Academic journal article Journal of Risk and Insurance

Equilibrium Price Dispersion in the Insurance Market

Academic journal article Journal of Risk and Insurance

Equilibrium Price Dispersion in the Insurance Market

Article excerpt

ABSTRACT

We consider price dispersion under nonsequential consumer search when a finite number of firms exists. We assume that firms have the same production technology. We find that single-price equilibrium exists only when it is the highest possible price (monopoly price). Price dispersion is possible in equilibrium only when firms use mixed strategies. We also find that increased competition may increase price dispersion and the intensity of consumer search while reducing the expected profits of firms. The number of firms in the long run is increasing regarding expected market demand and decreasing regarding production cost and entry cost. We reinterpret some empirical observations reported in the literature.

INTRODUCTION

Since Stigler (1961), price dispersion has been studied extensively in economics (see Burdett and Judd, 1983; Butters, 1977; Carlson and McAfee, 1983; Lippman and McCall, 1979; MacMinn, 1980; Reinganum, 1979; Rob, 1985; Salop and Stiglitz, 1977). The literature finds that price dispersion can be an equilibrium outcome when consumers who have imperfect information about goods search for the best price. At the same time, it is well recognized that consumers in the insurance market are poorly informed about insurance goods (Berger, 1988; Joskow, 1973). As a result, it is natural that price dispersion theory is applied to and tested in the insurance market.

Schlesinger and Schulenburg (1991) explain price dispersion in the insurance market via heterogeneity of products, search costs, and switching costs. In Berger et al. (1989), price dispersion in the insurance market results from a word-of-mouth effect due to consumers' imperfect information. Mathewson (1983) finds price dispersion in life insurance and argues that the combined effect of consumer search and price discrimination by firms can explain price dispersion. Dahlby and West (1986) also find the existence of price dispersion in the automobile insurance market in Alberta and explain it as a result of positive search costs and production cost differences. Price dispersion has been considered an equilibrium outcome when there is imperfect information or heterogeneity on the consumer side and/or the producer side of the market (e.g., search costs, different costs, or different quality).

Most existing literature assumes that the number of firms is infinite and that firms incur different production costs. Even though these assumptions are typical of the literature, they are worth revisiting. The number of firms facing a consumer in the insurance market is finite in reality. It is not clear if the results of the literature can still hold when the number of firms is finite. The effect of production cost differences is mixed with the effect of consumer search. It may be interesting to see whether price dispersion can hold under pure consumer search where the production costs are the same across firms.

The purpose of this article is to investigate the effects of consumer search on price dispersion in the insurance market, where firms are homogeneous and the number of firms is finite. The assumption of a finite number of firms enables us to explain price dispersion in a somewhat different aspect than current articles in which the number of firms is assumed to be infinite. This article investigates the effect of a finite number of firms on price dispersion. As it will be shown, the finiteness assumption leads to the nonexistence of pure strategy price dispersion equilibrium, in which each firm quotes only one price, unlike in most existing research.

The assumption of homogeneous firms enables us to focus on the pure effect of consumer search (and the following strategic behavior of firms). Although price dispersion in the insurance market is observed, the effect of consumer search is mixed with the effects of cost/product differentiation (see Dahlby and West, 1986; Jung, 1978; Mathewson, 1983; and Schlesinger and Schulenburg, 1991). …

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