Problem Set 2

Arthur de Amorim
April 2021

1 Insurance with adverse selection

1.1
00
The individual with risk type π has the highest willingness to pay for insurance.
The willingness to pay for insurance is increasing in the risk type π.

1.2
At price p, the lower bound of the interval I(p) of risk level of the customers
who buy insurance is π(p). The upper bound of this interval is 1 (since the risk
π ∈]0; 1[). The interval is thus: I ∈ [π(p); 1[.

1.3
We can guess from this graph that the distribution of risks is adversely selected,
as the marginal cost curve is a linear decreasing function. As the marginal cost
curve is a linear function decreasing by the same amount for each risk level π
we can assume that π is continuously uniformly distributed on ]0;1[.

1.4
The relation that has to hold between p,Q,N and the function F is: (1 −
F (π(p)))N = Q. Meaning that the total number of consumers with risk level
superior or equal to π(p), ie that are willing to pay for insurance at price p must
be greater or equal to the quantity of insurance demanded.

1.5
With these assumptions, the expected cost at any given price p can be read
graphically through the marginal cost curve as the expected cost is equal to the
marginal cost.

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1.6 Version 1
a) The difference between expected cost and price p must be 0, for supply at
price p to equal demand at price p. If the difference isn’t null, then in the case
where price p is superior than expected cost, supply will be infinite, and in the
opposite case, supply will be null.

b) There are 3 competitive equilibria (for which demand curve crosses the av-
erage cost curve): (p1,Q1);(p2,Q2);(p3,Q3).

1.7 Version 2
a) In this setting we assume that the insurance companies compete à la Bertrand,
since all costumers go to the company offering the lowest price. Indeed, all firms
have an incentive to fix a price lower than its competitors to get the whole mar-
ket and make a higher profit. Then, the firms compete in price until they reach
the lowest competitive price, at which they set their price level. This price is
p3, and thus the equilibrium is (p3,Q3). Consequently, the two other equilib-
rium prices of version 1are not equilibrium price anymore as firms would not sell
any contract at this price. More rigorously, if we start at the first equilibrium
(p1,Q1), then firms would have an incentive to deviate to the second equilibrium
(p2,Q2) to get the whole market. At the second equilibrium, firms will have an
incentive to deviate to the third equilibrium price (p3,Q3) as they will get the
whole market and still break even at that price. For a price lower than p3, no
firms will have an incentive to deviate, as they would not break even. Hence
(p3,Q3) is the equilibrium.

b) the other possible equilibria is one where demand is null and thus no in-
dividual is insured.

1.8
There are deadweight losses in the equilibria of version 1 because, there are
individuals that at the equilibrium prices, have expected costs lower than their
willingness to pay, but firms cannot insure these individuals and still break even.
For a visual representation, check the annex.

1.9
As the state knows the risk of each individuals, it could regulate the prices by
imposing different price for each type of risk, thus price discriminating.In this
case, we will not have only one graphical representation of a market, but different
markets for different types of individuals, and in each market, the individuals
will be able to afford insurance. This will be Pareto-improving for the customers
as some individuals with low risk that were not supplied with insurance before
the state intervention will now buy insurance.

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1.10
As the state is allow to run deficit, it can subsidize insurance coverage to remedy
for adverse selection. A lump sum subsidy towards the price of coverage given to
the costumers would shift the demand curve outward and lead to an equilibrium
quantity equal to Qm ax (with a high enough subsidy). The smallest deficit
required corresponds to the difference between the demand curve (blue line) and
the average cost (AC) curve at quantity Qm ax. That is, the smallest subsidy
should shift the demand curve in order to have the demand curve crossing the
AC curve at Qm ax.

1.11
In this setting, the government can intervene in a Pareto-improving way upon
the equilibrium outcome by making insurance coverage mandatory for everyone.
The government can do it only for the equilibrium (Q3 , p3 ) of version 1 because,
at this point, it seems that the gain in consumer surplus from the customers with
high risk will more than compensate the loss in consumer surplus for customers
with low risk at this price.

2 Credit rationing
2.1
The profit of the borrower as a function of R is:

π(R, r) = max(R − (1 + r)B; −C) (1)

2.2
E
r5 − 1 ⇐⇒ B(1 + r) 5 E (2)
B
Since E(R) = E and E(θ|E) = 0, then the expected profit is always higher
than the value of repayment. As a consequence, all borrowers would borrow
regardless of θ.

2.3
The profit of the borrower as a function of θ is:
1 1
max(E − θ + B(1 + r), −C) + max(E + θ + B(1 + r), −C) (3)
2 2
Assuming that E-B(1+r)¿ -C, since it can’t be inferior as the worst case scenario
is always to only repay the collateral. Expected profits can’t be lower than -C.
So for a low value of θ, the borrower is able to reimburse but expected profits
is very low and negative.

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 so θ◦ = C+E-B(1+r)
When θ increases above the threshold θ◦ , expected profits increase up to the
point where it becomes null.
The last threshold θ∗ is when expected profits become positive and increasing
when the risk of the borrower is superior to this threshold.
It is the case when we are only repay in good state so:
1 1
π= max(E − θ + B(1 + r), −C) − C = 0 ⇐⇒ θ∗ = C − E + B(1 + r) (4)
2 2

2.4
Since we assume that B(1+r) ¿ E then:
θ◦ < θ∗ ⇐⇒ −C −E +B(1+r)+C −E +B(1+r) > 0 ⇐⇒ B(1+r)−2E > 0
(5)

For θ∗ : It increases when r increases. We can interpret this being that as the
loan becomes increasingly expensive, the pool of applicants for loan will change
and there will be people with a higher risk applying as even though they have
a lower probability of success, they have a higher payoff when successful.

For θ◦ : It decreases when r increases since E-(1+r)B decreases. We can in-

terpret this as when the pool of borrowers become riskier, then the region of
possible losses becomes bigger hence θ◦ decreases.

2.5
The interval of agents who borrow is [θ∗ ;+∞].

2.6
The expected profit of the lending bank as a function of R is:
ρ(R, r) = min(R + C; B(1 + R)) (6)

2.7
The expected profit of the lending bank as a function of θ is:
1 1
min(E − θ + C, B(1 + r)) + min(E + θ + C, B(1 + r)) (7)
2 2

2.8
For a given interest rate r∗ , there is a critical value θ∗ such that a firm borrows
from the bank if and only if θ¿θ∗ (theorem 1 of the paper). The expected
reimbursed amount given r is:
1 1
min(E − θ + C) + min(B(1 + r)) (8)
2 2

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since in the bad state there is default and no default in good state. There are
two distinct effects of an increase in the interest r on the expected reimbursed
amount.The direct effect, where the amount repaid of the loan increases 12 (B(1+
r)), hence increases the profits of the bank. And the indirect effect, where the
pool of borrowers change as there are more people with higher risks borrowing
due to the effect of r on θ∗ (previously explained in section 2.4). Hence, the
indirect effect decreases the profits of the bank through 12 (E − θ(r) + C).

2.9
Explanation: Starting from the competitive equilibrium r2 (where supply =
demand), in a Bertrand competition setting, firms have an incentive to deviate
and offer interest rate r1, since you will attract the whole market as you’ll have
the lowest interest rate. Additionally, the firms profits increase up until r1, as
the indirect effect of a better pool of applicants (less risky borrowers) trumps
the direct effect of a lower interest rate (thus repayment). However, at r1, there
is no longer any incentive to deviate and it is the Bertrand equilibrium. This
equilibrium is also called a credit rationing equilibrium because for r1, demand
for loans is superior than supply of loans, thus excluding people from borrowing
even if they are willing to pay for the loan. the diagram can be seen in annex.