Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information

Abstract

Economic theorists traditionally banish discussions of infor- mation to footnotes. Serious consideration of costs of communication, imperfect knowledge, and the like would, it is believed, complicate without informing. This paper, which analyzes competitive markets in which the characteristics of the commodities exchanged are not fully known to at least one of the parties to the transaction, suggests that this comforting myth is false. Some of the most important con- clusions of economic theory are not robust to considerations of im- perfect information. We are able to show that not only may a competitive equilibrium not exist, but when equilibria do exist, they may have strange prop- erties. In the insurance market, upon which we focus much of our discussion, sales offers, at least those that survive the competitive process, do not specify a price at which customers can buy all the in- surance. they want, but instead consist of both a price and a quan- tity-a particular amount of insurance that the individual can buy at that price. Furthermore, if individuals were willing or able to reveal their information, everybody could be made better off. By their very being, high-risk individuals cause an externality: the low-risk indi- viduals are worse off than they would be in the absence of the high-risk individuals. However, the high-risk individuals are no better off than they would be in the absence of the low-risk individuals. These points are made in the next section by analysis of a simple model of a competitive insurance market. We believe that the lessons gleaned from our highly stylized model are of general interest, and attempt to establish this by showing in Section II that our model is robust and by hinting (space constraints prevent more) in the con- clusion that our analysis applies to many other situations. * This work was supported by National Science Foundation Grants SOC 74-22182 at the Institute for Mathematical Studies in the Social Sciences, Stanford University and SOC 73-05510 at Princeton University. The authors are indebted to Steve Salop, Frank Hahn, and Charles Wilson for helpful comments, and to the participants in the seminars at the several universities at which these ideas