Consider a restaurant that wants to avoid kitchen fires. The restaurant could make many investments both to avoid the fires in the first place and to quickly and safely put them out if they do occur. Suppose that the marginal cost (MC) and marginal benefit (MB) of these investments in fire control technologies is illustrated in the following figure.
a. If no fire insurance is available, how much investment in fire control would the restaurant purchase? b. If full insurance is available, how much investment in fire control would the restaurant purchase?
c. The moral hazard incentivized by full insurance creates a deadweight loss. Show the deadweight loss in the diagram.
d. Suppose that the insurance policy would only cover 50% of the losses from fire; that is, the restaurant has a 50% copay. How much fire control would the restaurant purchase?
e. Suppose that the insurance policy would cover only 50% of the losses but the insurance company also offered a discount on insurance to restaurants that installed water sprinklers or other fire suppression technologies. How would the curves shift? What quantity of fire investment would be purchased? Comment on the role of copays and discounts.