Consider the Figure, which depicts a scenario in the Rothschild–Stiglitz model of adverse selection.
a. Explain why α is not a valid pooling equilibrium.
b. Explain why your answer to the previous question depends on an assumption that expected utility theory holds.
c. Suppose the Pcorian government is trying to maintain α as a pooling equilibrium to ensure universal insurance for its long-suffering populace. The government health minister is familiar with the work of Kahneman and Tversky and wants to take advantage of the fact that Pcorians are loss averse and susceptible to framing. When a private insurance company begins offering contract δ, how should the government frame the tradeoff between α and δ to try to keep robust customers at α?
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