Wednesday, May 12, 2010
Posted by D. Daniel Sokol
Giuseppe De Feo (Department of Economics, University of Strathclyde) and Jean Hindriks (Department of Economics and CORE, Universite catholique de Louvain, Belgium) have posted Harmful competition in the insurance markets.
ABSTRACT: There is a general presumption that competition is a good thing. In this paper we show that competition in the insurance markets can be bad and that adverse selection is in general worse under competition than under monopoly. The reason is that monopoly can exploit its market power to relax incentive constraints by cross-subsidization between different risk types. Cream-skimming behavior, on the contrary, prevents competitive firms from using implicit transfers. In effect monopoly is shown to provide better coverage to those buying insurance but at the cost of limiting participation to insurance. Performing simulation for different distributions of risk, we find that monopoly in general performs (much) better than competition in terms of the realization of the gains from trade across all traders in equilibrium. However, most of the surplus is retained by the firm and, as a result, most individuals prefer competitive mark! ets notwithstanding their performance is generally poorer than monopoly.