Product Design in Selection Markets
University of Oxford - Nuffield College
E. Glen Weyl
Microsoft Research New England; University of Chicago
July 10, 2015
Downpayments and other product features in selection markets like insurance and finance aim to sort out the most profitable clients. Modeling this incentive requires multidimensional heterogeneity absent from standard contract models. Only in such a model can the composition of purchasers vary independently of their number. By assuming a single product of endogenous quality as in Spence (1975), we obtain a simple expression for firm marginal sorting incentives under general heterogeneity as the ratio of two terms. The numerator is the covariance, among marginal consumers, between marginal willingness to pay for quality and consumer cost to the firm. The denominator is marginal consumer surplus, a standard measure of market power. We use this characterization in three applications. First, sorting incentives are empirically important in the design of subprime auto loans studied by Einav et al. (2012). Second, sorting mitigates exploitative add-on pricing if and only if consumer sophistication is inelastic to income. Finally, increasing market power beneficially raises the quality of health insurance by mitigating "cream-skimming" in a calibration to Handel et al. (Forthcoming)'s data.
Number of Pages in PDF File: 36
Keywords: selection markets, cream-skimming, insurance markets, add-on pricing, subprime lending, product design
JEL Classification: D41, D42, D43, D86, G21, I13
Date posted: September 30, 2011 ; Last revised: July 11, 2015
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