(Neutrally) Optimal Mechanism under Adverse Selection: The canonical insurance problem

Theodoros Diasakos, Konstantinos Koufopoulos

Research output: Contribution to journalArticlepeer-review

Abstract

This paper revisits the problem of adverse selection in the insurance market of Rothschild and Stiglitz(1976). We extend the three-stage game in Hellwig(1987)by allowing firms to endogenously choose whether or not to pre-commit on their contractual offers (menus). We show how this mechanism can deliver the Miyazaki–Wilson–Spence allocation as the unique perfect-Bayesian equilibrium. This allocation is the unique incentive-efficient and individually-rational maximizer of the utility of the most profitable type. In fact, given that the informed player has only two types, it is the unique core allocation and thus the unique neutral optimum in the sense of Myerson(1983).
Original languageEnglish
Pages (from-to)159–186
Number of pages28
JournalGames and Economic Behaviour
Volume111
Early online date28 May 2018
DOIs
Publication statusPublished - Sep 2018

Bibliographical note

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Keywords

  • Insurance market
  • Adverse selection
  • Interim incentive efficiency
  • Neutral optimum

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