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Competitive Insurance Markets with Two Unobservables


  • Michael Smart


We study a screening game in a competitive insurance market, in which insurance customers differ with respect to both accident probability and degree of risk aversion. It is shown that indifference curves of customers in different risk classes cross exactly twice: thus the single crossing property does not hold. The existence of a unique reactive equilibrium is demonstrated. This equilibrium may be markedly different from the Pareto-dominant separating equilibrium that exists when single crossing holds. In particular, types may be pooled in equilibrium, so that cross-subsidization occurs. Moreover, insurance firms can earn positive expected profit in equilibrium, despite the usual assumption of Bertrand-like price-competition among firms. We study the implications of the model for the efficiency of market equilibrium and for the effects of rate-of-return regulation of insurance firms.

Suggested Citation

  • Michael Smart, 1996. "Competitive Insurance Markets with Two Unobservables," Working Papers msmart-96-01, University of Toronto, Department of Economics.
  • Handle: RePEc:tor:tecipa:msmart-96-01

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    References listed on IDEAS

    1. Myerson, Roger B, 1983. "Mechanism Design by an Informed Principal," Econometrica, Econometric Society, vol. 51(6), pages 1767-1797, November.
    2. Riley, John G, 1979. "Informational Equilibrium," Econometrica, Econometric Society, vol. 47(2), pages 331-359, March.
    3. Milgrom, Paul & Roberts, John, 1986. "Price and Advertising Signals of Product Quality," Journal of Political Economy, University of Chicago Press, vol. 94(4), pages 796-821, August.
    4. Engers, Maxim, 1987. "Signalling with Many Signals," Econometrica, Econometric Society, vol. 55(3), pages 663-674, May.
    5. Engers, Maxim & Fernandez, Luis F, 1987. "Market Equilibrium with Hidden Knowledge and Self-selection," Econometrica, Econometric Society, vol. 55(2), pages 425-439, March.
    6. In-Koo Cho & David M. Kreps, 1987. "Signaling Games and Stable Equilibria," The Quarterly Journal of Economics, Oxford University Press, vol. 102(2), pages 179-221.
    7. Wilson, Charles, 1977. "A model of insurance markets with incomplete information," Journal of Economic Theory, Elsevier, vol. 16(2), pages 167-207, December.
    8. Laffont, Jean-Jacques & Rochet, Jean-Charles, 1988. " Stock Market Portfolios and the Segmentation of the Insurance Market," Scandinavian Journal of Economics, Wiley Blackwell, vol. 90(3), pages 435-446.
    9. Maskin, Eric & Tirole, Jean, 1992. "The Principal-Agent Relationship with an Informed Principal, II: Common Values," Econometrica, Econometric Society, vol. 60(1), pages 1-42, January.
    10. Landsberger Michael & Meilijson Isaac, 1994. "Monopoly Insurance under Adverse Selection When Agents Differ in Risk Aversion," Journal of Economic Theory, Elsevier, vol. 63(2), pages 392-407, August.
    11. Quinzii, Martine & Rochet, Jean-Charles, 1985. "Multidimensional signalling," Journal of Mathematical Economics, Elsevier, vol. 14(3), pages 261-284, June.
    12. Bagwell, Laurie Simon & Bernheim, B Douglas, 1996. "Veblen Effects in a Theory of Conspicuous Consumption," American Economic Review, American Economic Association, vol. 86(3), pages 349-373, June.
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    JEL classification:

    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty


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