Business and Industrial Economics

Silvestri Daniela – Case discussion 09/03/2023

EXERCISE 1.1
A coal-fired power plant jointly produces electricity and air pollution. Air pollution adversely affects a nearby
farm producing agricultural products. Assume that pe = 20 is the price of electricity, pf = 10 is the price of the
agricultural products (both firms are price-takers), Ce (e, x) = e2 + (x2 – 8x) is the cost for the coal-power plant
of producing electricity (e) jointly with x units of pollution (pollution is a production externality), and C f (f, x) =
f2 + fx is the cost for the farm of producing f units of agricultural products when the coal-fired plant emits x
units of pollution.
First of all bear in mind that we are assuming that firms are price takers which means that the two firms must
accept the prevailing prices in the markets of their products, being unable to affect the market price.

a.) Suppose there are no property rights on air pollution and, thus, there is no market for pollution (the price
of pollution is 0). Calculate the produced amount of electricity (e*), agricultural products (f*), pollution
(x*), and the overall profit (π*), separately for the two firms.
The two firms set the level of e*, f*, and x* independently from each other. There are no property rights
on air thus the farmer has no control over x*.
We compute the profits of the two firms separately.
For the coal-fired power plant we would have that:
𝛱𝑒 (𝑒, 𝑥) = 20𝑒 − 𝑒 2 − (𝑥 2 – 8𝑥)
From the first order condition we have
𝜕𝐶𝑒 (e,x)
→ 20 = 2e → 𝒆∗ = 𝟏𝟎
𝜕𝑒
𝜕𝐶𝑒 (e,x)
→ −2x + 8 = 0 = 2e → 𝒙∗ = 𝟒
𝜕𝑥

𝛱𝑒 (𝑒, 𝑥) = (20 ∗ 10) − 102 − (42 – 8 ∗ 4) = 𝟏𝟏𝟔$

For the farmer we would have that:

𝛱𝑓 (𝑓, 𝑥) = 10𝑓 − 𝑓 2 − 𝑓𝑥
𝜕𝐶𝑓 (f,x) 𝑥
𝑝𝑓 = → 10 = 2f + x → 𝑓 = 5 −
𝜕𝑓 2
4
As 𝒙∗ = 𝟒, 𝒇∗ = 5 − =𝟑
2

The external cost for the farmer is f*x= 12$

𝛱𝑓 (𝑓, 𝑥) = (10 ∗ 3) − 32 − 12 = 𝟗$
The total profits are 116$+9$= 125$

To sum up
𝒆 ∗= 𝟏𝟎 𝒇 ∗= 𝟑 𝒙 ∗= 𝟒 𝛱𝑒 (𝑒, 𝑥) = 116$ 𝛱𝑓 (𝑓, 𝑥) = 9$ and tot profit=125$

1
b.) Suppose that property rights on the air are created and assigned to the farmer who can now sell pollution
rights at price px. Calculate the optimal amount of electricity (e*), the optimal amount of agricultural
products (f*), the traded property rights (x*) and the profits (π*) for the two firms.

In this case, the farmer can choose x and its profit function becomes:
𝛱𝑓 (𝑓, 𝑥) = 10𝑓 − 𝑓 2 − 𝑓𝑥 + 𝑝𝑥 𝑥
Starting from the first-order profit-maximization conditions, we obtain:
𝜕Π(f,x)
= −𝑓 + 𝑝𝑥 = 0 → 𝒇∗ = 𝑝𝑥 Supply of farms’ products
𝜕𝑥

𝜕Π(f,x)
= 10 − 2𝑓 − 𝑥 = 0 → 𝒙𝑺 ∗ = 10 − 2𝑝𝑥 Supply of pollution rights
𝜕𝑓
(since f=px we can write xs=10-2px)

The coal-fired power plant profit function would be:

𝛱𝑒 (𝑒, 𝑥) = 20𝑒 − 𝑒 2 − (𝑥 2 – 8𝑥) − 𝑝𝑥 𝑥
𝜕Π(e,x)
= 20 − 2𝑒 → 𝒆∗ = 10 Supply of electricity
𝜕𝑒

𝜕Π(e,x) 𝑝𝑥
= −2𝑥 + 8 − 𝑝𝑥 = 0 → 𝒙𝑫 ∗ = 4 − Demand of pollution rights
𝜕𝑥 2

In equilibrium 𝑝𝑥 is such that 𝒙𝑫 ∗ = 𝒙𝑺 ∗

𝑝𝑥
𝒙𝑫 ∗ = 4 − = 10 − 2𝑝𝑥 = 𝒙𝑺 ∗
2

Solving for 𝑝𝑥 we obtain that 𝒑𝒙 = 𝟒

By substitution we obtain that 𝒙𝑫 ∗ = 𝟐
Therefore, the profit functions for the two firms are:

𝛱𝑒 (𝑒, 𝑥) = 20𝑒 − 𝑒 2 − (𝑥 2 – 8𝑥) − 𝑝𝑥 𝑥 = (20 ∗ 10) − 102 − (22 − 16) − (4 ∗ 2) = 𝟏𝟎𝟒$

𝛱𝑓 (𝑓, 𝑥) = 10𝑓 − 𝑓 2 − 𝑓𝑥 + 𝑝𝑥 𝑥 = (10 ∗ 4) − 42 − 8 + 8 = 𝟐𝟒$

Total profits is 104$ + 24$ = 128$

To sum up
𝒆 ∗= 𝟏𝟎 𝒇 ∗= 𝟒 𝒙 ∗= 𝟐 𝑷𝒙 = 𝟒 𝛱𝑒 (𝑒, 𝑥) = 104$ 𝛱𝑓 (𝑓, 𝑥) = 24$ and tot profit=128$

2
c.) Suppose that the two firms merge to internalize the negative externality. Calculate the produced amount
of electricity (e*), agricultural products (f*), pollution (x*) and the overall profit of the merged firm (π*).
If the two firms merge, the merged entity produces both electricity and agricultural products (it can
choose e*, f* and x*) and its profit is:
𝛱 𝑀 (𝑒, 𝑓, 𝑥) = 20𝑒 + 10𝑓 − 𝑒 2 − (𝑥 2 – 8𝑥) − 𝑓 2 − 𝑓𝑥
Starting from the first-order profit-maximization conditions, we obtain:
𝜕Π(e, f, x)
= 20 − 2𝑒 = 0 → 𝒆∗ = 𝟏𝟎
𝜕𝑒
𝜕Π(e, f, x) 𝑥
= 10 − 2𝑓 − 𝑥 = 0 → 𝑓 = 5 −
𝜕𝑓 2
𝜕Π(e, f, x) 8−𝑓
= −2𝑥 + 8 − 𝑓 = 0 → 𝑥 =
𝜕𝑥 2
8−𝑓
𝑓 = 5− → 𝒇∗ = 𝟒
4
8−4
𝑥= → 𝒙∗ = 𝟐
2
𝛱 𝑀 (𝑒, 𝑓, 𝑥) = (20 ∗ 10) + (10 ∗ 4) − 102 − (22 − 16) − 42 − (2 ∗ 4) = 𝟏𝟐𝟖$
Merger has caused not only an increase in total profit, but also a reduction of pollution, likewise the
assignment of property rights in point b of the exercise

d.) Suppose the property rights on air would had instead been assigned to the coal-fired power plant. Would
the results you found in point c. of the exercise be different? Explain your reasoning.
No, the results would not change. According to the Coase’s theorem, the same outcome is achieved
independently of which firms was assigned the property rights.

3
EXERCISE 1.2
A coal-fired power plant jointly produces electricity and air pollution. Air pollution adversely affects a nearby
farm producing agricultural products. Assume: pe = 20 the price of electricity, pf = 8 the price of the agricultural
product of the farm (both firms are price-taker), Ce(e,x) = e2 + (x - 2.5)2 the cost for the coal-power plant of
producing electricity e jointly with x units of pollution (pollution is a production externality), and Cf(f,x) = f2 +
fx the cost for the farm of producing f units of agricultural products when the coal-fired plant emits x units of
pollution.
First of all bear in mind that we are assuming that firms are price takers which means that the two firms must
accept the prevailing prices in the markets of their products, being unable to affect the market price.
a) Suppose there are no property rights on air pollution and thus there is no market for pollution (the price
of pollution is 0). Calculate the produced amount of electricity (e*), agricultural products (f*), pollution (x*)
and the profits (π*), separately for the two firms.

The two firms set the level of e*, f* and x* independently from each other. There are no property rights on
air thus the farmer has no control on x*.
We compute the profits of the two firms separately.
For the coal-fired power plant we would have that:
𝛱𝑒 (𝑒, 𝑥) = 20𝑒 − 𝑒 2 − (𝑥 − 2.5)2
The first order profit maximization conditions for the coal-fired power plant producing electricity and
pollution are:
𝜕𝛱𝑒 (e,x)
= 20 − 2e = 0 → 𝒆∗ = 𝟏𝟎
𝜕𝑒
𝜕𝛱𝑒 (e,x) 𝟓
= −2x + 5 = 0 → 𝒙∗ = = 𝟐. 𝟓
𝜕𝑥 𝟐

𝛱𝑒 (𝑒, 𝑥) = (20 ∗ 10) − 10 − (2.5 − 2.5)2 = 𝟏𝟎𝟎$

2

For the farmer we would have that:

𝛱𝑓 (𝑓, 𝑥) = 8𝑓 − 𝑓 2 − 𝑓𝑥
𝜕𝛱𝑓 (f,x) 𝑥
= 8 − 2f − x = 0 → 𝑓 = 4 −
𝜕𝑓 2
2.5
As 𝒙∗ = 𝟐. 𝟓, 𝒇∗ = 4 − = 𝟐. 𝟕𝟓
2

The external cost for the farmer is f*x= 6.88$

𝛱𝑓 (𝑓, 𝑥) = (8 ∗ 2.75) − 2.75 − 6.88 = 𝟕. 𝟓𝟔$
The total profits are 100$+7.56$= 107.56$

4
b.) Suppose that property rights on the air are created and assigned to the farmer who can now sell pollution
rights at price px. Compute the optimal amount of electricity (e*), the optimal number of agricultural
products (f*), the traded property rights (x*) and the profits (π*) for the two firms.

In this case, the farmer can choose x (or can have a revenue stream from selling pollution rights) and its
profit function becomes:
𝛱𝑓 (𝑓, 𝑥) = 8𝑓 − 𝑓 2 − 𝑓𝑥 + 𝑝𝑥 𝑥
Starting from the first-order profit-maximization conditions, we obtain:
𝜕Π(f,x)
= 8 − 2𝑓 − 𝑥 = 0 → 𝒙𝑺 ∗ = 8 − 2𝑓 → Since f=px we have 𝒙𝑺 ∗ = 8 − 2𝑝𝑥 Supply of pollution
𝜕𝑓
rights
𝜕Π(f,x)
= −𝑓 + 𝑝𝑥 = 0 → 𝒇∗ = 𝑝𝑥 Supply of farmer’s products
𝜕𝑥

The coal-fired power plant profit function would be:

𝛱𝑒 (𝑒, 𝑥) = 20𝑒 − 𝑒 2 − (𝑥 − 2.5)2 − 𝑝𝑥 𝑥
𝜕Π(e,x)
= 20 − 2𝑒 = 0 → 𝒆∗ = 10 Supply of electricity
𝜕𝑒

𝜕Π(e,x) 𝑝𝑥 𝑝𝑥
= −2𝑥 + 5 − 𝑝𝑥 = 0 → 𝒙𝑫 ∗ = 5 − → 𝒙𝑫 ∗ = 2.5 − Demand of pollution rights
𝜕𝑥 2 2

In equilibrium 𝑝𝑥 is such that 𝒙𝑫 ∗ = 𝒙𝑺 ∗

𝑝𝑥
𝒙𝑫 ∗ = 2.5 − = 8 − 2𝑝𝑥 = 𝒙𝑺 ∗
2

Solving for 𝑝𝑥 we obtain that 𝒑𝒙 = 𝟏𝟏/𝟑

𝑝𝑥
2𝑝𝑥 − = 5.5 → 𝑝𝑥 = 11/3
2
By substitution we obtain that 𝒙𝑫 ∗ = 𝟎. 𝟔𝟕
Therefore, the profit functions for the two firms are:
11
𝛱𝑒 (𝑒, 𝑥) = 20𝑒 − 𝑒 2 − (𝑥 − 2.5)2 − 𝑝𝑥 𝑋 = (20 ∗ 10) − 102 − (0.67 − 2.5)2 − ( ∗ 0.67)
3
= 200 − 100 − 3.35 − 2.45 = 94.2

11 112 11 11
𝛱𝑓 (𝑓, 𝑥) = 8𝑓 − 𝑓 2 − 𝑓𝑥 + 𝑝𝑥 𝑥 = (8 ∗ )− − ( 3 ∗ 0.67) + ∗ 0.67 =
3 3 3

= 29.33 − 13.40 − 2.45 + 2.45= 15.93

Total profits is 94.2$ + 15.93$ = 110.13$

5
 c) Suppose that the two firms merge to internalize the negative externality. Compute the produced
amount of electricity (e*), agricultural products (f*), pollution (x*) and the overall profit of the merged
firm (π*).
In this case, the two firms internalize the costs of the negative production externality through a merge.
If the two firms merge, the merged entity produces both electricity and agricultural products (it can
choose e*, f* and x*) and its profit is given by:
5
𝛱 𝑀 (𝑒, 𝑓, 𝑥) = 20𝑒 + 8𝑓 − 𝑒 2 − (𝑥 − )2 − 𝑓 2 − 𝑓𝑥
2
Starting from the first-order profit-maximization conditions, we obtain:
𝜕Π(e, f, x)
= 20 − 2𝑒 = 0 → 𝒆∗ = 𝟏𝟎
𝜕𝑒
𝜕Π(e, f, x)
= 8 − 2𝑓 − 𝑥 = 0
𝜕𝑓
𝜕Π(e, f, x)
= −2𝑥 + 5 − 𝑓 = 0
𝜕𝑥
Solving the system I found f==11/3 and x=2/3
𝛱𝑀 (𝑒, 𝑓, 𝑥) = 110$

To sum up:
- No property right case:
𝒇∗ = 𝟐. 𝟕𝟓 𝒙 ∗= 𝟐. 𝟓
𝛱𝑒 (𝑒, 𝑥) = 100$ and 𝛱𝑓 (𝑓, 𝑥) = 7.56$ for a total of 107.56$ as total profit
- Property rights assigned to the farmer
𝟏𝟏 𝟐
𝒇∗ = = 𝟑. 𝟔𝟔 𝒙 ∗= = 𝟎. 𝟔𝟔
𝟑 𝟑
𝛱𝑒 (𝑒, 𝑥) = 94.2$ and 𝛱𝑓 (𝑓, 𝑥) = 15.93$ for a total of 110.13$ as total profit
- Merger case
𝟏𝟏 𝟐
𝒇∗ = = 𝟑. 𝟔𝟔 𝒙 ∗= = 𝟎. 𝟔𝟔
𝟑 𝟑
𝛱𝑀 (𝑒, 𝑓, 𝑥) = 𝟏𝟏𝟎. 𝟏𝟏$

6
EXERCISE 2.1
Consider a second-hand market for cars. There are high-quality cars, which buyers value at most 15,000 $, and
low-quality cars, which buyers value at most 6,000$ (buyers’ reservation price for bad quality cars). High-
quality sellers will accept at minimum10,000 $, while low-quality sellers will accept 5,000 $.
Quality Buyer’s value Seller’s value
Peaches (high quality cars) vP=15,000$ vP=10,000$
Lemons (bad quality cars) vL=6,000$ vL=5,000$
If buyers can distinguish good from bad quality cars there would not be any information asymmetry in the
market for used cars and good quality cars would be sold between 10,000 and 15,000$
a.) What is the maximum fraction of low-quality cars up to which sellers will still have incentives to sell high-
quality cars?
Assume that q is the fraction of low-quality cars and 1-q is the fraction of good-quality cars
The EV of buyers of any cars is:
EV= $6,000q + $15,000(1-q) = $15,000 - $9,000q
The EV is basically buyers willingness to pay and decreases when q (the fraction of low quality cars) increases
EV= $15,000 - $9,000q= $10,000 ($10,000 is the minimum that sellers accept for high quality cars
Solving for q we obtain that q= 5/9 = 0.55
The fraction of bad quality car is 0.55 which implies that 1-q is the fraction of good quality cars, that is 0.45
b.) Based on the fraction of low-quality cars you computed before, what is the buyers’ expected value?
Buyers’EV is:
EV= 0.45*$15,000 + 0.55 * $6,000 = 10,050$ This is what buyers are ready to pay
The buyers’ EV is slightly higher than the minimum that sellers accept for high quality cars and for low quality
cars. This condition enables that both types of cars are sold in the market.
c.) What are the implications if the fraction of low-quality cars is higher than what you computed before?
If q=0.55 sellers of good quality cars do not exit the market because less then 0.55 of all cars in the market are
lemons. A pooling equilibrium is achieved, that is an equilibrium in which both types of cars are sold.
If q <0.55 we are still in a situation of pooling equilibrium, both type of sellers remain in the market.
q>0.55 implies that EV< 10.000$ which is the minimum that high-quality sellers are willing to accept. More
than 0.55 of all cars are lemons and sellers of good quality cars have no incentives to remain in the market.
There is a separating equilibrium: a market equilibrium in which only one type of cars (lemons) is traded.

Ex-ante information asymmetry about cars’ quality lead to adverse selection, that is a problem of ex-ante
information asymmetry (a problem of hidden information) which is attempted to be solved by using signals
The article from the economist makes exactly the same point but just in terms of what sellers are willing to
accept. Sellers of good quality cars value peaches at $900 so they are not willing to accept a lower offer like
$750 as suggested in the text. Whereas obviously sellers of lemons are definitely willing to accept such an
offer.
Sellers may use signals in order to mitigate the issue of information asymmetry like for example technical
inspection by a third party, vehicle history reports, certification that offers buyer guarantees about the
quality of cars

7
EXERCISE 3.1 - signaling
Suppose there are two types of French teachers in the labor market: half are high skilled (aH) and the other
half are low-skilled (aL). Teachers know their type, but firms do not. Assume that the labor market is perfectly
competitive, so when a firm hires a worker it offers wage equal to the worker’s expected productivity (salary
reflects the productivity of the workers). A high-ability worker’s productivity is aH = 8,000 while low-skill
marginal productivity is aL = 3,000. Suppose that a local college offers a French certificate. (firms observe the
education level but not employees’ productivity).
The cost (counting tuition fees and effort invested) of obtaining the certificate for high-skill teachers) is cH =
1,500, while the cost for low-skilled teachers is cL = 4,000.

Suppose that a fraction h are high quality and a fraction 1-h are low quality
a.) Who has incentives to get the certificate?
Let e =1 if the teacher obtain the certificate and e=0 if not.
Compute the payoff of both types of teachers.
High-skill teachers’ payoff is:
πH(e = 1) = 8,000− 1,500 = 6,500 > πH(e = 0) = 3,000 which is strictly better than not getting the certificate πH(e
= 0) = 3,000.
Given the beliefs of the firms, high-skill teachers find it in their interest to choose e = 1. We can rephrase this
condition as ‘the expected gain in future income is greater than the cost of education, so high-skill workers
will choose to obtain the certificate’ that is cH< wH-wL
Low-skilled teachers’ payoff is:
Given the beliefs of the firms, πL(e = 1) = 8,000 – 4,000 = 4,000 > πL(e = 0) = 3,000, so low-skilled worker’s best
strategy is to obtain the certificate as well.

Therefore, under these circumstances, both type of workers have incentives to get the certificate. But this
may create some issues: specifically, employers see that all job applicants have the certificate and half of
them is unskilled, so the employers will update their beliefs and offer the same wage to all workers, which is
equal to the expected productivity:
w = 0.5*8,000+0.5 * 3,000 = 5,500.
When workers realize that having the certificate has no impact on the wage offered by the employers, they
choose not to get the education.
In conclusion, given the parameters of the model the separating equilibrium (which is desirable here) is not
reached in this case; in the pooling equilibrium nobody obtains the education or obtain the same level of
education making it difficult for the firm to separate the two types of workers. As a consequence, the
employers offer a salary equal for all employers which is equal to the expected productivity.

b.) Use the information on the previous exercise to compute the optimal level of education that will
enable to separate the two type of workers
In a perfect competitive market workers can choose their level of education as a way to signal their expected
productivity.
Contrary to the previous problem we now want to find what is the level of education eH that allows high
ability workers to credibly use the education as a signaling mechanism

The general formula for computing eH is wH-wL>cH*eH (the difference in wage has to make it worth for the Hs
to pay for and get education)
and wH-wL < cL *eH (the difference in wage OR the cost of education has to NOT make it worth for the low
ability workers to pay for and get education)
8
We can rearrange to find the optimal level of education by writing:
𝑤𝐻−𝑎𝐿 𝑤𝐻−𝑤𝐿
<𝑒 <
𝑐𝐿 𝑐𝐻

(8000−3000) (8000−3000) 5000 5000

< eH< = 4000 < eH< 1500 = 1.25 < eH< 3.33
4000 1500

Recall that aH and aL are the wages that worker will get depending on education.

EXERCISE 3.2
Suppose that half of population drives carefully and will get into an accident with probability 0.2. The other
half of the drivers is not as careful and faces the probability of accident 0.5. Assume all drivers have the same
income of $400 per year. Getting into an accident results into damages of $231. Drivers are risk-averse and
have utility function U = √𝑤 where w is the income per year. There is a risk-neutral insurance company in the
city.

a.) For now assume that information is perfect and symmetric. What happens if the insurance firm offers
full insurance at actuarially fair rates (such that the premium for each dollar insured is equal to the
expected payment by the insurance company)? What will be the total premiums for each type of
drivers? Which type of drivers will chose to buy the insurance?

Actuarially fair rate is such that premium for each dollar insured is equal to expected payment by the insurance
company (premium = p ·A where p is the expected probability of a claim, and A is the amount that the
insurance company will pay in the event of an accident), so the expected profits are zero (expected
revenue=expected cost).
Compute the expected costs:
When the insurance company sells full coverage to a high-risk driver, it knows that with probability 0.5 it will
have to pay $231, so the expected cost of covering such drivers is 0.5 · 231 (in this case they have to pay the
damages) = 115.5.
Whereas for the low-risk drivers the probability of the accident is only 0.2, so the expected cost of covering
such driver is 0.2 · 231 = 46.2.
Therefore:
Expected cost (EC) of covering high-risk driver is 0.5*231 = 115.5
Expected cost (EC) of covering low-risk driver is 0.2*231 = 46.2
At the fair rates the risk averse individuals maximize expected utility by fully insuring themselves, so both type
will chose to buy insurance and will be better off compared to the situation in which they are not insured.
Compute the expected utility
The expected utility of the two types of drivers with and without insurance is:

High-risk driver expected utility EU(uninsured) = 0.5 √400 + 0.5 √169 (400 − 231) = 16.5

High-risk driver expected utility EU(insured) = √400 − 115.5 (this is what high-risk driver have to pay)= 16.9

9
 ➔ EU (uninsured) = 0.5 √400 + 0.5 √169 = 16.5 < EU(insured) = √400 − 115.5 = 16.9

Low-risk driver expected utility EU(uninsured) = 0.8 √400+0.2 √169 (400-231) = 18.6

Low-risk driver expected utility EU(insured) = √400 − 46.2 (this is the premium that low-risk drivers have to
pay)= 18.8

➔ EU (uninsured) = 0.8 √400+0.2 √169 (400-231) = 18.6 < EU (insured) = √400 − 46.2 = 18.8

➔ Both types of drivers will choose to buy the insurance since their expected utility in case they will buy
the insurance is higher than in the case in which they decide not to buy it.

b.) Now let’s make a more realistic assumption: each driver knows his type, but this information is not
available to the insurance company. If all drivers decided to purchase the insurance, at what total
premium would the insurance company break-even (how high has to be the premium so that the
company survives)?
In a) we calculated that the insurance company has to pay 0.5 · 231 + 0.5 · 0= 115.5 for high-risk drivers and
0.2 · 231 + 0.2 · 0 = 46.2 for low risk drivers.
The insurance cannot distinguish who is a high-risk driver and who is low risk driver, so
If all drivers purchased the insurance, the company’s expected cost (EC) per customer would be:
EC: 0.5 · 115.5 + 0.5 · 46.2 = 80.85.
c.) Suppose the insurance company does charge the premium you calculated in part (b), which type of
drivers will decide to buy the insurance?

At this premium (80.85) the high-risk drivers would be happy to buy insurance, because the coverage is even
cheaper than in part (a) (115.5), they have surely a higher utility when they are insured compared to their
expected utility (insured) = √400 − 80.85=17.86>16.9
High risk drivers pay a lower premium relative to the one computed in part a) which further increases their
incentives to buy the insurance.

For the low-risk drivers now Utility (insured) =√400 − 80,85 = 17.86, which is lower then their expected utility
without insurance (18.6), so they will choose to stay uninsured.
The insurance company will only sell insurance to high-risk drivers. In this case asymmetric information about
the probability of an accident results in adverse selection because the insurance company will not get an
unbiased selection of customers. The price at which the insurance can be sold is not acceptable to the ‘high-
quality’ (low-risk) side of the market. If left unregulated, only ‘low-quality’ (high-risk) drivers would buy
insurance, market for insurance would collapse.

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