Economic insecurity, individual behavior and social policy

Abstract

This paper is an attempt to return the discussion on social insurance and protection to its economic foundations. The paper uses a framework proposed by Ehrlich and Becker (1972) in the economics of insurance literature to first clarify the concepts and then take a comprehensive approach to insurance and protection. The approach starts with the choice problem of a representative individual facing risk, who chooses optimal levels of market insurance, self-insurance and self-protection. Market insurance and self-insurance transfer incomes between good states and bad (without changing the probabilities) while self-protection lowers the probability of the bad state (without affecting any transfers across states). Prices and costs are crucial in determining the optimal allocation. The paper illustrates the usefulness of the framework by considering the example of unemployment insurance (as market insurance), precautionary saving (as self-insurance) and investments in human capital (as self-protection). Government action is warranted from an efficiency point of view only if markets for some instruments are missing, or if there are distortions that prevent individuals from achieving their optimal insurance and protection levels.

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