CAREER: Empirical Analysis of Markets with Adverse Selection

Stanford University, Stanford CA

Investigators

Abstract

This CAREER research is centered around the empirical analysis of markets with adverse selection. Despite the theoretical importance of adverse selection and evidence of its existence in particular markets, little is known about its quantitative relevance, its relative importance compared to other selection mechanisms, and about the way it affects the operation of markets. The broad aim of the research is to better understand these issues by developing models of consumer-demand and equilibrium firm-behavior in these markets. Markets with adverse selection are "special" in that firms' profits depend on the identity of their customers. Thus, not only do firms face the traditional price-quantity tradeoff, but also an additional price-quality tradeoff induced by selection. When such markets are oligopolistic, as often is the case, their industrial organization is further complicated because price changes by one firm do not only affect the level of demand faced by its rivals, but also their demand quality. Thus, firms may choose, for instance, to strategically affect their rivals' cost structure. The research consists of two components. Both rely on new and unique proprietary individual-level data sets. The first focuses on demand-side analysis in insurance markets in an attempt to estimate efficiency costs resulting from adverse selection, with emphasis on the important role of multiple dimensions of heterogeneity. Heterogeneity in both risk and preferences complicates the efficiency analysis and makes "reduced-form" relationship between choices and outcomes neither sufficient nor necessary for inference about market efficiency. The first part of this component develops a more structural approach to estimate the efficiency cost in the semi-compulsory annuity market in the United Kingdom. The second part applies similar ideas to new data on health insurance choices by Alcoa employees, in which a quasi-experiment allows to estimate the value of choice, and to identify heterogeneity along three dimensions, of health status, the extent of moral hazard, and risk aversion. The second component focuses on supply-side and equilibrium analysis in a particular consumer credit market. The various parts of this component estimate the value of information in such markets, the effect of centralization, and the interaction between better information and other strategies, such as second-degree price discrimination. The analysis utilizes new and rich transaction-level data from a large chain of automobile dealerships, which bundles used car sales with car financing, specializing in the subprime (high risk) market. Over the six year observation period, the company has gradually moved from an interview-based approach towards highly centralized pricing system, which relies on sophisticated credit-scoring and other means of risk-based pricing, thus providing a rare opportunity to estimate the effects of such policy changes within sample. Broader Impact: Due to the inefficiency caused by adverse selection, both insurance and consumer credit markets are highly regulated, and better understanding of these markets will lead to more efficient and directed intervention. All components of the research have direct policy implications. For example, the analysis of choice in the U.K. annuity market speaks to cost-benefit analysis of allowing more choice in defined-contribution social security, the Alcoa data sheds light on policies linked to the new Medicare prescription drug benefits, and the work on consumer credit markets addresses the consequences of states' usury laws and individual bankruptcy laws.