Question 3 With adverse selection, the main problem is for the insurance to design policies to attract the right mix of consumers. High risk individuals constantly want to present as low risk and buy policies for low risk individuals and this will be disastrous for the insurance company (kindly convince yourself). This means thatby all means, the insurance company must design a policy that will be attractive only to the different risk types. Now assume two individuals (a high risk and a low risk) have the same initial wealth (W*) and each face a potential loss, 1. a. Use a simple diagram (from our discussions in class) to show the market opportunities available for each person to trade wealth between a good and bad state by buying fair insurance under perfect information. b. Now under imperfect information, the insurance company would have to find ways of distinguishing the two individuals. The two possible solutions will result in a pooling equilibrium or a separating equilibrium. Using a simple graph, explain each of these solutions. In the separating equilibrium, show which set of policies will likely not be mimicked by the high-risk individual. Also show what will be optimal (the best of the lot) policies for the high risk and low risk individuals. Note that for the low risk, this may not be on the certainty line. He/she may prefer a compromise if that sets him/her aside to be identified as low risk and denies the high risk a chance to mimic. c. Separating equilibrium can be achieved through signaling or screening. Briefly explain these with practical examples