Price Equilibrium, Efficiency, And Decentralizability In Insurance Markets With Moral Hazard

Richard Arnott and Joseph Stiglitz

No 254, Boston College Working Papers in Economics from Boston College Department of Economics

Abstract: In this paper we investigate the descriptive and normative properties of competitive equilibrium with moral hazard when forms offer "price contracts" which allow clients to purchase as much insurance as they wish to at the quoted price. We show that a price equilibrium always exists and is one of three types i.) Zero-profit price equilibrium- zero profit, zero effort, and full insurance ii.) Positive- profit price equilibrium- positive profit, positive effort, partial insurance iii) zero- insurance price equilibrium- zero insurance, zero profit, positive effort. Suppose a client purchases an additional unit of insurance from an insurer and consequently reduces accident- avoidance effort. This will lower the profitability of insurance the client has obtained form other insurers. In setting price, the insurer neglects this effect, however. Thus, price insurance entails an externality. We show under what circumstances this externality can be fully internalized by a linear tax on insurance sales. Actual insurance contracts lie in the middle ground between exclusive quantity contracts (where an individual is effectively constrained to purchase all his insurance from one firm) and price contracts. We argue that our analysis of price contracts sheds light on the welfare properties of actual insurance contracts. Notably, since the externality we identify will still be operative, the taxation of insurance sales is typically desirable.

Date: 1993-12
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Working Paper: Price Equilibrium, Efficiency, and Decentralizability in Insurance Markets with Moral Hazard (1994)
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