WE - Introduction & Insurance Theory

Trend in social spending

rising for most OECD countries

Largest share of Spending

old age and health

Recent trends of the welfare

1) globalization
2) demographic change
3) increased female labor force participation
4) technological change
5) Flexwork, gig economy
6) COVID

Why is there a welfare state (2 functions)

1) Redistribution (Robin Hood)
2) Market failures (piggy-bank function)

Redistribution is about …

allocation of the pie (equity)

Parts of redistributive function of the welfare state

1) poverty relief
2) reducing inequality
3) social inclusion

Social welfare function (SWF)

aggregates utility functions of all individuals

Utilitarian social welfare

maximise the sum of individual utilities

Utilitarian social welfare function

W = U1 + U2 + U3 + … Un

Rawlsian social welfare

maximise the utility of the worst-off person in society

Rawlsian social welfare function

W = min(U1,U2,… Un)

Alleviating market failures is about …

the size of the pie (efficiency)

Parts of alleviating market failures

1) Externalities
2) Bounded rationality
3) Information asymmetry

Expected consumption (formula in words)

E(C) = probability of bad outcome * consumption in bad outcome + 1-probability of bad outcome * consumption in good outcome

Utility of expected consumption (formula)

U(E(C))

Expected utility in risky situation (formula words)

E(U) = probability of bad outcome * Utility function(consumption in bad outcome) + 1-probability of bad outcome* Utility function(consumption in good outcome)

Loss of utility due to risk (formula)

U(E(C)) - E(U)

Interpretation C*

with certain consumption C*, I am equally well of as in the risky situation (same utility)

Deriving Consumption with same utility (C*) - words

Expected Utility in risky situation = Utility of C*

Deriving Consumption with same utility (C*) - formula

Utility function(C*) = probability of bad outcome * Utility function(consumption in bad outcome) + 1-probability of bad outcome* Utility function(consumption in good outcome)

Willingness to pay for certainty (words)

= monetary value of utility loss

Willingness to pay for certainty (formula)

E(C) - C*

Willingness to pay for certainty (formula in words)

Expected consumption - C*

Three objectives when designing the welfare state

1) Equity
2) Efficiency
3) Administrative feasibility

Equity includes

1) poverty relief
2) reducing inequality
3) social inclusion

Def. efficiency

making the best use of limited resources given people’s tastes (or preferences) and the available technology

Administrative feasibility

1) system should be simple, easy to understand and cheap to administer
2) benefits should be as little open to abuse as possible

Types of government intervention

1) cash transfer
2) subsidies and taxes
3) production
4) regulation

Relationship of three objectives of the welfare state

cannot reach all three objectives together = always a trade off

Types of government intervention - cash transfers

1) unconditional
2) contribution-based
3) means-tested

Unconditional cash transfers example

child benefits

Contribution-based cash transfers

unemployment or disability benefits

Means-tested cash transfers

social assistance, housing benefits

Types of government intervention - subsidies and taxes

child care, taxes on cigarettes

Types of government intervention - production

of health or education

Types of government intervention - regulation

1) Quality standards
2) Quantity
3) Price

Regulation - Quality

consumption, health care, education

Regulation - Quantity

schooling

Regulation

minimum wage

Empirical tools to evaluate design of the welfare state

1) randomized trials
2) quasi-experiment
3) structural modelling

why government intervention is needed in the form of the welfare state

address redistribution issues and market failures

Why do people want insurance?

Risk/Loss aversion

Why does the government need to provide insurance in some cases?

asymmetric information

Actuarially fair premium (formula)

probability of bad situation x amount insurance firm hast to pay in bad situation

Willingness to pay for insurance (formula in words)

Willingness to pay for certainty + actuarially fair premium

Deductible in Insurance exercise

how much individual has to pay themselves

Def. Actuarially fair premium

How much insurance firm should ask so they do not go bankrupt

In situation with asymmetric information, how will insurance firm operate?

use the average probability of bad outcome of all groups

Calculating average probability of bad outcome

0.5* bad probability group 1 + 0.5*bad probability group 2