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Product Design in Selection Markets

Andre Veiga

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

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Date posted: September 30, 2011 ; Last revised: July 11, 2015

Suggested Citation

Veiga, Andre and Weyl, E. Glen, Product Design in Selection Markets (July 10, 2015). Available at SSRN: http://ssrn.com/abstract=1935912 or http://dx.doi.org/10.2139/ssrn.1935912

Contact Information

Andre Veiga
University of Oxford - Nuffield College ( email )
New Road
Oxford, OX1 1NF
United Kingdom
HOME PAGE: http://www.andreveiga.com
Eric Glen Weyl (Contact Author)
Microsoft Research New England ( email )
One Memorial Drive, 14th Floor
Cambridge, MA 02142
United States
(857) 998-4513 (Phone)
HOME PAGE: http://www.glenweyl.com
University of Chicago ( email )
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Chicago, IL 60637
United States
(773) 702-4862 (Phone)
(773) 702-8490 (Fax)
HOME PAGE: http://www.glenweyl.com
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