Academic journal article Journal of Risk and Insurance

Consumption Externality and Equilibrium Underinsurance

Academic journal article Journal of Risk and Insurance

Consumption Externality and Equilibrium Underinsurance

Article excerpt

ABSTRACT

Relative consumption has been found to be crucial in many areas, such as asset pricing, the design of taxation, and economic growth. This article extends this line of research to the individual's insurance decision. We first define "keeping up with the Joneses" in the purchase of insurance and find that jealousy does not necessarily give rise to "keeping up with the Joneses." We also identify several sufficient conditions that cause the optimal coverage in the private market to be less than the social optimum (equilibrium underinsurance). Jealousy is found to be neither a sufficient nor a necessary condition for equilibrium underinsurance. We further show that a social welfare maximizing government could adopt a tax system to correct for the consumption externality and make individuals better off.

INTRODUCTION

There has been a long debate in the literature over whether the government should intervene in the individual's choice of insurance if there exists a market for private insurance. Some studies (see Kaplow, 1992a,b; Selden, 1993; Blomqvist and Johansson, 1997) have shown that the government's intervention in insurance may distort the incentive of the individual to purchase insurance in the private market and thereby reduce the social welfare, whereas certain other studies have shown that the government's intervention in the insurance market could improve social welfare by taking into consideration government efficiency (see Diamond, 1992; Mitchell, 1998; Huang and Tzeng, 2007a,b), redistribution (see Rochet, 1991; Cremer and Pestieau, 1996; Coronado, Fullerton, and Glass, 2000; Gustman and Steinmeier, 2001; Liebman, 2002; Brown, 2003), and asymmetric information in the private insurance market (see Akerlof, 1970; Eckstein, Eichenbaum, and Peled, 1985).

Although the previous literature has provided many ingenious findings, as far as we know, none of the studies has ever considered the consumption externality, which is a very important factor discovered recently in support of the view that the government's intervention might increase social welfare. (1) Besides the government's intervention, relative consumption has been found to be crucial in many other areas, such as asset pricing (2) and economic growth. (3) This article extends this line of research to the individual's insurance decision. In this article, we intend to analyze the effect of the consumption externality on insurance and to examine whether the government could make individuals better off by intervening in the private insurance market. (4)

In the literature discussing the consumption externality and government intervention, Dupor and Liu (2003) have found that if the preference of the individual exhibits jealousy, then the individual will consume more than the socially optimal amount since the individual does not take the consumption externality into consideration. In this article, we intend to ask another question: if the preference of the individual exhibits jealousy, does the individual take more risks (i.e., purchase less insurance) than that supporting the social optimum? The above problem is closely related to, but not the same as, the issue in Dupor and Liu (2003) since the insurance decision could influence the individual's consumption not only in both the loss state and the no-loss state but also in the opposite direction. It is worth recognizing that by purchasing less insurance, the individual can generally save part of the insurance premium and consume more when the loss does not occur. However, if the individual purchases less insurance and the loss occurs, the net loss of the individual will increase and the individual will be forced to consume less since the risk is not well covered. By noting that the insurance decision is critical for the individual's consumption, we intend to analyze the optimal insurance choice for the individual with regard to relative consumption. Moreover, we further analyze whether the private optimum in terms of the insurance purchased is the same as the social optimum and whether or not it is necessary for the government to intervene in the private insurance market in order to correct for the consumption externality. …

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