Characterization, Existence, and Pareto Optimality in Markets with Asymmetric Information and Endogenous and Asymmetric Disclosures: Basic Analytics of Revisiting Rothschild-Stiglitz
We study the Rothschild-Stiglitz model of insurance markets, introducing endogenous information disclosure about insurance sales and purchases by firms and consumers. We show that a competitive equilibrium exists under unusually mild conditions, and characterize the unique equilibrium outcome. With two types of consumers the outcome is particularly simple, consisting of a pooling contract which maximizes the well-being of the low risk individual (along the zero profit pooling line) plus a supplemental (undisclosed and nonexclusive) contract that brings the high risk individual to full insurance (at his own odds). We show that this outcome is extremely robust and constrained Pareto efficient. Asymmetric equilibrium information flows with endogenous consumer disclosure are critical in supporting the equilibrium.
We are grateful to Gerry Jaynes for helpful comments on an earlier draft, to Michael Rothschild and Richard Arnott, long time collaborators on understanding insurance markets with asymmetric information, and to Byoung Heon Jun, Debarati Ghosh, Andrea Gurwitt, and Lim Nayeon for research and editorial assistance and to the Institute for New Economic Thinking and the Ford Foundation and Fulbright Foundation for financial support. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.