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(Neutrally) Optimal Mechanism under Adverse Selection: The canonical insurance problem

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  • Diasakos, Theodoros M.
  • Koufopoulos, Kostas

Abstract

This paper revisits the problem of adverse selection in the insurance market of Rothschild and Stiglitz (1976). We extend the three-stage game in Hellwig (1987) by allowing firms to endogenously choose whether or not to pre-commit on their contractual offers (menus). We show how this mechanism can deliver the Miyazaki–Wilson–Spence allocation as the unique perfect-Bayesian equilibrium. This allocation is the unique incentive-efficient and individually-rational maximizer of the utility of the most profitable type. In fact, given that the informed player has only two types, it is the unique core allocation and thus the unique neutral optimum in the sense of Myerson (1983).

Suggested Citation

  • Diasakos, Theodoros M. & Koufopoulos, Kostas, 2018. "(Neutrally) Optimal Mechanism under Adverse Selection: The canonical insurance problem," Games and Economic Behavior, Elsevier, vol. 111(C), pages 159-186.
  • Handle: RePEc:eee:gamebe:v:111:y:2018:i:c:p:159-186
    DOI: 10.1016/j.geb.2018.04.007
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    References listed on IDEAS

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    Cited by:

    1. Dosis, Anastasios, 2019. "Optimal ex post risk adjustment in markets with adverse selection," Journal of Mathematical Economics, Elsevier, vol. 85(C), pages 52-59.
    2. Gemmo, Irina & Kubitza, Christian & Rothschild, Casey G., 2018. "The existence of the Miyazaki-Wilson-Spence equilibrium with continuous type distributions," ICIR Working Paper Series 32/18, Goethe University Frankfurt, International Center for Insurance Regulation (ICIR).

    More about this item

    Keywords

    Insurance market; Adverse selection; Interim incentive efficiency; Neutral optimum;

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law

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