Optimal demand management policies with probability weighting

We review the optimality of partial insurance contracts in the presence of moral hazard when consumers are affected by probability weighting. In valuing risky prospects individuals commonly overweight extreme outcomes at the expense of intermediate outcomes; these deviations systematically bias the ex-ante value of insurance. We characterize optimal contracts for the case of perfectly competitive insurance markets taking this bias into account and find that full insurance is preferred more often for illness that has low probability, while partial insurance or even no insurance are preferred for illness that has higher probability. The latter result justifies the existence of a universal compulsory minimum level of health insurance.