Reference no: EM132482518

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.

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, and u(c)=c^(1/2). Ignore any intertemporal considerations of interest rates, inflation or discount factors, i.e. r=0.

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 for the normal weight and the overweight?; 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.)