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Uncertain Costs and Vertical Differentiation in an Insurance Duopoly

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  • Radoslav S. Raykov
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    Abstract

    Classical 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 Info

    Paper provided by Bank of Canada in its series Working Papers with number 14-14.

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    Length: 41 pages
    Date of creation: 2014
    Date of revision:
    Handle: RePEc:bca:bocawp:14-14

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    Keywords: Market structure and pricing; Economic models;

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    15. Maxwell, John W., 1998. "Minimum quality standards as a barrier to innovation," Economics Letters, Elsevier, vol. 58(3), pages 355-360, March.
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