Uncertain Costs and Vertical Differentiation in an Insurance Duopoly
AbstractClassical oligopoly models predict that firms differentiate vertically as a way of softening price competition, but some metrics suggest very little quality differentiation in the U.S. auto insurance market. I explain this phenomenon using the fact that risk-averse insurance companies with uncertain costs face incentives to converge to a homogeneous quality. Quality changes are capable of boosting as well as reducing profits, since quality differentiation softens price competition, but also undermines the lower-end firm’s ability to charge the markup commanded by risk aversion. This can make differentiation suboptimal, leading to a homogeneous quality; the outcome depends on consumers’ quality tastes and on how costly quality is. Additional trade-offs between quality costs, profits and profit variances compound this effect, resulting in equilibria at very low quality levels. I argue that this provides one explanation of how insurer competition drove quality down in the nineteenth-century U.S. market for fire insurance.
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Bibliographic InfoPaper provided by Bank of Canada in its series Working Papers with number 14-14.
Length: 41 pages
Date of creation: 2014
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Market structure and pricing; Economic models;
Find related papers by JEL classification:
- G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
- D43 - Microeconomics - - Market Structure and Pricing - - - Oligopoly and Other Forms of Market Imperfection
- L22 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Firm Organization and Market Structure
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
This paper has been announced in the following NEP Reports:
- NEP-ALL-2014-05-09 (All new papers)
- NEP-BEC-2014-05-09 (Business Economics)
- NEP-COM-2014-05-09 (Industrial Competition)
- NEP-IAS-2014-05-09 (Insurance Economics)
- NEP-IND-2014-05-09 (Industrial Organization)
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