Optimal Health Insurance in the Presence of Risky Health Behaviors *

Abstract In this paper I develop an overlapping generations model that incorporates bad behaviors (such as smoking and unhealthy eating habits that lead to obesity) to investigate the equilibrium effects of different cost sharing mechanisms and excise taxation on bad behaviors and medical expenditures. I show that while higher cost sharing induces individuals to refrain from bad behaviors, it has mixed welfare effects across different individuals. For example, if coinsurance rate is increased by 20 percentage points, smoking prevalence goes down by about 2 percentage points and medical expenditures to GDP ratio slightly declines. Although higher cost sharing increases the overall welfare in the economy, unhealthy individuals are either worse off or have much less welfare gains compared to healthy individuals. The quantitative implications of the model are consistent with the variation in smoking prevalence and excise taxes across tobacco and non-tobacco states