Product Design in Selection Markets
University of Oxford - Nuffield College
E. Glen Weyl
Microsoft Research New England; University of Chicago
November 14, 2014
We take a price theoretic approach to the design of insurance contracts: consumers are heterogeneous in cost and risk-aversion but insurers offer a single, parametric contract. An insurer's incentive to use quality to sort for low-cost consumers appears only under multidimensional heterogeneity and is quantified by the covariance, among marginal consumers, between marginal willingness-to-pay and cost to the insurer. Under monopoly, standard forms of quality (e.g. lower cost-sharing, deductibles) disproportionately attract costly consumers. When the two dimensions of type are uncorrelated, we recover Rothschild and Stiglitz (1976)'s non-existence result for competitive equilibrium. However, realistic frictions of negative correlation and market power relax this result. If this correlation is sufficiently negative, competitive equilibrium with positive insurance can exist and is characterized by the quality level causing the sorting incentive to vanish. Moreover, market power increases equilibrium quality. In calibrations to Handel, Hendel and Whinston (2014)'s data, we show that 1) a perfectly competitive symmetric equilibrium fails to exist but 2) when market power is sufficient to make premia 82% above cost, welfare is 98% and consumer surplus is 79% of their first best levels.
Number of Pages in PDF File: 50
Keywords: selection markets, cream-skimming, insurance markets, multidimensional heterogeneity, product design
JEL Classification: D41, D42, D43, D86, I13
Date posted: September 30, 2011 ; Last revised: November 15, 2014
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