Question

Give an example and discuss when morality should be considered in calculating producer

and consumer surplus.

Answer 1

Example: healthcare insurance policy, where consumers has to maintain moral ethic while choosing insurance policy. Such morality should be considered in order to calculate any sort of surpluses. Discussion: The following graph is required for understanding. Price P1 Supply Demand Quantity

Demand curve is the policy requirement by a consumer and supply curve is the insurance policy provided by an insurance company.

These two curves meet at point E, indicating equilibrium. Corresponding equilibrium price is P0 and quantity is Q.

The maximum willingness-to-pay by the consumer is P1; therefore, the consumer surplus (CS) is [0.5 × Difference in price × Equilibrium quantity = 0.5 × (P1 – P0) × Q]. Such maximum willingness-to-pay depends on the risk associated with consumers (policy holder) – suppose the policy holder smokes heavily but he didn’t disclose it while taking a healthcare policy; this is a moral hazard in insurance policy; if the policyholder gets a policy by paying lesser amount of premium, which is P0, his CS would be very high; on the other hand, if there is no moral hazard, there CS would be low. Therefore, morality is very important while calculating CS.

The minimum acceptable price by an insurance company is P2; suppose this is applicable in case of normal policy having no moral hazard. Producer surplus (PS) is [0.5 × Difference in price × Equilibrium quantity = 0.5 × (P0 – P2) × Q]. Since the company doesn’t know the risk on consumer, its PS would be high, which is not appropriate; if the company able to know the risk-factor associated with the policyholder, the minimum acceptable price would have been higher and PS would be low. Therefore, morality is very important here too for calculating PS.