Type II Diabetes is a costly and potentially debilitating disease. The total costs incurred over a lifetime by a person with Type 2 diabetes were recently estimated to be $85,000 - from treating the disease directly, and complications like nerve damage, amputations, and stroke.

Consider a simplified model of the market for health insurance, where diabetes is the only future health risk people face. Assume that there are 1,000 people classified as "normal weight" and 1,000 people classified as "overweight." Normal weight people face a 20% chance of developing Type II diabetes in their lifetime, and overweight people a 30% chance.

E1)Assume an individual can expect to earn $2,000,000 over the course of their lifetime. Additionally, assume individuals spend all their money on consumption, andu(c)=c. Ignore any intertemporal considerations of interest rates, inflation or discount factors, i.e.r=0. What is the amount,x, that each type of individual would be willing to pay for an insurance contract that fully insures them against the lifetime costs of developing diabetes?

x(normal weight)=?

x(overweight)= ?

E2)Suppose insurance companies may measure the weight of an individual prior to offering them an insurance contract, and price their contract based on the result. Assume the only costs the insurance company faces are payments for medical costs if a person develops diabetes, that insurance companies are risk-neutral, and that the market for providing insurance is perfectly competitive.

What prices for insurance contracts will be offered?

p(normal weight)=?

p(overweight)= ?

E3)Who will purchase insurance? (more than one can be correct)

a)Normal weight individuals

b)Overweight individuals

c) Neither

E4)What will be the consumer and producer surplus in this market? (Note: If you round off the intermediate results, those rounding errors may be amplified in your final result. We suggest finding exact solutions.)

CS=?

PS=?

E5)In order to increase fairness and equity, in 1996 lawmakers in Massachusetts enacted a requirement that insurers utilize "community rating": they must charge everyone the same price.

Consider the impact of this policy change.

If all individuals purchase insurance, at what price would the insurer break even?

p=?

E6)Who will purchase insurance at this price? (More than one can be correct)

a)Normal weight individuals

b)Overweight individuals

c)Neither

E7)Given this, what price will insurers actually set?

p=?

E8)What is happening in this market?

a)Moral hazard

b)Adverse selection

c)Time-inconsistent preferences

d)Loss aversion

e)None of the above

E9)What will be the consumer and producer surplus in this market?

CS=?

PS=?

Compared to when insurers could weigh people prior to offering them a contract (in PS11.2.2), what is the deadweight loss from this policy change? (Enter a positive number for a loss.)

DWL=?

E10)In 2006, Governor Mitt Romney enacted "Romneycare," which mandated that all individuals purchase health insurance.

Assuming community rating is still in effect, what will be the price of insurance?

p=?

What will be the consumer and producer surplus in this market?

CS=?

PS=?

Compared to when insurers could measure an individual's weight prior to offering them a contract (in PS11.2.2), what is the deadweight loss from this policy change? (Enter a positive number for a loss.)

DWL=?