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CAREER: Empirical Analysis of Markets with Adverse Selection
Title: CAREER: Empirical Analysis of Markets with Adverse Selection
Principal Investigator: Liran Einav
Dates: September 1, 2007 - August 31, 2012
Sponsor: National Science Foundation
The proposed career development plan consists of research and educational projects 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 long-term goal of this research is to better understand and shed light on these issues by developing models of consumer-demand and equilibrium firm-behavior that can be applied to these markets. Unlike traditional models of supply and demand, 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. Two empirical initiatives are described. Both rely on new and unique proprietary individual-level data sets. The first initiative describes two projects, which focus on demand-side analysis in insurance markets in an attempt to estimate efficiency costs resulting from adverse selection. As in my earlier work on auto insurance, the projects emphasize 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 proposed career development plan consists of research and educational projects 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 long-term goal of this research is to better understand and shed light on these issues by developing models of consumer-demand and equilibrium firm-behavior that can be applied to these markets. Unlike traditional models of supply and demand, 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. Two empirical initiatives are described. Both rely on new and unique proprietary individual-level data sets. The first initiative describes two projects, which focus on demand-side analysis in insurance markets in an attempt to estimate efficiency costs resulting from adverse selection. As in my earlier work on auto insurance, the projects emphasize 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.