Behavioral Welfare Analysis of Insurance Markets: The Case of Narrow Framing and Loss Aversion

Abstract

This paper explores the socially optimal level of insurance given that individuals are subject to behavioral biases, in particular narrow framing and loss aversion. The central issue of this normative analysis is whether or not a social welfare function (SWF) should take into consideration the behavioral components of preferences. One school of thought claims that social planners should not consider behavioral components since they are anomalies or mistakes that are often self-destructive. Another school of thought argues that social planners should respect behavioral components because these components determine actual choices and may reflect true and stable preferences. After exploring both viewpoints, this paper concludes that narrow framing and loss aversion need to be considered in normative analysis at least to some extent because these behavioral biases may partially, if not completely, shape authentic and stable preferences. This paper then shows that the socially optimal level of insurance could be lower than full insurance when these behavioral components are reflected in the SWF.