Adverse Selection When Loss Severities Differ: First-Best and Costly Equilibria

Neil A. Doherty and Hong Joo Jung
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Neil A. Doherty: Department of Insurance and Risk Management, The Wharton School, University of Pennsylvania, 304 CPC, 3641 Locust Walk, 19104 Philadelphia PA
Hong Joo Jung: Department of International Trade, College of Business, Sung Kyun Kwan University, 110-745 Seoul Korea

The Geneva Risk and Insurance Review, 1993, vol. 18, issue 2, 173-182

Abstract: With information asymmetry between contracting parties, adverse selection may result. A separation may be achieved if low-risk types can signal their identity—for example, by selecting from a menu of price-quantity contracts. In such models, signaling is costly and solutions are, at best, second best. These models characterize risk types by differences in the probability, rather than in severity, of the costs they impose. However, when severity differences also are considered, first best solutions become feasible. We identify the circumstances in which costly separating equilibria prevail and those in which full-information equilibria can be attained. The Geneva Papers on Risk and Insurance Theory (1993) 18, 173–182. doi:10.1007/BF01111468

Date: 1993
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