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Risk Spreading/Mutual Insurance 100 risk-neutral persons each independently risk a $10,000 loss. Loss probability = 0.01. Initial wealth is $40,000. No insurance: expected wealth is Risk Spreading/Mutual Insurance Mutual insurance: Expected loss is Each of the 100 persons pays $1 into a mutual insurance fund. Mutual insurance: expected wealth is Risk-spreading benefits everyone. A Brief Summary Key ideas of this Chapter: State-contingent consumption; Expected utility function; Risk averse (loving or neutral) preferences; Preferences Under Uncertainty What is the MRS of an indifference curve? Get consumption c1 with prob. ?1 andc2 with prob. ?2 (?1 + ?2 = 1). EU = ?1U(c1) + ?2U(c2). For constant EU, dEU = 0. Preferences Under Uncertainty Preferences Under Uncertainty Cna Ca EU1 EU2 EU3 Indifference curvesEU1 EU2 EU3 Choice Under Uncertainty Q: How is a rational choice made under uncertainty? A: Choose the most preferred affordable state-contingent consumption plan. State-Contingent Budget Constraints Cna Ca m The endowment bundle. Where is the most preferredstate-contingentconsumption plan? Affordableplans State-Contingent Budget Constraints Cna Ca m Where is the most preferredstate-contingentconsumption plan? More preferred State-Contingent Budget Constraints Cna Ca m Most preferred affordable plan State-Contingent Budget Constraints Cna Ca m Most preferred affordable plan MRS = slope of budget  constraint State-Contingent Budget Constraints Cna Ca m Most preferred affordable plan MRS = slope of budget  constraint; i.e. Competitive Insurance Suppose entry to the insurance industry is free. Expected economic profit = 0. I.e. ?K - ?aK - (1 - ?a)0 = (? - ?a)K = 0. I.e. free entry ? ? = ?a. If price of $1 insurance = accident probability, then insurance is fair. Competitive Insurance When insurance is fair, rational insurance choices satisfy Competitive Insurance When insurance is fair, rational insurance choices satisfy I.e.