(Neutrally) Optimal Mechanism Under Adverse Selection: The Canonical Insurance Problem
68 Pages Posted: 27 Oct 2015
Date Written: October 26, 2015
This paper revisits the problem of adverse selection in the insurance market of Rothschild and Stiglitz. We extend the game-theoretic structure in Hellwig to a mechanism in which the Miyazaki-Wilson-Spence allocation is the unique perfect-Bayesian equilibrium. As is well-known, this allocation is the unique incentive-efficient and individually-rational maximizer of the utility of the profitable type. In fact, given that the informed player has only two types, it is the unique core allocation and, thus, the unique neutral optimum in the sense of Myerson.
Keywords: Insurance Market, Adverse Selection, Interim Incentive Efficiency, Neutral Optimum
JEL Classification: D86
Suggested Citation: Suggested Citation