Optimal Contract Regulation in Selection Markets

Abstract We develop a tractable model of competitive insurance markets with a continuum of types and exogenous restrictions on the set of allowed contracts. Our model nests, as special cases, the market for lemons of Akerlof (1970) and the unrestricted contracts setting of Rothschild and Stiglitz (1976). We allow purchase to be mandatory or voluntary. Equilibrium generically exhibits partial pooling and therefore depends non-trivially on the type distribution. An increase in the maximal allowed coverage always increases welfare. Increases in the minimal allowed coverage have ambiguous (and possibly non-monotonic) effects on welfare. In markets for lemons, if the first best is not an equilibrium, then the socially optimal level of mandated coverage is interior (i.e, below full insurance)