Monday, August 30, 2010

Personal Accountability is an Economic Issue

Personal Accountability is something we are all bound to feel strongly about. We don't want to fund our neighbors foolishness, and it is human nature to reject the idea that paying for this is at all a good idea.

We should plunge headlong into an exercise in not judging behaviour, as that is not the purpose for this blog, but to recognize what is good for our wallets.

So a simple example. Using previous expectation, suppose there is a rare disease. It costs ten thousand dollars to treat, and there is a 1% chance you get it in your lifetime. This would then imply you would need to keep 100 dollars in your pocket at all times based on this expectation. Essentially 100 is the new 0 for your wallet.

Your first reaction should be "This is not how people work" Your second should be "Why should I care, we shoud all keep a bit more money on hand"

This is correct. Now, change the model a tiny bit. Let us suppose that there is a second disease, and a third and a fourth...

Clearly, I can tie up you entire income for diseases you will probably never have. The economy grinds to a halt as we sit on massive piles of income for radiation treatment we may or may not need.

So clearly, you shout at me "This is a market failure!" Well observed!

Now, obviously a business model should step in, and fix all of this for us and we can go on being complete free market capitalists.

This is where the insurance company steps in, but yet for some reason, we are not any better off. We have only begun to go into the rabbit hole unfortunately.

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I hope I can start an argument here, because the similarities between modern insurance and standard oil are there, just not obvious.

First a detour: Making choices under uncertainty

Expected value is a simple enough notion, and critical for our discussion.

Suppose we play a game. Heads I give you a dollar, tails you give me a dollar. The coin is fair, so what we do is we multiply the outcomes (plus and minus one) with the probabilities (one half for each) and add. We get zero.

So this game, in the long run, you expect to make zero dollars playing this game.

Suppose now we play a new game. Heads I give you a dollar, tails you give me nothing. The coin is fair.
We perform the same arithmetic and arrive at 50 cents is the amount you would expect to make per play.

Thus if i charge 50 cents, you would be indifferent between playing and not playing.

This was quite quick, but what we need to understand here is only the basic element of how we can go about making decisions under uncertainty.

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