First‐Best Equilibrium in Insurance Markets With Transaction Costs and Heterogeneity

Jerry W. Liu and Mark J. Browne

Journal of Risk & Insurance, 2007, vol. 74, issue 4, 739-760

Abstract: We investigate extensions of the classic Rothschild and Stiglitz (1976) (RS) model of adverse selection under asymmetric information. In RS, low‐risk customers are worse off owing to an externality created by high‐risk buyers in the market. We find critical changes in insurance buyers' behavior under the joint assumptions of transaction costs and buyer heterogeneity with respect to either risk aversion or wealth. Combining transaction costs and heterogeneity, we find a separating equilibrium in which neither high‐risk nor low‐risk individuals are penalized due to information asymmetry.

Date: 2007
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https://doi.org/10.1111/j.1539-6975.2007.00232.x

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