ADVERSE SELECTION PRACTICE PROBLEMS Problem I: An insurance company can insure two types of drivers: risky drivers and safe drivers. The cost to insure a risky driver is $350, while the cost to insure a safe driver is only $50. A risky driver is willing to pay up to $500 for insurance, while a safe driver is willing to pay up to $100 for insurance. Explain and analyze the market outcomes under different informational scenarios (full information, asymmetric information, and incomplete but symmetric information). For each case, state who gets to purchase insurance, at what price, and what are the resulting surpluses (for buyers, seller, and in total). Assume there is only one insurance company in town (so it gets to price its insurance as high as it wants without any competition and consumers can either take it or leave it). Also assume there are 300 drivers in total - 100 of them are risky and 200 are safe. Case III: Incomplete but Symmetric Information (nobody knows who is risky and who is safe) - you might say this is unrealistic, but it serves a purpose to pretend that this can actually happen. We want to see that is NOT the simple missing of information that creates the problem of adverse selection, but the ASYMMTERY of it. 1. If drivers also don't now their true type (but they know the likelihood of being risky vs. safe), what is their expected willingness to pay for insurance? 2. We already know from Case II, what is the expected cost for the insurance company. But if we didn't, we would need to calculate it here again, because in this case there is uncertainty on both sides of the market. 3. Given the expected cost, and expected willingness to pay, will there be trade possible on this market? If so, at what price? 4. Imagine now that after everyone buys, drivers realize their true types. Carefully calculate all the relevant individual surpluses and the total market surplus. For individual surpluses, you need to calculate the surplus of a risky driver, the surplus of a safe driver, the surplus of the insurance company when selling to a risky driver, and the surplus of the insurance company when selling to a safe driver. 5. Summarize and contrast with Case I and Case II. ADVERSE SELECTION PRACTICE PROBLEMS Problem I: An insurance company can insure two types of drivers: risky drivers and safe drivers. The cost to insure a risky driver is $350, while the cost to insure a safe driver is only $50. A risky driver is willing to pay up to $500 for insurance, while a safe driver is willing to pay up to $100 for insurance. Explain and analyze the market outcomes under different informational scenarios (full information, asymmetric information, and incomplete but symmetric information). For each case, state who gets to purchase insurance, at what price, and what are the resulting surpluses (for buyers, seller, and in total). Assume there is only one insurance company in town (so it gets to price its insurance as high as it wants without any competition and consumers can either take it or leave it). Also assume there are 300 drivers in total - 100 of them are risky and 200 are safe. Case III: Incomplete but Symmetric Information (nobody knows who is risky and who is safe) - you might say this is unrealistic, but it serves a purpose to pretend that this can actually happen. We want to see that is NOT the simple missing of information that creates the problem of adverse selection, but the ASYMMTERY of it. 1. If drivers also don't now their true type (but they know the likelihood of being risky vs. safe), what is their expected willingness to pay for insurance? 2. We already know from Case II, what is the expected cost for the insurance company. But if we didn't, we would need to calculate it here again, because in this case there is uncertainty on both sides of the market. 3. Given the expected cost, and expected willingness to pay, will there be trade possible on this market? If so, at what price? 4. Imagine now that after everyone buys, drivers realize their true types. Carefully calculate all the relevant individual surpluses and the total market surplus. For individual surpluses, you need to calculate the surplus of a risky driver, the surplus of a safe driver, the surplus of the insurance company when selling to a risky driver, and the surplus of the insurance company when selling to a safe driver. 5. Summarize and contrast with Case I and Case
