THE WELFARE IMPLICATIONS OF MORAL HAZARD AND ADVERSE SELECTION IN COMPETITIVE INSURANCE MARKETS

I model a competitive insurance market with both moral hazard and adverse selection, and analyze the effect on welfare when both problems are present simultaneously. An examination of the interaction between these two problems leads to two hypotheses. First, the nature of the equilibrium contracts is such that each problem partially offsets the welfare loss associated with the other. And second, the degree to which this occurs increases as agents become more heterogeneous. Simulation results overwhelmingly support both hypotheses.