Supply, demand, and selection in insurance markets: Theory and applications in pictures

Abstract

AbstractThis paper recapitulates and extends the Einav, Finkelstein, and Cullen (EFC) approach to modeling equilibrium in insurance markets. After describing the basic EFC model and showing that it can be understood as a supply–demand model, we show how it can be extended to: markets featuring nonexclusive contracting and linear pricing; markets featuring selection on ex‐ante moral hazard; and multiple‐margin markets with price competition over two coverage tiers. In markets with nonexclusive‐contracting‐cum‐linearly pricing, we show that the EFC model, graphs, and lessons all go through, essentially unchanged. In markets with selection on moral hazard, we show that two natural notions of adverse selection—notions that coincide in the basic EFC framework—may diverge. This divergence is a result of the fact that, with moral hazard, the average cost curve measured by EFC can no longer be interpreted as a supply curve. Finally, in a two‐tier market, we show that the lessons depend on whether contracts are offered “simultaneously” or “sequentially,” where coverage is purchased in layers.