Excel Homework Due Wednesday October 30 At 11 PM

This homework takes the insurance model we did in the last class and applies it to Akerlof's Market for Lemons, which is a very well known approach to Adverse Selection (hidden information).  Depending on the underlying distribution over types, the competitive market may not work very well in this instance - the bad risks drive out the good risks. 

The economics here is more sophisticated, because there is a possibility of a pooling equilibrium or a separating equilibrium and students may not understand what determines which will occur.  We will discuss this in class, after the homework is due. 

If you have questions about doing the homework itself, please post them as comments on this post.

I want to note two bits of reality that aren't in the model in the homework. 

(a) In the homework it is assumed that the insurance company faces no costs in issuing a policy nor costs in administering the coverage when loss occurs.  Under this assumption, a competitive market will produce equilibrium policies where the fixed load, F, is 0.   More realistically, you should consider that F is positive, to cover these type of costs.  In that case the good risk type really might buy no insurance whatsoever.  Our model doesn't predict that but instead predicts that the good risks may get only a little coverage.

(b) In the homework it is assumed that regardless of type the insured can afford to pay the premium.  (We would say the insured is not liquidity constrained.)  But in reality, fair insurance premiums for bad risks may be too high for people to afford.  So rather than buy full coverage, as in the case of a separating equilibrium in our model, the people will go entirely without purchasing insurance. 

Of course, you can model both of these considerations, but then the model itself becomes much harder.  So the homework is suggestive of what happens, without giving the full picture.