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Thursday, July 17, 2014

Uncertain Costs and Vertical Differentiation in an Insurance Duopoly

Radoslav S. Raykov, Bank of Canada explores Uncertain Costs and Vertical Differentiation in an Insurance Duopoly.

ABSTRACT: Classical oligopoly models predict that firms differentiate vertically as a way of softening price competition, but some metrics suggest very little quality differentiation in the U.S. auto insurance market. I explain this phenomenon using the fact that risk-averse insurance companies with uncertain costs face incentives to converge to a homogeneous quality. Quality changes are capable of boosting as well as reducing profits, since quality differentiation softens price competition, but also undermines the lower-end firm’s ability to charge the markup commanded by risk aversion. This can make differentiation suboptimal, leading to a homogeneous quality; the outcome depends on consumers’ quality tastes and on how costly quality is. Additional trade-offs between quality costs, profits and profit variances compound this effect, resulting in equilibria at very low quality levels. I argue that this provides one explanation! of how insurer competition drove quality down in the nineteenth-century U.S. market for fire insurance.

http://lawprofessors.typepad.com/antitrustprof_blog/2014/07/uncertain-costs-and-vertical-differentiation-in-an-insurance-duopoly-.html

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