Stiglitz’s 1976 paper on insurance markets cut through a puzzling problem: what happens when you know more about your own health risks than the company insuring you?
The answer isn’t pretty. When customers understand their personal risk better than insurers do, the whole market gets wobbly.
Insurance companies naturally want to charge everyone a price based on average risk. But this creates a dilemma – healthy people find these average rates too expensive and walk away, while high-risk folks eagerly sign up for what they see as a bargain. As healthier people drop out, the customer pool gets riskier, forcing prices up further, driving away even more low-risk customers.
What emerges instead are split markets where insurers offer different packages – high premiums with comprehensive coverage versus cheaper policies with hefty deductibles. The clever part? These options naturally sort customers. High-risk people gravitate toward fuller coverage despite the cost, while healthier customers accept higher deductibles to save money.
Through this process, customers essentially reveal their hidden risk levels through their choices. Insurers learn what they couldn’t otherwise know.
The trouble is, this sorting mechanism comes with hidden costs. Low-risk individuals often end up with less protection than they’d actually prefer, just to prove they’re low-risk. The market reaches stability, but at the expense of efficient outcomes.
Stiglitz showed that even fierce competition can’t eliminate these distortions when information is unevenly distributed. This insight fundamentally changed how economists think about markets – perfect competition doesn’t guarantee perfect outcomes when information problems exist.
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