Adverse Selection and (un)Natural Monopoly in Insurance Markets

Edward Kong, Timothy Layton and Mark Shepard

No 33187, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Adverse selection is a classic market failure known to limit or “unravel”' trade in high-quality insurance and many other economic settings. While the standard theory emphasizes quality distortions, we argue that selection has another big-picture implication: it unravels competition among differentiated firms, leading to fewer surviving competitors—and in the extreme, what we call “un-natural” monopoly. Adverse selection pushes firms toward aggressive price cutting to attract price-sensitive, low-risk consumers. This creates a wedge between average and marginal costs that (like fixed costs in standard models) limits how may firms can profitably survive. We demonstrate this insight in a simple model of insurer entry and price competition, estimated using administrative data from Massachusetts' health insurance exchange. We find a large “selection wedge” of 20-30% of average costs, which (without corrective policies) unravels the market to monopoly. Our analysis suggests a surprising policy implication: interventions that limit price-cutting can improve welfare by supporting more entry, and ultimately lower prices.

JEL-codes: D4 I11 I13 L1 L40 (search for similar items in EconPapers)
Date: 2024-11
New Economics Papers: this item is included in nep-com, nep-hea, nep-ind and nep-reg
Note: AG EH IO PE
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