Efficiency and Adverse Selection: T he Role of Mutual Contracts (joint with V. V. Chari and Ariel Zetl in-Jones)
Abstract:
We study compe
titive equilibria in economies with adverse selection. In our model, a larg
e population of agents contracts with a finite set of firms. Firms compete
over privately informed agents by offering non-linear and endogenous contra
cts. These contracts are allowed to depend on the composition of agents tha
t trade with one firm. In an insurance context, this is equivalent to mutua
lization of insurance contracts whereby each insuree’s contract depends on
the distribution of other insurees’ claims. Our main result is that when th
is notion of contracts are allowed, a competitive equilibrium always exists
. Furthermore, the competitive equilibrium is always constrained efficient
(in the sense of interim efficiency) and is unique. We show this result for
a variety of environments (the insurance market a la Rothschild and Stigli
tz (1976), Spence’s signaling model, Bester’s loan market model, among othe
rs) and for one-dimensional distributions of private information among agen
ts. Our result sheds light on optimal regulation of markets with adverse se
lection specially that of health insurance markets. It suggests that rather
than using traditional tools such as mandates and regulation of contract c
haracteristics, government must monitor insurance companies and enforce the
mutualization of contracts whereby firms share the losses and gains from c
laims with all the insurers.