Overconfidence, Insurance and Paternalism

It is well known that when agents are fully rational, compulsory public insurance may make all agents better o¤ in the Rothschild and Stiglitz (1976) model of insurance markets. We …nd that when su¢ ciently many agents underestimate their personal risks, compulsory insurance makes low-risk agents worse o¤. Hence, behavioral biases may weaken some of the well-established rationales for government intervention based on asymmetric information. The behavioral economics literature has produced broad empirical evidence that agents do not always act in their own best interest. When considering single-agent models, a possible implication of behavioral biases is paternalism: Policies designed to a¤ect agents’ choices for their own good. However, this implication has not been thoroughly investigated in fully-developed market models. As behavioral biases are di¢ cult to observe, it is natural to approach this investigation in markets with asymmetric information. This paper explores the policy implications of behavioral biases in the classic model of insurance markets with asymmetric information by Michael D. Rothschild and Joseph E. This paper has previously circulated under the title “Paternalism in a Behavioral Economy with Asymmetric Information”We thank the Editor, Vince Crawford, two referees, the audiences of University College London, Northwestern University, Boston University, the Stony Brook Summer Workshop 2004, Gerzensee ESSET 2006, Luca Anderlini, Mark Bils, Erik Eyster, Guillaume Frechette, Faruk Gul, Bart Lipman, Ben Lockwood, Michael Manove, Costas Meghir, Lars Nesheim and Jean Tirole for their comments. yKellogg School of Management, MEDS Department, 2001 Sheridan Rd., Evanston, IL 60208, USA and Department of Economics, 3708 Locust Walk, Philadelphia, PA 19104. zDepartment of Economics, Via S. Faustino, 74/B, 25122 Brescia, Italy.