Arthur Snow

Evidence on Adverse Selection: Equilibrium Signaling and Cross-Subsidization in the Insurance Market

The configuration of equilibrium in the market for automobile collision insurance is examined empirically by representing the premium-deductible menu and the demand function as a standard hedonic system. Using contractual data from a representative insurer, we estimate a reduced-form hedonic premium equation and the inverse of the marginal bid equation for insurance coverage. The data reveal an equilibrium with adverse selection and market signaling but lead us to reject the hypothesis that high risks receive contracts subsidized by low risks.

The marginal welfare cost of public funds: Theory and estimates

Abstract We derive a general analytic formula for the marginal welfare cost (MWC) of public funds without imposing restrictive assumptions on preferences or technologies. The framework encompasses the various special cases previously considered, and reconciles the disparities among the reported estimates of MWC. Unresolved differences in existing estimates are fully explained by appropriate interpretations of intended thought experiments and alternative assumptions about the elasticity of labor supply with respect to public spending. Further progress in measuring MWC requires empirical estimation of labor-supply functions that include government spending as an explanatory variable.

Tax evasion and the size of the underground economy

Abstract The theoretical literature on the relationship between the tax system and the ‘underground’ economy is extended using a model similar to the one examined by Watson (Journal of Public Economics, 1985, 27, 231–246), in which tax evasion is possible in one sector of the economy, but is impossible in the other. We prove that a rise in the tax rate increases (decreases) the number of agents in the sector in which tax evasion is possible if preferences exhibit increasing (decreasing) relative risk aversion. We also use our model to investigate the relationship between the tax rate and the total amount of tax evaded.

The Theory of Risk Classification

Risk Classification is the avenue through which insurance companies compete in order to reduce the cost of providing insurance contracts. While the underwriting incentives leading insurers to categorize customers according to risk status are straightforward, the social value of such activities is less clear. This chapter reviews the theoretical and empirical literature on risk classification, which demonstrates that the efficiency of permitting categorical discrimination in insurance contracting depends on the informational structure of the environment, and on whether insurance applicants become informed by the classification signal.

The Marginal Cost of Raising Tax Revenue and Redistributing Income

We present analytic formulas for calculating marginal welfare costs when taxes are levied against the wages of a heterogeneous population of households and marginal tax revenue finances either the supply of a public good or lump‐sum transfers. The formulas are applied to explain the wide discrepancy between estimates of marginal welfare costs for redistribution previously obtained through computer simulation procedures. Our calculations reveal that these procedures introduced lump‐sum transfers that were not specified as part of the reforms to be simulated, but explain most of the differences between their estimates. We also show that welfare cost estimates are quite sensitive to the elasticity of labor supply with respect to exhaustive public spending.

Progressive income taxation and the underground economy

Abstract With a progressive income tax system, decreasing absolute and nondecreasing relative risk aversion are sufficient conditions for either a rise in the tax rate or a revenue-neutral increase in progressivity to cause growth in the underground economy.

HUMAN CAPITAL INVESTMENT AND LABOR SUPPLY UNDER UNCERTAINTY

The authors extend the theory of human capital investment under uncertainty by incorporating postinvestment labor supply as a choice variable. They show that human capital investment decreases in response to an increase in risk about its return if such investment is an inferior activity and preferences exhibit decreasing risk aversion. However, if investment is normal, then the effect of an increase in risk is indeterminate. These results highlight the importance of obtaining empirical evidence on the income elasticity of demand for human capital investment for arriving at refutable hypotheses about the effect of risk. Copyright 1990 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.

Greater Downside Risk Aversion

Although investors are concerned foremost with mean and variance, they are also sensitive to downside risk. In this paper, we introduce an index of downside risk aversion to distinguish risk aversion from higher-order aspects of risk preference, including prudence. We show that the index of downside risk aversion S increases with monotonic downside risk averse transformations of utility, thereby directly linking S to the definition of downside risk aversion introduced by Menezes et al. (American Economic Review, 70, 921–932, 1980). Although the index S applies equally to risk averse and risk loving decision makers, for a given positive degree of risk aversion, S is greater when the index of prudence is greater and vice versa.

The social value of hidden information in adverse selection economies

Abstract When agents possess imperfect hidden knowledge at the time contracts are negotiated, the social value of agents having access to additional hidden knowledge before contracts are implemented is positive to the extent that incentive-constrained agents are sorted more finely, but is negative to the extent that incentive-constraining agents impose more stringent signalling requirements on others. Hence, the intuition developed by Hirshleifer (1971), Marshall (1974), and Milgrom and Stokey (1982), that privately acquired information has neither positive nor negative social value when agents possess no prior hidden knowledge, does not apply when agents possess imperfect hidden knowledge during contractual negotiations.

Greater downside risk aversion in the large

In this paper, we advance a definition of greater downside risk aversion that applies to both large and small changes in risk preference, and thereby complements the results for small changes reported previously. We show that a downside risk-averse transformation of a utility function results in a function that is more downside risk averse in the same manner that a risk-averse transformation increases risk aversion. Our demonstration is conducted first by using the compensated approach introduced by Diamond and Stiglitz [P. Diamond, J. Stiglitz, Increases in risk and in risk aversion, J. Econ. Theory 8 (1974) 337-360] and then by using an adaptation of the risk premium approach taken by Pratt [J. Pratt, Risk aversion in the small and in the large, Econometrica 32 (1964) 122-136].