ECO 317 - Economics of Uncertainty - Fall Term 2009 Slides To Accompany
ECO 317 - Economics of Uncertainty - Fall Term 2009 Slides To Accompany
ECO 317 - Economics of Uncertainty - Fall Term 2009 Slides To Accompany
Slides to accompany
15. Adverse Selection in Insurance Markets
1
Solution requires conveying credible information about
qualities of individual cars. Works in two ways:
Signaling – action taken by informed party (owner)
Screening – action required / initiated by uninformed (prospective buyer)
(i) direct inspection at a cost
(ii) mechanism using informed player’s self-selecting (info. revealing) action
Direct inspection (get car checked by professional,
give test to job applicant or check-up to health/life insurance applicant)
Possible but costly, imperfect; ignore these here and focus on other actions.
General idea – action should be optimal if information is “good”
but not if it is “bad”, so wrong type won’t imitate, pretend to be good.
Signaling example – seller offers warranty on car, but is this credible?
Screening by self-selection example – restricted fares on airlines
We will develop three examples (models) in detail:
[1] Rothschild-Stiglitz (QJE 1976): competitive screening in insurance (today)
[2] Spence (QJE 1973): job market signaling (later)
[3] Pricing policy of monopolist facing unknown demand (later)
(version of Baron-Myerson Econometrica 82,Mussa-Rosen JET 1978)
2
PERFECT INSURANCE – Reminder From Handout 9, pp. 1-4
Initial wealth W0 , loss L in state 2; probability of loss π
Can choose level of insurance; p = premium per dollar of coverage (indemnity)
Budget line in state-contingent wealth space (W1 , W2 ):
(1 − p) W1 + p W2 = (1 − p) W0 + p (W0 − L)
EU = (1 − π) u(W1) + π u(W2)
3
TWO RISK TYPES, SYMMETRIC INFORMATION
Loss probabilities πL < πH
MRS for type i in (W1 , W2 ) space is
dW2 ∂EU/∂W1
−
=
dW1 EU =const ∂EU/∂W2
1 − πi u(W1 )
=
πi u(W2 )
4
ASYMMETRIC INFO – SEPARATING EQUILIBRIUM
Each firm offers one contract
Free entry; firms compete in contracts
In equilibrium, each has zero expected profit
Ignore other costs, so a contract with
only type-L customers must be on
fair premium line of slope (1 − πL )/πL ;
if only H-types,line of slope (1 − πH )/πH .
Full fair coverage contracts CH , CL are
not incentive-compatible: H will take up CL
Must restrict coverage available to L-types
Can at best offer SL , so H-types
only just prefer CH to SL .
Then single-crossing property ensures
that L-types definitely prefer SL to CH
So separation by self-selection (screening). But at a cost: L-types can’t get full coverage.
H-types’ existence exerts a kind of negative externality on L-types.
5
ASYMMETRIC INFORMATION – POOLING?
Separation may be Pareto inferior if
there are very few H-types in population
Population proportions θH , θL
population average loss probability is
πM = θH πH + θL πL
Contract with randomly drawn customers
from whole population has zero profit line
of slope = (1 − πM )/πM
On it, any point between P1 and P2
is Pareto-better than the contracts
CH , SL of separating “equilibrium”
Segment P1 P2 exists when πM is
close to πL, i.e. θH is small
Then new firm can offer contract just below segment P1 P2 .
This will attract full sample of pop’n and make profit.
Then the original separating contracts CH , SL cannot be an equilibrium.
6
But can pooling itself be a
(Nash) equilibrium? No.
Consider any point PM on
population-average zero-profit line
By single-crossing property
can find S that appeals only to L-types
and is below zero-profit line for
contracts with only L-type customers
So company offering S makes positive profit
Entry of such insurers will destroy pooling
Then equilibrium may not exist at all –
competition can generate cycles
between separation and pooling.