Part I. For each of the statements below, indicate whether the statement is true or false and explain why it is true or false.
1. Uncertainty regarding the effectiveness of a specific health service for a particular individual is an important reason why patients have difficulty assessing quality of care.
2. If we define a health care service as needed if the expected health effect for a person is positive, then society should ensure that all health care needs are met.
3. A doctor who acts as a perfect agent for her patients will always provide care that is expected to improve a patient’s health.
4. The effectiveness of pooling financial risk through insurance increases as the number of individuals in the risk pool grows.
5. Adverse selection is likely to be most severe when the government requires private insurance companies to charge all individuals the same premium
6. If the production of health care generated positive externalities, the welfare costs of moral hazard would be smaller than suggested by M. Pauly’s analysis.
Part II. Suppose an individual has the following utility function defined over wealth:
U = U( ). The individual has an initial wealth level of $20,000.
a. The individual has a 30% chance of a heart attack and the loss associated with the attack is $5000.
i. What is the expected loss from a heart attack?
ii. What is the maximum amount this individual is willing to pay for insurance against a heart attack?
iii. What is the risk premium?
b. A new drug has been developed that is effective in preventing heart attacks. Taking the drug reduces the chance of a heart attack to 10%, but the loss associated with the attack increases to $10,000.
i. Now what is the expected loss?
ii. What is the maximum amount this individual is willing to pay for insurance against a heart attack?
iii. What is the risk premium?
c. Explain why some of the answers change before and after the individual begins taking the drug.