Insurance and the Hidden Action Problem
We may change the model of the market for insurance discussed in Chapter 5 by assuming that the probability of theft of the individual’s car is no longer exogenous but depends upon the individual’s actions, say whether he locks his car or not on leaving it. In a full information world the optimum insurance contract would make compensation contingent upon the probability of theft, with a higher price per unit of compensation the higher the probability of theft. In this case, the market for insurance would continue to function efficiently, since if an individual chose to behave in a more risky way, he would pay for this behaviour by paying a higher price per unit of compensation.
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