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Efficiency of competition in insurance markets with adverse selection

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  • DE FEO, Giuseppe
  • HINDRIKS, Jean

Abstract

There is a general presumption that competition is a good thing. In this paper we show that competition in the insurance markets can be bad when there is adverse selection. Using the dual theory of choice under risk, we are able to fully characterize both the competitive and the monopoly market outcomes. When there are two types of risk, the monopoly dominates competition if and only if competition leads to market unravelling. When there are a continuum of types the efficiency of competition is less trivial. In effect monopoly is shown to provide better insurance but at the cost of driving out some agents from the market. Performing simulation for different distributions of risk, we find that monopoly in general performs (much) better than competition in terms of the realization of the gains from trade across all traders in equilibrium. The reason is that the monopolist can exploit its market power to relax the incentive constraints.

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Bibliographic Info

Paper provided by Université catholique de Louvain, Center for Operations Research and Econometrics (CORE) in its series CORE Discussion Papers with number 2005054.

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Date of creation: 00 Aug 2005
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Handle: RePEc:cor:louvco:2005054

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Keywords: monopoly; competition; non-expected utility; insurance; adverse selection;

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References

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  1. Wilson, Charles, 1977. "A model of insurance markets with incomplete information," Journal of Economic Theory, Elsevier, vol. 16(2), pages 167-207, December.
  2. Satterthwaite, Mark A & Williams, Steven R, 1989. "The Rate of Convergence to Efficiency in the Buyer's Bid Double Auction as the Market Becomes Large," Review of Economic Studies, Wiley Blackwell, vol. 56(4), pages 477-98, October.
  3. Chassagnon, Arnold & Villeneuve, Bertrand, 2005. "Optimal risk-sharing under adverse selection and imperfect risk perception," Economics Papers from University Paris Dauphine 123456789/5357, Paris Dauphine University.
  4. Jeleva, Meglena & Villeneuve, Bertrand, 2004. "Insurance contracts with imprecise probabilities and adverse selection," Economics Papers from University Paris Dauphine 123456789/5358, Paris Dauphine University.
  5. Engers, Maxim & Fernandez, Luis F, 1987. "Market Equilibrium with Hidden Knowledge and Self-selection," Econometrica, Econometric Society, vol. 55(2), pages 425-39, March.
  6. Aldo Rustichini, 1992. "Convergence to Efficiency in a Simple Market with Incomplete Information," Discussion Papers 995, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  7. Thomas A. Gresik & Mark A. Satterthwaite, 1985. "The Rate at Which a Simple Market Becomes Efficient as the Number of Traders Increases: An Asymptotic Result for Optimal Trading Mechanisms," Discussion Papers 641, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  8. Jaffee, Dwight & Stiglitz, Joseph, 1990. "Credit rationing," Handbook of Monetary Economics, in: B. M. Friedman & F. H. Hahn (ed.), Handbook of Monetary Economics, edition 1, volume 2, chapter 16, pages 837-888 Elsevier.
  9. Mark J. Machina, 1995. "Non-Expected Utility and The Robustness of the Classical Insurance Paradigm," The Geneva Risk and Insurance Review, Palgrave Macmillan, vol. 20(1), pages 9-50, June.
  10. Stiglitz, Joseph E, 1977. "Monopoly, Non-linear Pricing and Imperfect Information: The Insurance Market," Review of Economic Studies, Wiley Blackwell, vol. 44(3), pages 407-30, October.
  11. Segal, Uzi & Spivak, Avia, 1990. "First order versus second order risk aversion," Journal of Economic Theory, Elsevier, vol. 51(1), pages 111-125, June.
  12. Yaari, Menahem E, 1987. "The Dual Theory of Choice under Risk," Econometrica, Econometric Society, vol. 55(1), pages 95-115, January.
  13. Riley, John G, 1985. "Competition with Hidden Knowledge," Journal of Political Economy, University of Chicago Press, vol. 93(5), pages 958-76, October.
  14. Abhinay Muthoo & Suresh Mutuswami, 2005. "Competition and Efficiency in Markets with Quality Uncertainty," Economics Discussion Papers 593, University of Essex, Department of Economics.
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  16. DE DONDER, Philippe & HINDRIKS, Jean, . "The politics of redistributive social insurance," CORE Discussion Papers RP -1674, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
  17. Mailath, George J, 1987. "Incentive Compatibility in Signaling Games with a Continuum of Types," Econometrica, Econometric Society, vol. 55(6), pages 1349-65, November.
  18. Gul, Faruk & Postlewaite, Andrew, 1992. "Asymptotic Efficiency in Large Exchange Economies with Asymmetric Information," Econometrica, Econometric Society, vol. 60(6), pages 1273-92, November.
  19. Spence, Michael, 1978. "Product differentiation and performance in insurance markets," Journal of Public Economics, Elsevier, vol. 10(3), pages 427-447, December.
  20. Rothschild, Michael & Stiglitz, Joseph E, 1976. "Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information," The Quarterly Journal of Economics, MIT Press, vol. 90(4), pages 630-49, November.
  21. Machina, Mark J, 1989. "Dynamic Consistency and Non-expected Utility Models of Choice under Uncertainty," Journal of Economic Literature, American Economic Association, vol. 27(4), pages 1622-68, December.
  22. Crocker, Keith J. & Snow, Arthur, 1985. "The efficiency of competitive equilibria in insurance markets with asymmetric information," Journal of Public Economics, Elsevier, vol. 26(2), pages 207-219, March.
  23. Doherty, Neil A & Eeckhoudt, Louis, 1995. "Optimal Insurance without Expected Utility: The Dual Theory and the Linearity of Insurance Contracts," Journal of Risk and Uncertainty, Springer, vol. 10(2), pages 157-79, March.
  24. Harris Milton & Townsend, Robert M, 1981. "Resource Allocation under Asymmetric Information," Econometrica, Econometric Society, vol. 49(1), pages 33-64, January.
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Cited by:
  1. Giuseppe De Feo & Jean Hindriks, 2009. "Harmful competition in the insurance markets," Working Papers 0921, University of Strathclyde Business School, Department of Economics.
  2. Philippe Donder & Jean Hindriks, 2009. "Adverse selection, moral hazard and propitious selection," Journal of Risk and Uncertainty, Springer, vol. 38(1), pages 73-86, February.

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