Practice Problems - Advanced Microeconomics

Alessandro Di Nola
A.Y. 2011-2012, Spring Term
Exercise 1 - Financial Contracts
Consider the following asymmetric information problem in the nancial market. The principal
is a lender who provides a loan of size / to a borrower. Capital costs 1/ to the lender since it
could be invested elsewhere in the economy to earn the risk-free interest rate 1. The lender has
thus a utility function \ = t 1/. The borrower makes a prot l = 0)(/) t where 0)(/) is the
production with / units of capital and t is the borrowers repayment to the lender. We assume that
)
0
0 and )
00
< 0. The parameter is a productivity shock drawn from O =
_
0, 0
_
with respective
probabilities 1 i and i.
1. Write down incentive and participation constraints directly in terms of the borrowers infor-
mation rents l= 0)(/)t and l = 0)(/) t.
2. Write down and solve for the optimal contract assuming the lender perfectly observes the
productivity of the borrower.
3. Write down the principals maximization problem. Clearly denote the constraints.
4. Which constraints are binding at the optimum? Explain. Is there a capital distortion with
respect to the rst-best outcome?
Exercise 1 - Solution
1. The Incentive Compatibility constraints for this problem (ICs) are:
0)(/) t 0)(/) t,
0)(/) t 0)(/) t.
The Participation Constraints (also called Individual rationality constraints, IR) are:
0)(/) t 0,
0)(/) t 0.
1
Using the denitions for information rents (and letting ^0 00 0), they can be rewritten
as:
l l ^0)(/), (IC
L
)
l l ^0)(/), (IC
H
)
l 0, (PC
L
)
l 0. (PC
H
)
2. Assuming that the lender can observe the borrowers productivity 0 we can can nd the
rst-best menu of contracts by solving:
max
t;k
\ = t 1/
s.t.
0)(/) t 0. (1)
Clearly the constraint is binding at the solution, hence the above problem is equivalent to:
max
ft;kg
\ = 0)(/) 1/
The rst-order condition with respect to / delivers:
0)
0
(/) = 1.
Therefore the menu of contracts oered by the principal under full information is
_
(t

, /

) , (t

, /

)
_
such that 0)
0
(/

) = 1 and 0)
0
(/

) = 1 and the optimal transfers t

and t

can be derived
from (1) with equality. Note furthermore that /

< /

since 0)
0
(/

) =0)
0
(/

) and ) is con-
cave. It is easy to see that the FB contract we just derived is not incentive compatible, since
it violates the IC constraint for 0-agent. In fact
0)(/

) t

= 0)(/

) 0)(/

) =
_
0 0
_
)(/

) 0 = 0)(/

) t

meaning that the high-productivity borrower will not choose (t

, /

) but (t

, /

) if oered the
FB contract.
3. Under second-best (assuming asymmetric information), the principal is maximizing
max
f(U;k);(U;k)g
i
_
0)(/) 1/
_
(1 i) (0)(/) 1/)
_
il (1 i)l
_
(2)
s.t. constraints (IC
L
) to (PC
H
).
Note that the optimization variables are now
_
(l, /) ,
_
l, /
__
(we substituted out transfers
by using the denitions of information rents). A rst approach to solve (2) could be to apply
the Lagrangian techniques but there is a more practical route, that calls for the simplication
of the number of relevant constraints (see Prof. Pavonis slides). First we claim that the
2
0-agent participation constraint (PC
H
) is always strictly satised (hence it is redundant). In
fact, considering (IC
H
) we have:
l l ^0)(/) ^0)(/) 0
where the second inequality holds since l 0 by (PC
L
) and the last inequality holds since
^0)(/) 0 as long as / 0. Hence l 0. Then we state and prove the following:
. Claim: Both (IC
H
) and (PC
L
) must be binding at the solution.
. Proof : Suppose not. Then either (PC
L
) or (IC
H
) is not binding (or both). Consider
the case (PC
L
) is not binding, i.e. l 0. Then we can nd another contract, call it
1 =
_
(l -, /) ,
_
l -, /
__
, - small enogh, that still satises the constraints. But under
contract B the principals prot increases by - 0. This contradicts the assumption that
_
(l, /) ,
_
l, /
__
was the optimal contract. Hence l = 0. Consider instead case (IC
H
) is not
binding. Then
l l ^0)(/) = ^0)(/)
since we showed l = 0. But if l ^0)(/), then the Principal can decrease l by - 0, for -
small enough, and gain - 0. This again contradicts the assumption that
_
(l, /) ,
_
l, /
__
was the optimal contract.
4. After simplifying the number of relevant constraints we can restate problem (2) as follows:
max
f(U;k);(U;k)g
i
_
0)(/) 1/
_
(1 i) (0)(/) 1/)
_
il (1 i)l
_
(3)
s.t.
l = ^0)(/), (3a)
l = 0, (3b)
l l ^0)(/). (IC
L
)
Now we guess that (IC
L
) is slack at the optimum (we will verify that the solution obtained
by neglecting this constraint indeed satises IC
L
). Thus we are left with only two remaining
constraints, (3a) and (3b). Substituting (3a) and (3b) into (3) we obtain a reduced program with
_
/, /
_
as the only choice variables:
max
fk;kg
i
_
0)(/) 1/
_
(1 i) (0)(/) 1/) ^0)(/)
The rst-order condition with respect to / is:
0)
0
(/) = 1.
which is equal to the FB condition: we therefore showed that there is no distortion at the top:
/
SB
= /

. The rst-order condition with respect to /, however, reads as:

_
0

1
^0
_
)
0
(/
SB
) = 1.
3
Recalling that the FB output choice for the less productive borrower is /

s.t. 0)
0
(/

) = 1 we have
_
0

1
^0
_
)
0
(/
SB
) = 0)
0
(/

) (4)
from which
1
it follows )
0
(/
SB
) )
0
(/

), hence /
SB
</

. It remains now to check that the solution

to (3) satises strictly the omitted constraint (IC
L
), which can be simplied as follows:
l l ^0)(/)
0 l ^0)(/)
But l = ^0)(/) from (3a) hence
0 ^0
_
)
_
/
SB
_
)(/
SB
)
_
(5)
Inequality (5) is equivalent to /
SB
< /
SB
since ) is strictly increasing. But this is true since
/
SB
< /

< /

= /
SB
where the rst inequality follows from (4), the second from our characterization of FB contract (see
point 2), and the last equality comes from the fact that the SB contract calls for no distortion for
the ecient type.
1. We can summarize our results for the second-best (SB) contract in the following proposition:
Proposition.
(a) At the optimum, only the incentive constraint for the 0-agent and the participation constraint
for the 0-agent are binding.
(b) There is no capital distortion with respect to FB for the 0-agent, i.e. /
SB
= /

, where
0)
0
(/

) = 1 (hence for the high-type the return on capital is equalized to the risk-free rate.
(c) There is a downward distortion in loan given to the 0-agent: /
SB
< /

,where in particular
_
0

1
^0
_
)
0
(/
SB
) = 0)
0
(/

).
Exercise 2 - My Little Red Corvette
Everybody likes red Corvettes (testimony to this is the famous song by Prince "My Little Red
Corvette"). Assume that there exist two types of potential Corvette purchasers. On one hand,
snobs are willing to pay 25000 for a red Corvette but only 20000 for a Corvette of another colour.
On the other hand, less snobbish purchasers are willing to pay 22000 for a red Corvette and 20000
if it is any other colour. The percentage of snob purchasers is c, so that (1 c)/ of purchasers
1
Note that
v
1v
< for any v 2 (0; 1) :
4
are less snobbish. The production cost of a Corvette is independent of its colour. Assume the car
seller does not know the type of the buyer (or, even if he knew it, the law would prevent him from
price discrimination). Why are Corvettes of all colours seen on the streets? What parameters does
your answer depend on?
Exercise 2 - Solution
It is clear that there are only two possibly optimal contracts the seller is willing to oer. The
rst is a separating contract: sell red corvettes at price 2000 and corvettes of other colour at price
20000. Snob consumers will then buy only red corvettes making zero net utility and less snobbish
consumers will buy only other colour corvettes (in fact the price of a red corvett is higher than
their willingness to pay for it). The expected prot for the seller under this separating contract is:
H = c2000 (1 c)20000.
The other possible contract is a pooling contract asking a price of 22000 for a car of either colour.
Clearly the snob consumers will purchase only red corvettes, earning a positive payo equal to
2000 22000 = 8000. Less snobbish consumers will buy only red corvettes as well, earning a zero
payo. Under this pooling contract the expected prot of the seller is 22000. Hence red corvettes
are always sold and the car seller oers the separating contract (charging a higher price for red
corvettes) if and only if the parameter c is such that
c2000 (1 c)20000 22000,
i.e. c
2
5
(i.e. if and only if the percentage of snob consumers is high enough).
Exercise 3 - Price Discrimination I
A company oers the only ight service between two cities. The cost per passenger is 400.
Assume that the airlines potential clients can be divided into two groups: executives who travel
for business reasons, and tourists who travel for vacations. For this particular service, if the meeting
that an executive wants to attend takes place, then he is willing to pay a price of 1000. On the
other hand, tourists are willing to pay 600 for the same trip.
1. What price will the airline charge if it can perfectly observe whether an individual is an
executive or a tourist? What are the prots of the airline in this case?
Now assume that the airline cannot distinguish between tourists and executives.
2. What price (or prices) will the company charge for a ticket? What are the prots of the
airline now?
Assume that tourists are perfectly informed as to when they have their vacations, and the
probability that they must cancel their trip is zero. On the other hand executives believe that there
is a 50% chance that their meeting will be cancelled or will be changed to another date. Assume
now that the company can x not only the price of the ticket but also the refund conditions when
a ticket is cancelled.
3. What contracts (or tickets) will the airline oer? Discuss.
5
Exercise 3 - Solution
1. If the company can observe the buyers type (full information case) it will set the price of a
ticket for an executive at 1000 and the price of a ticket for a tourist at 600, thus extracting
all the surplus. Let ` denote the percentage of travelers who are executives. Then the prots
of the airline are 1000` 600(1 `) 400 200.
2. Under asymmetric information the company cannot observe the travellers type. If she pro-
poses the rst best contract, the executives clearly will not choose the ticket designed for them
but will buy the cheaper ticket for tourists, earning a net utility equal to 1000 600 = 400.
In other words, the menu of contracts we derived in (1) is not incentive-compatible here. The
only feasible contract is a pooling contract asking a price of 600 to both types of travellers.
The prots of the airline are now equal to 600 400 = 200 (strictly less than the rst best).
3. Now the airline is able to oer a contract that leads to self-selection. Consider for example the
following menu of contracts: (a) tourist-tari at price 600 with no refund and (b) business-
tari at price 1000 with a full refund clause in case the ight is cancelled by the traveller.
Clearly such contract is incentive compatible: if the executive buys (b) he gets zero in expected
utility but if he pretends to be a tourist and buys (a) his expected utility is
1
2
(1000 600)
1
2
(0 600) = 100.
Remark - This exercise illustrates a typical feature of adverse selection problems: under
asymmetric information, if the principal can set only the price then only pooling contracts are
incentive-compatible. Instead, if he is allowed to choose also other variables (such as the refund
clause in the above exercise) he is able to discriminate among dierent types of customers.
Exercise 4 - Price Discrimination II
Air Shangri-la is the only airline allowed to y between the islands of Shangri-la and Nirvana.
There are two types of passengers, tourist and business. Business travelers are willing to pay more
than tourists. The airline, however, cannot tell directly whether a ticket purchaser is a tourist or a
business traveler. The two types do dier, however, in how much they are willing to pay to avoid
having to purchase their tickets in advance.
More specically, the utility levels of each of the two types net of the price of the ticket, 1, for
any given amount of time \ prior to the ight that the ticket is purchased are given by
Business : 0
B
1 \,
Tourist : 0
T
1 \,
where 0 < 0
B
< 0
T
. (Note that for any given level of \), the business traveler is willing to pay
more for his ticket. Also, the business traveler is willing to pay more for any given reduction in
\.). The proportion of travelers who are tourists is `. Assume that the cost of transporting a
passenger is c.
Assume in (1) to (4) that Air Shangri-la wants to carry both types of passengers.
6
1. Draw the indierence curves of the two types in (1, \)-space. Draw the airlines isoprot
curves. Now formulate the optimal (prot-maximizing) price discrimination problem mathe-
matically that Air Shangri-la would want to solve. (Hint: Impose nonnegativity of prices as
a constraint since, if it charged a negative price, it would sell an innite number of tickets at
this price).
2. Show that in the optimal solution, tourists are indierent between buying a ticket and not
going at all.
3. Show that in the optimal solution, business travelers never buy their ticket prior to the ight
and are just indierent between doing this and buying when tourists buy.
4. Describe fully the optimal price discrimination scheme under the assumption that they sell
to both types. How does it depend on the underlying parameters `, 0
B
, 0
T
, and c?
5. Under what circumstances will Air Shangri-la choose to serve only business travelers?
Exercise 4 - Solution
(1) We represent the indierence curves for the two types of travelers and the isoprot curve
for the airline in the picture below:
From gure above we note that the indierence curve for business travelers is atter since
business travelers are willing to pay more for a given reduction in \. Furthermore, the prot
function of the airline depends only on price 1 and production cost c, as stated in the text, and
hence it is a vertical line in the (1, \) space.
7
The optimal (second-best) price discrimination problem that Air Shangri-la would want to solve
is
max
fP
T
;W
T
;P
B
;W
B
g
`1
T
(1 `)1
B
c (1)
s.t.
0
T
1
T
\
T
0
T
1
B
\
B
, (IC1)
0
B
1
B
\
B
0
B
1
T
\
T
, (IC2)
0
T
1
T
\
T
, (P1)
0
B
1
B
\
B
, (P2)
1
T
, \
T
, 1
B
, \
B
0. (2)
(2) We are asked to show that in the optimal solution tourists are indierent between buying
a ticket or not. This is equivalent to say that the participation constraint (P1) for the 0
T
-agent
(here, the low type) is binding at the optimum. First, we show that (P2) is redundant. In fact,
(IC2) together with (P1) imply:
0
B
1
B
\
B
0
B
1
T
\
T
< 0
T
1
T
\
T
,
hence 0
B
1
B
\
B
< . Since (P2) is slack, it can be safely neglected. Now we are ready to show
that (P1) is binding. If it is not the case, i.e. if
0
T
1
T
\
T
<
then the Principal (hereafter, P) could increase 1
T
and 1
B
by - 0 and all the relevant constraints
would still be satised, provided - is small enough. But this modication would earn the P higher
prot, a contradiction.
(3) We are asked to show that \
B
= 0 and that (IC2) is binding. Assume that f(1
T
, \
T
), (1
B
, \
B
)g
is an optimal, incentive compatible contract, and assume in negation that \
B
0. Now we can
reduce \
B
by - 0 and increase 1
B
by
"

B
so that the 1 type utility does not change, and the
rm earns higher prots from the 1 type. We need to check that the T type will not choose this
new compensation package. Indeed ,
0
T
1
T
\
T
0
T
1
B
\
B
= 0
T
_
1
B

-
0
T
_
(\
B
-) < 0
T
_
1
B

-
0
B
_
(\
B
-).
It follows that f(1
T
, \
T
), (1
B
, \
B
)g cannot be an optimal, incentive compatible contract. There-
fore, we must have \
B
= 0. It remains to show that the (IC2) constraint is binding. If, in an
optimal contract, the business travelers were not indierent between (1
T
, \
T
) and (1
B
, \
B
), i.e.
if
0
B
1
B
\
B
< 0
B
1
T
\
T
,
we could slightly raise 1
B
and all the constraints would remain satised (recall that (P2) is slack),
and the rm would earn higher prots from the 1 types. Therefore in an optimal contract we must
have the business types indierent between (1
T
, \
T
) and (1
B
, \
B
).
8
(4) Using our results from the previous points, we are allowed to restate the rms price
discrimination program as:
max
fP
T
;W
T
;P
B
g
`1
T
(1 `)1
B
c (3)
s.t.
0
T
1
T
\
T
= , (3a)
0
B
1
B
= 0
B
1
T
\
T
, (3b)
1
T
, \
T
, 1
B
0.
By substituting (3a) and (3b) into (3) we can leave \
T
as the only choice variable:
max
fW
T
g
`
_
\
T
0
T
_
(1 `)
_
\
T
0
T

\
T
0
B
_
c
s.t.
0 \
T

2
.
Note that the objective function is linear in \
T
so we have to deal with corner solutions. We need
to distinguish two cases:
(a) If
1

B

1

T
0 then the rms prot is strictly increasing in \
T
over the interval [0, [ so that
\

T
= . It follows that the optimal scheme will be f(1
T
, \
T
), (1
B
, \
B
)g =
_
(0, ), (
v

B
, 0)
_
:
only 1 types will be served.
(b) If instead
1

B

1

T
< 0 then the rms prot is strictly decreasing in \
T
over the interval
[0, [ so that \

T
= 0. It follows that the optimal scheme will be f(1
T
, \
T
), (1
B
, \
B
)g =
__
v

T
, 0
_
,
_
v

T
, 0
__
: both types will be served for the same price (pooling contract).
Since the direction of the inequality in the condition above determines the type of scheme, it
is easy to see how changes in `, 0
T
and 0
B
will aect the optimal scheme. In particular, if the
proportion of 1 types is large enough (` small enough) the rm will choose to serve only the 1
types (i.e. case (a) applies). If the 1 types suer less from prices (0
B
is smaller) then the rm is
more likely to serve only them (i.e. case (a) applies again). If the T types suer less from prices
(0
T
is smaller) then the rm is more likely to serve them as well as the 1 types (i.e. case (b)
applies). Changes in the cost parameter c are discussed in point (5) below.
(5) As long as c <
v

B
, and we are in case (a) described in point (4) above, the rm will decide
to serve only the business types. If, however, we are in case (b) above, and
v

T
< c <
v

B
, then
the scheme described above cannot be optimal because the rm is losing money. In such a case
the rm will choose the scheme described in case (a) above, and serve only the business types. If
c
v

B
the rm will choose not to operate at all.
2
The second constraint on WT comes from the fect that PT = (v WT ) =T and PT 0.
9
Exercise 5 - Regulation revisited
The regulator is concerned with costumer welfare, therefore he wants to force a natural monopoly
to charge competitive prices. The problem is that the regulator does not know as much about the
rms cost structure as he would like to. More precisely, we will consider a natural monopoly with
an exogenous cost parameter 0 which can take on two values: 0
L
and 0
H
, where 0
L
< 0
H
. The
rms cost of producing the good is
c = 0 c,
where e stands for eort. Exerting eort has cost
w(c) =
c
2
2
,
which is increasing and convex in c. We will assume that the regulator wants the good to be
produced for the lowest possible payment 1 = : c, which consists of two parts: the subsidy : and
the accounting cost c. The payo of the rm is
1 c w(c).
1. Assume that regulator has perfect information: he can observe 0 and c. Write down the
optimization problem for the regulator and solve it.
From now on we consider the incomplete information case. The regulator can observe c and can
not observe 0, but he believes it is 0
H
with probability (1 ,) and 0
L
with probability ,.
2. Write down the regulators minimization problem.
3. Show that the IR (participation) constraint for type 0
L
is redundant.
4. Argue that the IR constraint for type 0
H
is binding at the optimum.
5. Argue that the IC constraint for type 0
L
is binding at the optimum.
6. Show that IC constraints imply c
H
c
L
.
7. Argue that the IC constraint for the high type is redundant at the optimum.
8. Now we get to one of our favorite after-class activities. Compute the regulators minimization
problem.
Exercise 5 - Solution
(1) Recall the regulators problem:
min
fs;eg
: 0 c
10
s.t.
:
c
2
2
0. (IR)
Since the regulators payment to the rm (which he is minimizing) is strictly increasing in the
subsidy :, for each c he will decrease the subsidy as much as possible. Therefore at the optimum
the rms participation constraint (or IR, individual rationality) is binding and we have : =
e
2
2
.
Plugging this equation back into the original minimization problem we obtain a new minimization
problem:
min
feg
c
2
2
0 c
Being this function strictly convex, the solution is obtained by computing the rst-order condition:
c

= 1.
(2) The regulator is minimizing the expected payment subject to the rms IC and IR con-
straints:
min
fs
L
;c
L
;s
H
;c
H
g
,(:
L
c
L
) (1 ,)(:
H
c
H
)
s.t.
:
H

(0
H
c
H
)
2
2
:
L

(0
H
c
L
)
2
2
, (IC
H
)
:
L

(0
L
c
L
)
2
2
:
H

(0
L
c
H
)
2
2
, (IC
L
)
:
H

(0
H
c
H
)
2
2
0, (IR
H
)
:
L

(0
L
c
L
)
2
2
0. (IR
L
)
Notice that the eort c in IC and IR constraints was replaced by 0 c.
(3) We are asked to show that the IR (participation) constraint for type 0
L
is redundant. Note
that
:
L

(0
L
c
L
)
2
2
:
H

(0
L
c
H
)
2
2
,
:
H

(0
H
c
H
)
2
2
,
0,
where the rst inequality is IC for the type 1, the second follows from the fact that 0
H
0
L
and
the third is IR for type H.
(4) We prove the claim by contradiction. Suppose at some optimal contract, which satises all
four constraints, (IR
H
) was not binding. Then one could decrease both :
L
and :
H
by the same
amount, still have all the four constraints satised, and the regulators payment would be lower.
Therefore the starting contract is not optimal, a contradiction.
11
(5) Again by contradiction. Suppose we started with a contract for which all the constraints
were satised and the IC for 1 was not binding. Then we could decrease :
L
by a little bit and the
IC for 1 would still not be binding. All the other constraints would be satised after the decrease
(make sure you understand why). Since :
L
is lower in the new contract the regulator pays less.
Therefore the starting contract is not optimal, a contradiction.
(6) Substracting the two IC constraints yields:
(0
L
c
H
)
2
(0
H
c
H
)
2
(0
L
c
L
)
2
(0
H
c
L
)
2
,
which after some boring algebra yields
c
H
(0
H
0
L
) c
L
(0
H
0
L
).
After canceling out some terms one obtains c
H
c
L
.
(7) We are asked to argue that the IC constraint for the high type is redundant at the optimum.
From (5) we know :
L

(
L
c
L
)
2
2
= :
H

(
L
c
H
)
2
2
. After rearranging it one obtains :
H
= :
L

(
L
c
L
)
2
2

(
L
c
H
)
2
2
. Now, plugging this into :
H

(
H
c
H
)
2
2
one has
:
H

(0
H
c
H
)
2
2
= :
L

(0
L
c
L
)
2
2

(0
L
c
H
)
2
2

(0
H
c
H
)
2
2
= :
L

(0
H
c
L
)
2
2

(0
H
c
L
)
2
2

(0
L
c
L
)
2
2

(0
L
c
H
)
2
2

(0
H
c
H
)
2
2
:
L

(0
H
c
L
)
2
2
.
The inequality follows, after some rearranging, from the fact that c
H
c
L
.
(8) Using the fact that high types IR constraint and low types IC constraints are binding and
the other two irrelevant, we can rewrite the original problem as follows:
min
c
L
;c
H
, [w(0
H
c
H
) w(0
L
c
H
) w(0
L
c
L
) c
L
[ (1 ,) [w(0
H
c
H
) c
H
[
Taking the rst-order conditions with respect to c
L
and c
H
, yields:
0
L
c
sb
L
= 1,
1
1 ,
(0
H
c
sb
H
)
,
1 ,
(0
L
c
sb
H
) = 1.
The two equations can be rewritten as:
c
sb
L
= 0
L
c
sb
L
= 1,
c
sb
H
= 0
H
c
sb
H
= 1
,
1 ,
(0
H
0
L
).
Exercise 6: Car Insurance
Recently, a friend of ours mentioned that he had gone to insure his car and he had been oered
several dierent policies. He could choose between an expensive contract with full insurance, or a
contract with voluntary excess of $ 900 (a voluntary excess clause means that the company will
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pay all losses from accidents over and above the rst $900 but not below). The policy with excess
was signicantly cheaper. Our friend argued the insurance companies oer contracts with excess
clause since that way they make the drivers who suer many accidents pay each time $ 900. Is this
a reasonable argument? Whether your answer is armative or not, you should argue in terms of
an adverse selection situation (the insurance company cannot observe whether or not the driver is
reckless).
Exercise 6 - Solution
The argument is not very resonable. If insurance companies could determine only the price
per unit of coverage, the only incentive compatible contract would be a pooling one (assuming
that the companies cannot distinguish "reckless" drivers from "safe" ones). But under a pooling
contract it is possible that the insurance companies always make losses or that in equilibrium only
the reckless drivers buy the insurance (remember Akerlofs example with "lemons"), leading to a
market failure. Therefore it is more ecient to design more complex contracts (like the one proposed
in the text) that leave greater leeway to insurance companies: by oering dierent price/coverage
packages between which the clients can freely choose, there is hope that the bad-risk guys will
self-select themselves. We then have a separating equilibrium in which safe drivers will buy the
cheaper policy with voluntary excess and "reckless" drivers will buy the more expensive one without
voluntary excess.
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