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A Welfare Analysis of Competitive Insurance Markets with Vertical Differentiation and Adverse Selection

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  • W. Bentley MacLeod
Abstract
A feature of many insurance markets is that they combine vertical differentiation (all consumers prefer high to low-coverage policies) and adverse selection (high cost customers prefer high-coverage plans). Building on Novshek and Sonnenschein (1978) and Azevedo and Gottlieb (2017), this paper characterizes the competitive equilibria in a vertically differentiated market characterized by adverse selection. This provides a simple, dynamic model of the market, along with their welfare consequences over time in response to policy changes. The model makes predictions consistent with recent evidence on the ACA exchange in the US (Frean et al. (2017)). Moreover, it provides a complete characterization of the health insurance “death spiral”. The death spiral leads to an inefficient outcome, but does not lead to a complete breakdown of the market. Rather, it predicts a large number of plans, with coverage that falls with an individual’s willingness to pay. It is shown that introducing a minimum coverage standard combined with an insurance mandate cannot restore efficiency. The optimal system depends on both the valuation of public funds and the social value of insurance. Depending on these parameters, a number of different types of systems may be optimal, including a single payer system with mandatory participation for all, such as the Canadian system, a mixed private-public system, as one sees in many countries, or a pure, free market system.

Suggested Citation

  • W. Bentley MacLeod, 2021. "A Welfare Analysis of Competitive Insurance Markets with Vertical Differentiation and Adverse Selection," NBER Working Papers 28565, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:28565
    Note: EH IO TWP
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    More about this item

    JEL classification:

    • D01 - Microeconomics - - General - - - Microeconomic Behavior: Underlying Principles
    • D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory
    • D41 - Microeconomics - - Market Structure, Pricing, and Design - - - Perfect Competition
    • I11 - Health, Education, and Welfare - - Health - - - Analysis of Health Care Markets
    • I13 - Health, Education, and Welfare - - Health - - - Health Insurance, Public and Private
    • L15 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Information and Product Quality

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