Market Power in the Presence of Adverse Selection

Abstract

Market power can reduce the symptoms of adverse selection. To see the relationship, consider the incentive for a firm to offer a product that appeals to low-risk consumers and leads high-risk consumers to purchase insurance elsewhere. This incentive problem can be addressed through regulation but is also absent in a monopoly. This paper develops a model of welfare to explicitly characterize the substitutability between adverse selection regulation and market power. Market concentration has welfare benefits by reducing inefficient sorting of consumers among available plan options, a symptom of adverse selection. However, since market concentration also carries the welfare cost of higher markups, the magnitude and net direction of the effects are an empirical question. The model is estimated for the non-group market using novel choice data from a private online broker and a risk prediction model to relate preferences to marginal cost. The analysis focuses on two policies that target different dimensions of adverse selection: risk adjustment and the individual mandate. A simulation of a proposed merger of two insurance firms shows that, in the absence of a risk adjustment policy, the merger improves consumer welfare in markets that are not already highly concentrated. While the risk adjustment policy does not optimally price the sorting externality, it is successful in reducing the welfare cost of inefficient sorting and also eliminating the potential benefit to consumers from additional market power. The individual mandate is successful in increasing the insurance rate and lowering prices in the least concentrated markets, but leads to higher prices in the most concentrated markets. These results suggest that selection regulation is advantageous in competitive insurance markets, and less necessary and potentially harmful in very concentrated markets.