6. Consider the basic RothschildStiglitz model with asymmetric information and t

Question

6. Consider the basic RothschildStiglitz model with asymmetric information and two types on
consumers. A policymaker who has taken this class suggests that is might be beneficial to
impose a flat tax on healthy people and distribute the tax revenue to sick people, providing
partial insurance to people.
a. Since the tax will only offer partial insurance, there will still be a private competitive
market for additional insurance. Will a separating equilibrium be possible in the
insurance market if this tax is implemented? Draw a diagram to justify you answer.
b. After the tax is implemented a recession hits and a new policymaker decides to make up
for a tax revenue shortfall by expanding the tax to include sick people as well as healthy
people. Will a separating equilibrium be possible in the insurance market under this
policy?

Explanation / Answer

a) when a flat tax is imposed for all then in the private market then the healthy participant already pay up. Thus they will not participate in the private market as they know like others they will be covered partially if sick. And they know they are healthier. So the private market is a merket of lemons with only sick people trying for full coverage, thus prices will be high.

b) when both sick and healthy get benefits from tax revenues they cannot be seperated for in the private market. and hence the private market may again get a mix.

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