Contrary to popular belief, standard economic theory does not provide a theoretical foundation for the notion that "competition is everywhere and always good." It turns out that legislation that promotes competition among producers may
improve consumer welfare. Or it may not. As so many things in economics (and in life), it all depends.
I recently came across an interesting paper demonstrating this idea by Ben Lester, Ali Shourideh, Venky Venkateswaran, and Ariel Zetlin-Jones with the title "Screening and Adverse Selection in Frictional Markets," forthcoming in the Journal of Political Economy.The paper is written in the standard trade language. Like any trade language, it's difficult to understand if you're not in the trade! But I thought the idea sufficiently important that I asked Ben to translate the basic results and findings for a lay audience. I'm glad to say he was very happy to oblige.
And so, without further ado, today's guest post by Ben Lester, my colleague at the Philadelphia Fed.
You can follow Ben on Twitter : @benjamminlester
Competition in Markets with Asymmetric Information
In many basic economic models, competition is good – it
As a result, policy
makers often introduce reforms that they hope will reduce barriers or
“frictions” in order to increase competition.
For example, the Dodd-Frank Act contains regulations aimed at promoting
more competition in certain financial markets, such as derivatives and swaps,
while the Affordable Care Act contained provisions that were intended to
promote competition across health insurance providers.
In a recent paper with Ali Shourideh, Venky Venkateswaran,
and Ariel Zetlin-Jones, we re-examine the question of whether more competition
is welfare-improving in markets with a particular feature – what economists
call “asymmetric information.”
markets where one side has information that is relevant for a potential trade,
but the other side can’t see it. Classic examples include insurance markets,
where an individual knows more about his own health than an insurer; loan
markets, where a borrower knows more about her ability to repay than a lender; and
financial markets, where the owner of an asset (like a mortgage-backed
security) may know more about the value of the underlying assets than a
Unfortunately, understanding the effects of more or less
competition in markets with asymmetric information has been constrained by a
shortage of appropriate theoretical frameworks.
As Chiappori et al. (2006) put it, there is a “crying need for [a model]
devoted to the interaction between imperfect competition and adverse selection.”
We develop a mathematical model of a market – to fix ideas,
let’s call it an insurance market – that has three key ingredients.
The first ingredient is adverse selection: one
side of the market (consumers) know more about their health than the other side
of the market (insurers).
allow the two sides of the market to trade sophisticated contracts: as in the
real world, insurers can offer consumers a rich set of options to choose from,
consisting of different levels of coverage that can be purchased at different
Last, we introduce imperfect
competition by assuming that consumers don’t always have access to multiple
insurers: in particular, each consumer will get offers from multiple insurers
with some probability, but there is also a chance of receiving only one offer.
Hence, our model allows us to capture the
case of perfect competition (where all consumers get multiple offers), monopoly
(where all consumers get only one offer), and everything in between.
One of our main results is that increasing competition can
actually make people worse off.
To understand why, it’s important to
understand the types of contracts that our model predicts will be offered by
insurers. Let’s say that there are two
types of consumers: those who are likely to require large medical expenses
(“sick” consumers), and those who are not (“healthy” consumers). Then insurers will often find it optimal to
offer two different plans: one that is expensive but provides more coverage,
and one that is cheaper but provides less coverage.
Designed correctly, these two options will
induce consumers to self-select into the plan intended for them, so that sick
consumers will pay a higher price for more coverage and healthy consumers will
pay a lower price for less coverage.
An important property of these contracts is that they fully
insure sick consumers, but they under-insure healthy consumers. Ideally, insurers would like to offer healthy
patients more coverage, but they can’t: given the lower price, sick consumers
would choose this new plan, making it no longer profitable for insurers to
offer it. This theoretical result – that
separating the sick from the healthy requires under-insuring healthy consumers
– is a fundamental result in markets where asymmetric information is
present. The relevant question for us
is: how does the amount of competition determine the extent to which healthy
consumers are under-insured? The answer we find is that some
competition can induce insurers to provide healthy consumers
with more insurance, but too much
can have the opposite effect.
The intuition is as follows.
When consumers are more likely to receive multiple offers, insurers
respond by making more attractive offers to consumers, as they try to retain
market share. The key question turns out
to be: does increasing competition make them sweeten the deal more for sick consumers,
or for healthy consumers? On the one hand, as the offer intended for sick
consumers gets better, they have less incentive to take the offer intended for
healthy consumers – in the parlance of economics, their “incentive constraint”
loosens. Hence, as insurers sweeten the
offer intended for sick consumers, they are able to offer healthy consumers
more coverage, and welfare rises.
On the other hand, however, as the offer
intended for healthy consumers become more attractive, sick consumers are more
tempted to take it – their incentive constraint tightens – and the only way to
keep the two separate is to reduce the amount of coverage being offered to
healthy consumers, causing welfare to decline.
In the paper, we show that the former, positive effect dominates in markets where insurers have a lot of market power, while the latter, negative effect dominates when the market is relatively competitive. Hence, in markets with asymmetric information, welfare is
maximized at some interior point, where there is some competition, but not too
Other results and
In the paper, we also show that increasing transparency has
ambiguous effects on welfare. In
particular, we study the effects of a noisy signal about a consumer’s type – in
the insurance example, this could be a blood test or information about an
individual’s pre-existing conditions. We
show that increasing transparency is typically beneficial when insurers have a
lot of market power, but it can be detrimental to welfare in highly competitive
More generally, our model provides a tractable framework to confront
a variety of theoretical questions regarding markets that suffer from
asymmetric information, and offers a number of insights into existing empirical
For example, there is a large literature that
tests for the presence of asymmetric information by studying the quantitative
relationship between, e.g., the amount of insurance that consumers buy and
their tendency to get sick.
However, according to our analysis, insurers
find it optimal to offer menus that separate consumers only when markets are
sufficiently competitive, and when there is a sufficiently large number of sick
consumers in the population. Otherwise,
they find it best to offer a single insurance plan. This finding implies that, when insurers have
sufficient market power, there will be no relationship between the quantity of
insurance a consumer buys and his health status. In other words, one can’t empirically test
for asymmetric information without controlling for the market structure. This is just one of many positive predictions
of our model that we plan to test in the data.
Burdett, K., and K. L. Judd (1983) “Equilibrium Price
51, pages 955–69.
Chiappori, P.-A., B. Jullien, B.
Salanié, and F. Salanié (2006) “Asymmetric Information in Insurance: General
Testable Implications,” RAND Journal of
, 37, pages 783–98.
Chiappori, P.-A., and B. Salanié (2000) “Testing for Asymmetric Information in
Insurance Markets” Journal of Political
108, pages 56–78.
Lester, B., A. Shourideh, V.
Venkateswaran, and A. Zetlin-Jones (2018) “Screening and Adverse Selection in
Frictional Markets,” Journal of Political
The views expressed here are those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.