The price increasing effect of insurance

This paper examines the effects of introducing an optional insurance into a pharmaceutical market with a monopolistic manufacturer of medication. With the help of a model the changes in the price of medication are identified and evaluated. It is found that under certain conditions the insurance allows the manufacturer to increase his price, since the manufacturer can incorporate the presence of insurance into the determination of the optimal price. Furthermore, it is identified that due to this insurance the price can even be increased beyond the maximum individual liquidity constraints in the population. This model explains why risk neutral individuals strictly prefer insurance, even with an above actuarially fair premium. In a later extension a profit margin for the insurer is added to the model, from which it follows that this does not further increase the price for consumers, but rather takes away some of the manufacturer’s profits. This price increase is constrained by the amount of harm the disease does. In an extension it is also shown how adding a competitor constrains this increase in prices further and provides incentives for innovation. The contribution to scientific literature of this paper is the explanation why risk neutral individuals strictly prefer insurance and how insurance can lead to increases of prices.