Product Design in Selection Markets

42 Pages Posted: 30 Sep 2011 Last revised: 5 Nov 2015

Andre Veiga

University of Oxford - Nuffield College

E. Glen Weyl

Microsoft Research; Yale University

Date Written: November 4, 2015

Abstract

In selection markets, where the cost of serving consumers is heterogeneous and noncontractible, non-price product features allow a firm to sort profitable from unprofitable consumers. An example of this “sorting by quality” is the use of downpayments to dissuade borrowers unlikely to repay. We study a model in which consumers have multidimensional types and a firm offers a single product of endogenous quality, as in Spence (1975). These two ingredients generate a novel sorting incentive in a firm’s first-order condition for quality, which is a simple ratio. The denominator is marginal consumer surplus, a measure of market power. The numerator is the covariance, among marginal consumers, between marginal willingness to pay for quality and cost to the firm. We provide conditions under which this term is signed, and contrast the sorting incentives of a profit maximizer and a social planner. We then use this characterization to quantify the importance of sorting empirically in subprime auto lending, analytically sign its impact in a model of add-on pricing, and calibrate optimal competition policy in health insurance markets.

Keywords: selection markets, cream-skimming, insurance markets, add-on pricing, subprime lending, product design

JEL Classification: D41, D42, D43, D86, G21, I13

Suggested Citation

Veiga, Andre and Weyl, E. Glen, Product Design in Selection Markets (November 4, 2015). Quarterly Journal of Economics, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1935912 or http://dx.doi.org/10.2139/ssrn.1935912

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 ( email )

641 Avenue of the Americas
7th Floor
New York, NY 10011
United States
(857) 998-4513 (Phone)

HOME PAGE: http://www.glenweyl.com

Yale University ( email )

28 Hillhouse Ave
New Haven, CT 06520-8268
United States

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