the sick state is still less than income in the healthy state.
insurance) 0 0
IS < IH
• A contract that does not achieve state independence is
called partial
Just as we insurance:
derived sizer of
the premium in payout
the cases<ofdifference
actuarially of
fair and unfair
incomeweacross
insurance, states
can derive the payout q in the cases of full and partial insurance. We
rely on the state-independence property of full insurance and the state-dependence
property of partialyou
• This means insurance:
still have more money when healthy
⌅ Full insurance ⌅ Partial insurance

IS0 = 0
IH IS0 < 0
IH
IS r+q = IH r IS r+q < IH r
IS + q = IH IS + q < IH
q = IH IS q < IH IS
• Size of payout q determines how close contract is to full
insurance. Closer it is to IH – IS, the fuller the contract.
The size of the payout q determines the fullness of the insurance contract. A
contract with a payout that fully covers the spread between IH and IS is full, while
contracts with payouts that do not fully cover this difference are partial. The closer
 ECON 236 -- Professor Atal -- 32

Definition: Actuarially fair insurance

• From point of view of insurer:
• Getting certain income r
• Paying out q with probability p

• E[Π] = Expected profits:

• Actuarially fair ó 0 profits (implied by perfect competition,

assuming no other (e.g admin) costs to insurance
company)
• Actuarially unfair : Positive profits (individual is paying
extra to insure, r – pq > 0)
 ECON 236 -- Professor Atal -- 33

Actuarially fair and full Insurance (like our

numerical example)
• Optimal for consumer. Completely reducing uncertainty
without giving up extra money or risk premium in process

• Consumers achieve expected income with certainty!

• Loses some income in good state, gets income in bad
state. Because of risk aversion, you want this!!!
 ECON 236 -- Professor Atal -- 34

Simple Insurance Categorization

 ECON 236 -- Professor Atal -- 35

Characterizing actuarially fair contracts

Actuarially fair contracts : r = pq

Let E[I] the expected income under actuarially-fair contracts

E[I ] = pI 'S + (1− p)I ' H
E[I ] = p(I S + q − r) + (1− p)(I H − r)
E[I ] = pI S + pq − pr + I H − r − pI H + pr
E[I ] = pI S + I H − pI H
E[I ] = pI S + (1− p)I H
• Actuarially fair contracts (either full or partial): expected income is equal
to
• Expected income without insurance.
• Income (certain) under full insurance, (called IF in the book)

• In words? In expectation, no transfer between individual and insurance

company.
 ECON 236 -- Professor Atal -- 36

Characterizing actuarially fair contracts

• All contracts that specify payments with expected income IF are

actuarially fair
• (ISP , IHP) is one example
 ECON 236 -- Professor Atal -- 37

Characterizing actuarially fair contracts

Among AF contracts,
contracts with less uncertainty
have higher utility

• All contracts that specify payments with expected income IF are

actuarially fair
• (ISP , IHP) is one example
 ECON 236 -- Professor Atal -- 38

fairness v/s “fullness”

 ECON 236 -- Professor Atal -- 39

fairness v/s “fullness”

AF,2

IF,2
• Full-unfair contracts (AF,2) may be more desirable than partial-fair (AP)

• But, if too unfair (IF,2<<IF), AF2 may generate less utility than AP
• There is a tradeoff between expected income (“fairness”), and uncertainty
of income (“fullness”).
 ECON 236 -- Professor Atal -- 40

Market equilibrium under perfect

competition
• Actuarially fair? Yes!
• Why? Perfect competition: If insurance is unfair, any
competitor can lower the premium (or increase payouts) and
get all the market.

• Full? Yes!
• Why? Individual preferences: Individuals prefer full insurance
over partial insurance. Any competitors offering fair but
partial insurance will loose market over competitors offering
fair and full insurance.

• Thus, in equilibrium: income-risk is fully transferred from the risk-

averse agent (consumer) to the insurance company (assumed to
be risk-neutral). Pareto Optimality!
 ECON 236 -- Professor Atal -- 41

Two Major ‘s
• How much do consumers
benefit from competitively
provided full insurance
that earns zero profit?

• How much income would

consumers be willing to
give above to have
certain income as
opposed to uncertain
income?
 ECON 236 -- Professor Atal -- 42

Conclusion
 ECON 236 -- Professor Atal -- 43

Final Discussion
• Demand for insurance driven by risk aversion with respect to
income level
• Desire to reduce uncertainty
• In our model: consequence of diminishing marginal utility

• Risk aversion can also explain:

• Portfolio diversification in finance
• Farmers scattering crops and land holdings

• Model gives key insights regarding demand under uncertainty. A

lot of other things going on in reality to discuss.