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9
Adverse Selection: The
Rothschild-Stiglitz Model
Comprehension Questions
Review the basic assumptions of the Rothschild-Stiglitz model before answering
these questions. Many exercises will refer to these basic assumptions.
1. In a Rothschild-Stiglitz model with asymmetric information and heteroge-
neous risk types, the frail population would be worse off if insurance compa-
nies were suddenly able to distinguish between the two types of customers,
because they could no longer pretend to be healthy.
FALSE. Frail consumers already have full and actuarially-fair insurance con-
tracts. If insurance companies could suddenly distinguish between frail and
robust customers, frail customers would remain insured and robust customers
could become fully insured.
2. The Rothschild-Stiglitz model predicts that people who own life insurance
should have fewer unobserved traits (that is, unobserved by insurance com-
panies) that lead to a higher risk of death when compared against people
with the same level of income but who do not own life insurance.
FALSE. We would expect people with life insurance to have more unob-
served risk factors – presumably that is why they want life insurance in the
first place.
3. In a Rothschild-Stiglitz model separating equilibrium, there is a volume dis-
count for insurance purchases – those who choose to buy more insurance pay
1
2 | Health Economics Answer Key
FALSE. There is actually a bulk markup for large amounts of insurance. In-
tuitively, this reflects the fact that insurers are suspicious of people who want
a lot of insurance. The companies assume they are frail, and charge them a
higher per-unit premium.
TRUE. Robust individuals would like to have full, fair insurance but the sep-
arating equilibrium offers them two less attractive choices: full insurance that
is actuarially unfair or fair insurance that is partial.
TRUE. If there are enough robust people in the population, a pooled con-
tract can be offered that will break the separating equilibrium.
7. A pooling equilibrium can exist if the contract being offered lies on the same
indifference curve as the endowment point of the robust population.
FALSE. There exists a contract that can be offered that will attract the ro-
bust population away from the ”pooled” equilibrium. In essence, a pooling
equilibrium will never exist unless mandated.
FALSE. If firms offer generous insurance that lies below a robust individual’s
indifference curve through their endowment point, firms can indirectly dis-
tinguish between robust and frail customers because robust customers will
not choose the generous insurance.
9. Private markets are powerless to combat adverse selection, so the only solu-
tion is a government-mandated insurance contract.
FALSE. If health differences emerge only later in life, there are ways to design
private insurance contracts that would eliminate adverse selection.
10. The main advantage of a Cochrane insurance contract over a guaranteed re-
newable contract is that it does not rely on a legally unenforceable binding
lifetime commitment.
Analytical Problems
11. A medical test that an insurance company could use to distinguish between
high and low risk types would create an equilibrium in which both high and
low risks types could have full insurance. Sketch a brief proof using a dia-
gram. Why is this equilibrium not an equilibrium under the normal informa-
tion asymmetry assumptions? Show which of the three equilibrium criteria
does not hold.
Ω1
UR
UF
E
IH
IS
Ω1
Ω2
UF E
IH
(a) Explain why the frail-type indifference curve pictured, UF , is not a valid
indifference curve.
The following figure depicts two points that fit these criteria:
IS
Ω1
Ω2
B
UF A E
IH
IS
Ω1
UF Ω2
IH
It is not, because the it does not fulfill the third criterion for valid equi-
libria. A contract could enter at the intersection of the full-insurance line
and the frail zero-profit line and make at least zero profits.
13. A tax on healthy people. Consider the basic Rothschild-Stiglitz model with
asymmetric information and robust and frail customers.
(a) Suppose the government imposes a Wellness Tax τ > 0, on robust and
frail types but collects on this tax only when they are healthy (that is,
there is no tax if they turn out to be sick). Will a separating equilibrium
still be possible? Draw a version of the Rothschild-Stiglitz diagram to
support your answer.
The tax only serves to shift the endowment to the left. The rest of the
analysis is just the same as without out the tax. In the figure below, E0
represents the endowment before the tax and E1 represents the after-tax
endowment.
IS
UR
Ω1
Ω2
UF
E1 E0
IH
Again, the tax only serves to shift the endowment. In the figure be-
low, E0 represents the endowment before the tax and E1 represents the
after-tax endowment.
14. Review Figure 9.18, which depicts a separating equilibrium breaking down.
In this figure, the separating equilibrium breaks down because the zero-profit
line is too far to the right. But this is not the only way that a separating
equilibrium can fail.
IS
UR
Ω1
Ω2
UF
E1
E0
IH
Response to exercises 14(a) and (b). The dashed line is the new robust-type indifference
curve that represents increased risk aversion. Note that there is now an exploit region
between the dashed line and the zero-profit line.
IS
Ω1
Ω3
UF
E
UR
IH
IS
B
C
UF
E
IH
surance Program (PNIP) that will bring full insurance to all the citizens of
Pcoria.
(a) Figure 9.21 depicts the current state of the insurance market in Pcoria
before the plan is implemented. The insurance market had settled into
a separating equilibrium at ( A, C ). Explain why no insurance company
enters with a contract at point B.
IS
B
C
UF
E URC
UR P
IH
No. Frail Pcorians are better off at P than they were at A, but the same
can not be said of robust Pcorians, who used to be at C and are now at
P.
(e) A robust Pcorian citizen named Hercules sues PNIP because he says the
new insurance rules are harming him. Due to the explosive nature of
the case, it goes straight to the Pcorian Supreme Court. The chief justice
asks Hercules how PNIP could possibly be harming him if he went from
having barely any insurance (point C) to full insurance (point P). How
should Hercules respond?
Response to exercises 15(f). Contract Z could have been placed anywhere in the patterned
area, between the indifference curves and southwest of the robust-type zero-profit line.
These two conditions guarantee that only the robust join the contract and that the contract
is profitable, respectively.
IS
B
UF
A Z
E
UR P
IH
Just like Hercules skimmed the robust customers off contract P, a new
entrant can skim the robust customers off contract Z. The new company
should situate a new contract to the southeast of Z below the frail-type
indifference curve that passes through Z but above the robust-type in-
difference curve that passes through Z.
16. Genetic testing. After the fiasco with the Pcorian National Insurance Pro-
gram (see Exercise 15), a Pcorian senator proposes a new policy that will go
to a referendum of voters in the next election. Below is the text of the refer-
endum.
You can assume that the genetic test costs nothing and is perfect at distin-
guishing frail and robust people. Under current law, genetic testing for the
(a) Assume that all Pcorians will vote to maximize their own utility, and
that their utility is totally determined by their healthy-state and sick-
state incomes. Which Pcorians will vote for the proposition?
All Pcorians will vote for the proposition. Robust Pcorians like it be-
cause they will know be able to prove their robustness and get full in-
surance. Frail Pcorians like it because their insurance status will not
change, and they will get a bonus compensation payment. Note: you
must assume that the tax is not large enough to influence the vote of the
robust Pcorians.
(b) Explain how Proposition 99 can be thought of as a Coasian transfer.
What property rights are being sold in this situation, and by whom?
(Review Chapter 20 for our discussion of Coasian transfers.)
Previously, the law forbade genetic testing. This old law established
a property right to privacy for the frail Pcorians that allowed them to
masquerade as robust. Under the proposed law, the frail Pcorians are
selling this privacy right in exchange for a small payment.
(c) A privacy watchdog group called Anonymity sues to prevent the ge-
netic testing from taking place. They claim that Proposition 99 harms
frail Pcorians. Explain why they are wrong if utility is totally a function
of income. Explain also why they might be right if utility is not deter-
mined wholly by income.
They are wrong if utility is totally a function of income because the in-
come of frail Pcorians increases under Prop 99. They receive the same
full and fair insurance as before (point A), and also receive a compen-
sation payment. But if there are non-pecuniary costs to being publically
identified as frail – perhaps there is a massive social stigma against peo-
ple who are definitively labeled as “frail” – then Prop 99 may harm frail
Pcorians on net.
17. In this exercise, we will formally show the two properties of indifference
curves in IH -IS space we discussed in Section 9.2. To prove that indiffer-
ence curves are downward sloping, we calculate the slope of the indiffer-
ence curves dIS/dIH directly. Recall that the individual with income IH in the
healthy-state and IS in the sick state, and with probability p of becoming sick
has an expected utility E[U ] p of:
(a) Take the total derivative of E[U ] p . This will give us a formula explaining
how changes in IH and IS contribute to changes in E[U ] p .
(c) Using what you know about the signs of p, U 0 ( IH ), and U 0 ( IS ), prove
dI
that the sign of S is negative.
dIH
Because p, U 0 ( IH ), and U 0 ( IS ) are all positive (since the probability of
sickness is positive and utility isincreasing in income), we know that
the slope of the indifference curves is negative, which is another way
of saying that indifference curves are downward sloping in the IH -IS
space.
(d) A curve is convex in IH -IS space if its second derivative is positive ev-
erywhere. Derive the second derivative of the indifference curves by
dI
taking the derivative of your expression for S with respect to IH .
dIH
d2 IS (1 − p) U 0 ( IH )
d
2
= − · 0
dIH dIH p U ( IS )
1−p
1 d 0 0 d 1
=− U ( IH ) + U ( IH )
p U 0 ( IS ) dIH dIH U 0 ( IS )
1 − p U 00 ( IH ) U 0 ( IH ) 00
dIS
=− − 0 U ( IS )
p U 0 ( IS ) U ( IS )2 dIH
dIS
And then subbing in the expression for dIH .
d2 IS (1 − p) 1−p 0
1 0 2 00 2 00
2
=− · 0 U ( IS ) U ( IH ) + U ( IH ) U ( IS )
dIH p U ( IS )3 p
(e) Using what you know about the signs of p, U 0 ( I ), and U 00 ( I ), prove that
your expression for the second derivative is positive everywhere.
Essay Questions
18. One major premise of the Rothschild-Stiglitz model is that there is a perfectly
competitive market for health insurance. Suppose instead that the market
is not perfectly competitive, and in fact competitor firms have a hard time
entering the market. Could a pooling equilibrium occur in this case? What
is it about competition that prevents pooling in the RS model? No formal
proof is necessary, but do make your reasoning clear. Evaluate the following
statement: competition in health insurance markets is harmful.
but nevertheless, competition might be good for welfare. For example, a mo-
nopolist insurer might offer only the contract which maximizes profits but
that those with lower-incomes could not afford. In this case, competition
would improve consumer welfare.
On the other hand, recall that in a separating equilibrium with two types,
the frail types receive full insurance but the robust types do not. If there are
few frail types but many robust types, all consumers might benefit from a
pooling equilibrium on the population full-insurance line.
—De Kaiser!
—Willem!
—Achterweg?
—Welneenet!.. Slangetje!
—Joapeke!
—Jaapeke uit?..
—Lemperweg!..
—Hassel!..
—Welleke Hassel?.…
—Gerrit!
Hij wist eigenlijk wel dat ie twaalf sloffies met vuil goed
had meegekregen. Ouë Gerrit wou, woù nou eenmaal
van de berijpte vervreten hoek wat pluksel verstoppen
ònder de beteren, om zoo nog wat te beuren van z’n
teelt, denkend dat in de drukte geen sterveling ’r op
letten zou. Drie tuinders hadden ’t er op die manier al
door gekregen, waarom kon ’t hèm ook niet lukken?
—Ikke hep ses pakke, skraif moar roak! beet Dirk af,
de rist manden over z’n schouers gooiend na ’t
bindtouw eerst stevig om z’n hand gekneld te hebben,
dat ’m niemand wat afnemen kon. Luchtig was ie den
wagon uitgesprongen, lollig zich voelend, dat hij weer
voor ’n pluk geborgen was met sloffen.