The insurance mechanism is based on an assumption that people:

• A. do not consider future consequences when making decisions
• B. change their behavior in response to financial incentives
• C. always act irrationally when faced with risk
• D. prefer to avoid all forms of risk regardless of cost

Answer: (B)

Verified step by step guidance

1. Understand the concept of insurance in microeconomics: Insurance is a mechanism that allows individuals to manage risk by transferring it to an insurer in exchange for a premium.
2. Recognize that insurance works because individuals respond to financial incentives, such as premiums and coverage, which influence their behavior regarding risk-taking.
3. Analyze each option by considering how it relates to the fundamental assumption behind insurance: whether people change behavior due to financial incentives or act irrationally or ignore future consequences.
4. Recall that the key assumption in insurance theory is that people change their behavior in response to financial incentives, which affects their decisions about purchasing insurance and managing risk.
5. Conclude that the correct assumption underlying the insurance mechanism is that people change their behavior in response to financial incentives, as this explains how insurance markets function effectively.