Economic Processes in Insurance Industry - Essay Example

The Insurance Industry The Price Elasti of Demand Price is a determinant of demand. Specifically, it has an inverse relationship with the quantity demanded so that price increase will cause demand to decline. However, the magnitude of change in demand due to price change is determined by elasticity. By definition, elasticity is “the measure of responsiveness in the quantity demanded for a commodity as a result of change in price of the same commodity” (Wikimedia Foundation, Inc.). It is computed as a percentage change in quantity demanded divided by percentage change in price (About.com). There are several factors that determine the elasticity of demand. Demand elasticity varies with necessities versus luxuries. Since necessities are important they tend to be inelastic, which means even though prices change by much the quantity demanded does not change by much because of the said reason (Mankiw). If water prices suddenly increased, we do not expect consumption of water to plummet sharply. On the other hand, luxuries tend to be elastic. If for example the price of yacht suddenly increased, the affluent can opt for other hobbies causing a much decline in the quantity of yacht demanded. The availability of close substitutes also affects the elasticity of demand. Specifically, commodities with available close substitutes such as butter are observed to have an elastic demand (Mankiw). It can easily be replaced by margarine; therefore demand for such product will decline by a great magnitude. On the other hand, since egg has no close substitute demand for such is inelastic. Lastly, time horizon also constitutes a factor in the price elasticity of demand. “Goods tend to have more elastic demand over long time horizons” (Mankiw). This is explained by the fact that longer time horizon gives consumers more flexibility to alter their consumption pattern such that goods whose price are increased or are relatively higher can be replaced. In the insurance industry, where the competition is stiff, given the presence of many competitors and therefore many substitutes, the demand for the product is considered elastic. Wage Increase and Short-Run Cost Wage is one of the costs in production. Depending on the type of industry, wage can be a huge part of the total cost. In the insurance industry for example, where the cost of sales people and managers are paid through wages, wage increase can represent a huge boost of the total cost. To discuss the ways in which an increase in wage affects the variable cost, average variable, total cost and marginal cost, let us define each. a) Variable cost- “A cost of labor, material or overhead that changes according to the change in the volume of production units” (InvestorWords.com) b) Average Variable Cost – “is an economics term to describe a firms variable costs (labor, electricity, etc.) divided by the quantity (Q) of total units of output (Wikimedia Foundation, Inc). c) Total cost – the over-all cost of production, includes the fixed and the variable costs d) Marginal Cost – “The extra cost incurred for an extra unit of output” (WikiAnswers.com) Since wage is considered a variable cost, an increase in wage constitutes an increase int he variable cost. With fixed amount of production or quantity, an increase in wage also increases the average variable cost. Also, since an additional payment in wage is an increase in the extra cost for every output produced, by definition marginal cost also increases. In that graph, it looks like the one below: The graph showed that both the variable cost and total cost curves shifted up to signify an increase. The marginal cost curve also moved which also signifies an increase. The bigger box is the profit at original wage, which yields VC1 and TC1. The increase in wage yielding to VC2 and TC2 will result to a smaller profit represented by the smaller box. Market Structure Empirically, there has not been a completely perfect competitive market although there are those which exhibit the characteristics of this kind of market. The insurance industry in the United States of America is one which is composed of many companies. Although there are few more popular companies such as the New York Life Insurance Company (New York Life), the American International Group (AIG) and the Prudential Financial Inc., still no dominant or monopolistic company was found to exist. This means that no single or a few insurance companies in the United States has or have the power to affect the industry price and quantity. All companies or players therefore are found to be price-takers as opposed to a monopoly or an oligopoly in which one player can dictate the industry price. Second, the insurance industry is one with many players resulting to a high level of competition. According to the “manta” website, there are at least 263,140 insurance-related companies in the entire United States, with the Insurance Agents, Brokers and Service as the highest category with 223, 029 companies (http://www.manta.com). Having many buyers and sellers is also a characteristic of a perfectly competitive market. The insurance products are also found to be homogenous, with little variations to differentiate from other companies. However, usually the nature of the product or service such as life insurance, auto and health insurance are the same among all players. They may vary on longevity and design of program but the nature is comparable. Lately, the annuities programs are also included in the product portfolio in the business. Lastly, small insurance companies are not in any way barred to enter the industry. Insurance companies, agents and brokers can come in and go out of the industry without mammoth sunk cost, making the industry more attractive to many businesses. All these characteristics; the presence of many buyers and sellers, the absence of market power on any player to dictate the price and quantity, product homogeneity and no barriers to entry and exit are all characteristics of a perfectly competitive market. They are also exhibited by the insurance industry, therefore we conclude that the insurance industry has the structure of a perfectly competitive market. The Business Cycle The business cycle is defined as “the periodic but irregular up-and-down movements in economic activity, measured by fluctuations in real GDP and other macroeconomic variables” (About.com). The business cycle is found as a sequence of four phases: a) Contraction b) Through c) Expansion d) Peak The fluctuation of real GDP and other macroeconomic variables shows that the industry is facing intermittent business “luck”; therefore it has to be ready at times of contraction and trough. The insurance products can be considered both a necessity and in investment. In a sophisticated economy such as the United States, insurance can be seen as a necessity already. It is mostly offered to households than to businesses. However, it falls under the consumer durables rather than an everyday household item, making it less preferred to the latter in times of economic difficulty. This means that insurance is not a sturdy industry in times of economic recession. What makes it even weaker in times of contraction and trough is its being susceptible to speculations. The insurance industry depends much on its credibility in order to sell. Once there are speculations of losses or possible bankruptcy, people will be afraid to invest their money on insurance. This makes the effect of the recession worse. The insurance industry is not recession proof. In fact, it can be hurt badly by any news of economic downturns. Works Cited About.com. http://economics.about.com. 26 May 2009 . —. http://economics.about.com. 26 May 2009 . http://www.manta.com. 26 May 2009 . InvestorWords.com. http://www.investorwords.com. 26 May 2009 . Mankiw, N. Gregory. Principles of Macroeconomics. Orlando, Florida: The Dryden Press, 1998. WikiAnswers.com. http://www.answers.com. 26 May 2009 . Wikimedia Foundation, Inc. http://en.wikipedia.org. 2 November 2008. 26 May 2009 . Wikimedia Foundation, Inc. http://en.wikipedia.org. 7 May 2009. 26 May 2009 . Read More