Perfect Competition in Markets With Adverse Selection

Abstract

© 2017 The Econometric Society This paper proposes a perfectly competitive model of a market with adverse selection. Prices are determined by zero-profit conditions, and the set of traded contracts is determined by free entry. Crucially for applications, contract characteristics are endogenously determined, consumers may have multiple dimensions of private information, and an equilibrium always exists. Equilibrium corresponds to the limit of a differentiated products Bertrand game. We apply the model to establish theoretical results on the equilibrium effects of mandates. Mandates can increase efficiency but have unintended consequences. With adverse selection, an insurance mandate reduces the price of low-coverage policies, which necessarily has indirect effects such as increasing adverse selection on the intensive margin and causing some consumers to purchase less coverage.