Competition Leverage: How the Demand Side Affects Optimal Risk Adjustment
CentER Working Paper Series No. 2011-071
37 Pages Posted: 20 Jun 2011 Last revised: 5 Sep 2011
There are 2 versions of this paper
Competition Leverage: How the Demand Side Affects Optimal Risk Adjustment
Competition Leverage: How the Demand Side Affects Optimal Risk Adjustment
Date Written: July 4, 2011
Abstract
We study optimal risk adjustment in imperfectly competitive health insurance markets when high-risk consumers are less likely to switch insurer than low-risk consumers. First, we find that insurers still have an incentive to select even if risk adjustment perfectly corrects for cost differences among consumers. Consequently, the outcome is not efficient even if cost differences are fully compensated. To achieve first best, risk adjustment should overcompensate for serving high-risk agents to take into account the difference in markups among the two types. Second, the difference in switching behavior creates a trade off between efficiency and consumer welfare. Reducing the difference in risk adjustment subsidies to high and low types increases consumer welfare by leveraging competition from the elastic low-risk market to the less elastic high-risk market. Finally, mandatory pooling can increase consumer surplus even further, at the cost of efficiency.
Keywords: health insurance, risk adjustment, imperfect competition, leverage
JEL Classification: I11, I18, G22, L13
Suggested Citation: Suggested Citation
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