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Uncertain Costs and Vertical Differentiation in an Insurance Duopoly

Radoslav Raykov

Staff Working Papers from Bank of Canada

Abstract: Classical oligopoly models predict that firms differentiate vertically as a way of softening price competition, but some metrics suggest very little quality differentiation in the U.S. auto insurance market. I explain this phenomenon using the fact that risk-averse insurance companies with uncertain costs face incentives to converge to a homogeneous quality. Quality changes are capable of boosting as well as reducing profits, since quality differentiation softens price competition, but also undermines the lower-end firm’s ability to charge the markup commanded by risk aversion. This can make differentiation suboptimal, leading to a homogeneous quality; the outcome depends on consumers’ quality tastes and on how costly quality is. Additional trade-offs between quality costs, profits and profit variances compound this effect, resulting in equilibria at very low quality levels. I argue that this provides one explanation of how insurer competition drove quality down in the nineteenth-century U.S. market for fire insurance.

Keywords: Market structure and pricing; Economic models (search for similar items in EconPapers)
JEL-codes: D43 D81 G22 L22 (search for similar items in EconPapers)
Pages: 41 pages
Date: 2014
New Economics Papers: this item is included in nep-bec, nep-com, nep-ias and nep-ind
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Persistent link: https://EconPapers.repec.org/RePEc:bca:bocawp:14-14

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