Product Design in Selection Markets

Economics

Speaker:Andre Veiga, University of Oxford
Date: Wednesday 20 May 2015
Time: 14.00 - 15.30
Location: Streatham Court 0.28

Further details

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.