Question

Consider the Rothschild-Stiglitz Model (1976) of adverse selection in health insurance market, with asymmetric information and heterogeneous customers. How do we define a separating equilibrium in this model?

Answer 1

In the Rothschild-Stiglitz Model of adverse selection, a separating equilibrium occurs when different types of individuals can be distinguished based on their choices and the insurance premiums they pay.

Step-by-step explanation:

In the Rothschild-Stiglitz Model of adverse selection in health insurance markets, a separating equilibrium occurs when different types of individuals can be distinguished based on their choices and the insurance premiums they pay. In this model, individuals are divided into two types: low-risk and high-risk. A separating equilibrium ensures that low-risk individuals choose a low insurance premium, while high-risk individuals choose a high insurance premium.

For example, let's say there are two types of individuals: healthy individuals and individuals with pre-existing conditions. A separating equilibrium results in a sorting of individuals based on their risk types, allowing the insurance company to price the premiums according to the expected costs associated with each group, thus overcoming the adverse selection problem.