Adverse selection is an important problem in many markets. Governments respond
to it with complex regulations: mandates, community rating, subsidies, risk adjustment,
and regulation of contract characteristics. This paper proposes a perfectly competitive
model of a market with adverse selection. Prices are determined by zero-profit conditions,
and the set of traded contracts is determined by free entry. Crucially for applications,
contract characteristics are endogenously determined, consumers may have
multiple dimensions of private information, and an equilibrium always exists. Equilibrium
corresponds to the limit of a differentiated products Bertrand game.
We apply the model to show that mandates can increase efficiency but have unintended
consequences. An insurance mandate can increase adverse selection on the
intensive margin and lead some consumers to purchase less coverage. Optimal regulation
addresses adverse selection on both the extensive and the intensive margins, can
be described by a sufficient statistics formula, and includes elements that are commonly
used in practice.
