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 I. Full Information (everybody knows who is a risky/safe driver) the market essentially functions as two separate mini-markets: the one for risky drivers and the one for safe drivers.

1. Given, the cost of insuring a risky driver and his willingness to pay, is trade possible between risky drivers and the insurance company?

2. If YES, how much should the insurance company charge a risky driver to maximize its profit and make sure these drivers will buy it? Remember there is no competition!

3. At this price, what is the surplus for a risky driver? What is the surplus (profit) for the insurance company from selling to a risky driver?

4. What is the total market surplus (keep in mind there are more than 1 risky driver on the market so you need to all the surpluses for each transaction)?

5. Repeat 1-4 for the safe drivers.

6. Summarize the market outcome for the case of full information.