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QUESTION 1 Suppose a car insurance company has determined that clients who prefer their coffee black, i.e., without milk or sugar, have a higher chance of getting involved in a serious car accident than those who drink their coffee with milk and sugar. In fact, it has been observed that those who drink their coffee black tend to drive more recklessly than those who do not, and the more reckless the driving, the greater the likelihood of accidents. But suppose that the insurance company has no way of determining their customers preferences over coffee, since it is a very personal piece of information not collected by the usual data collection agency. Suppose further that the insurance company has no way of ascertaining whether its customer was driving recklessly at the time of accident. (a) Describe the informational asymmetry in this problem, i.e., whether there is any problem of moral hazard or adverse selection. If the insurer believes a customer has a 50% chance of being a black coffee drinker, would it succeed in breaking even if it offered a standard insurance policy with deductibles? (Recall that a deductible policy pays only a part of the damage in case of an accident; the customer pays the rest.) (b) Now suppose the insurer asks its customers to state whether they like black coffee or not, when they purchase insurance policies from the firm. The insurer is unable to verify the truth as the customer can lie about their preferences if they want to. However, the insurer offers two different policies depending on their customers response. If the customer reveals a preference for black coffee, the insurer will charge a high premium, but will compensate the customer fully in case of an accident. If the customer does not reveal a preference for black coffee, the insurer will charge a low premium, but the customer will be compensated only partly if there is an accident. Explain why such a policy will work.