Moral Hazard and State-Dependent Utility Function

Abstract

This paper presents first the choice of the optimal insurance policy under a state-dependent utility function (S.D.U.F.) when the probabilities of loss are dependent on the actions of the insured. Moral hazard is shown to be an important problem under the S.D.U. F.. This paper also verifies whether the problem of moral hazard is more or less important under a S.D.U.F. than under a state-independent utility function (S.I. U.F.). The measure of moral hazard in terms of insurance coverage is a function of two factors: 1) the undesirability to the individual of the accident or illness and 2) the dependence of the marginal utility of income on the states of the world. The first factor always has a negative effect on moral hazard, but the second may affect moral hazard in different ways. Finally the paper analyses the variation of the with moral hazard and finds that the optimal deductible does not necessarily vary in the same way as moral hazard.