Uncertain costs and vertical differentiation in an insurance duopoly

Arbeitspapier

Classical oligopoly models predict that firms differentiate vertically as a way of softening price competition, but some metrics suggest very little quality differentiation in the U.S. auto insurance market. I explain this phenomenon using the fact that risk-averse insurance companies with uncertain costs face incentives to converge to a homogeneous quality. Quality changes are capable of boosting as well as reducing profits, since quality differentiation softens price competition, but also undermines the lower-end firm's ability to charge the markup commanded by risk aversion. This can make differentiation suboptimal, leading to a homogeneous quality; the outcome depends on consumers' quality tastes and on how costly quality is. Additional trade-offs between quality costs, profits and profit variances compound this effect, resulting in equilibria at very low quality levels. I argue that this provides one explanation of how insurer competition drove quality down in the nineteenth-century U.S. market for fire insurance.

Object Details

• Language: Englisch

References and Relationships

• Bibliographic citation: Series: Bank of Canada Working Paper ; No. 2014-14

Classification and Topics

• Classification: Wirtschaft ; Insurance; Insurance Companies; Actuarial Studies ; Market Structure, Pricing, and Design: Oligopoly and Other Forms of Market Imperfection ; Firm Organization and Market Structure ; Criteria for Decision-Making under Risk and Uncertainty
• Subject: Market structure and pricing ; Economic models

Contributors, Places and Time

• Event: Geistige Schöpfung
• (who): Raykov, Radoslav S.
• Event: Veröffentlichung
• (who): Bank of Canada
• (where): Ottawa
• (when): 2014

Further information

• DOI: doi:10.34989/swp-2014-14
• Handle: http://hdl.handle.net/10419/103045
• Last update: 10.03.2025, 11:42 AM CET