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Uncertain Costs and Vertical Differentiation in an Insurance Duopoly

Author

Listed:
  • Radoslav Raykov
Abstract
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.

Suggested Citation

  • Radoslav Raykov, 2014. "Uncertain Costs and Vertical Differentiation in an Insurance Duopoly," Staff Working Papers 14-14, Bank of Canada.
    • Handle: RePEc:bca:bocawp:14-14
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Market structure and pricing; Economic models;

    JEL classification:

    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
    • D43 - Microeconomics - - Market Structure, Pricing, and Design - - - Oligopoly and Other Forms of Market Imperfection
    • L22 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Firm Organization and Market Structure
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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