Perfect Competition in Markets with Adverse Selection

40 Pages Posted: 4 Sep 2014 Last revised: 26 Sep 2017

See all articles by Eduardo M. Azevedo

Eduardo M. Azevedo

University of Pennsylvania - The Wharton School

Daniel Gottlieb

London School of Economics

Date Written: May 5, 2015

Abstract

Adverse selection is an important problem in many markets. Governments respond to it with complex regulations: mandates, community rating, subsidies, risk adjustment, and regulation of contract characteristics. This paper proposes a perfectly competitive model of a market with adverse selection. Prices are determined by zero-profit conditions, and the set of traded contracts is determined by free entry. Crucially for applications, contract characteristics are endogenously determined, consumers may have multiple dimensions of private information, and an equilibrium always exists. Equilibrium corresponds to the limit of a differentiated products Bertrand game.

We apply the model to show that mandates can increase efficiency but have unintended consequences. An insurance mandate can increase adverse selection on the intensive margin and lead some consumers to purchase less coverage. Optimal regulation addresses adverse selection on both the extensive and the intensive margins, can be described by a sufficient statistics formula, and includes elements that are commonly used in practice.

Keywords: adverse selection, insurance, asymmetric information

Suggested Citation

Azevedo, Eduardo M. and Gottlieb, Daniel, Perfect Competition in Markets with Adverse Selection (May 5, 2015). Econometrica, Vol. 85, No. 1, The Wharton School Research Paper No. 70, Available at SSRN: https://ssrn.com/abstract=2491867

Eduardo M. Azevedo (Contact Author)

University of Pennsylvania - The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

HOME PAGE: http://www.eduardoMazevedo.com

Daniel Gottlieb

London School of Economics ( email )

New Academic Building 5.30
Houghton Street
London, WC2A 2AE
United Kingdom

HOME PAGE: http://https://personal.lse.ac.uk/gottlied/

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