The Effect of Default Risk, Price, and Tax on Demand and Consumer Surplus: An Example Used in the Insurance Industry

In this article, we theoretically analyze the effect of price, default rate, equity capital, and consumption tax on demand and consumer surplus. We show that demand is a function of price and default rate, and it is concave in price and default rate. The default rate is an increasing function of equity capital given that price and equity capital are exogenous, and it is endogenously determined. We include the negative effect of the expected default option in our calculation of consumer surplus. Our numerical results for an insurance example show that increases in price or the premium tax rate will reduce consumer surplus; however, a lower expected value for the default option will help offset the reduction in consumer surplus.