Suppose that there are only two types of drivers: high-risk drivers, who have a higher chance of accidents, and low-risk ones who have a lower chance of accident. Suppose also that car insurance companies cannot tell apart these two groups (for example, this will be true for young drivers who do not have a driving history yet). For this reason they will have to charge the same premium to both groups.

a) If car insurance were not mandatory, then, which group of drivers would you expect not to buy insurance and why? If this group opts not to buy insurance, how would insurance premiums be affected? Discuss using the concept of adverse selection. How would making car insurance mandatory alleviate adverse selection issues?

b) A cornerstone of the recent health care reform is the individual mandate: individuals have to obtain coverage or pay a penalty. Use a reasoning similar to the one you used for question a) in order to explain why the architects of the reform thought that an individual mandate was necessary (as a side, note that this is not a question about the virtues, or lack thereof, of the Affordable Care Act; it is just a question about the logic of including the mandate in the reform).

c) Now back to car insurance. In Massachusetts car insurance is mandatory, with a required minimum limit of coverage. A driver may choose to insure for a higher amount. If a driver injures someone by driving, then his insurance company will be able to provide some compensation to the injured person, up to the insured amount. Explain how the choice of the amount to insure affects not only the driver but also other road users: in other words, it is an externality. Using the concept of private marginal benefit and social marginal benefit, explain why it is likely that drivers will insure less than the socially optimal amount.