Question

1. Tamara and Jay both bought life insurance. Tamara has always been a rock climber, but she did not disclose this to the insurance company before she bought insurance. Jay will only attempt rock climbing now that he has insurance. Jay did not disclose this to the insurance company before he bought insurance. Describe the result of the asymmetric information held by Tamara and Jay.

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2. An airline practices third-degree price discrimination. Each month, it sells 1,500 business-class tickets from London to Paris at $200 a ticket, and 6,000 economy-class tickets at $80 a ticket. Use this information to construct the demand curves of business travelers and tourists respectively, if it is given that the demand curves for both groups are linear and that the marginal cost of a ticket is constant at $50.

Answer 1

1) Asymmetric information occurs when either party of a transaction has incomplete information ie buyers can have more information than sellers or vice versa. It is commonly observed in the insurance market.

In this case, Tamara does not disclose the information that she is a rock climber. Being a rock climber, she is exposing herself to a higher risk than any other person and hence the insurance company has the right to know about it. But since Tamara doesn't disclose it, this becomes the case of adverse selection. In this type of asymmetric information, the chances of the individual claiming the insurance increases and this would be biased in favor of buyer, which is Tamara than seller ie the insurance company since they have incomplete information.

In the next case, Jay has started rock climbing after taking the insurance. This is also a type of asymmetric information which occurs after the transaction has taken place. This would also increase the chances of claiming by Jay from the insurance company. In such type of asymmetric information, the buyer becomes careless after the transaction because now there is a security net which exists, due to which the person starts taking more and more risk. Eg: after the car insurance, the owner may leave the car unlocked, which would increase the risk of theft.

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