Imperfect Competition in Selection Markets

Standard policies to correct market power and selection can be misguided when these two forces co-exist. Using a calibrated model of employer-sponsored health insurance, we show that the risk adjustment commonly used by employers to offset adverse selection often reduces the amount of high-quality coverage and thus social surplus. Conversely, in a model of subprime auto lending calibrated to Einav, Jenkins and Levin (2012), realistic levels of competition among lenders generate a significant oversupply of credit, implying greater market power is desirable. We build a model of symmetric imperfect competition in selection markets that parameterizes the degree of both market power and selection and use graphical price-theoretic reasoning to provide a general analysis of the interaction between selection and imperfect competition. We use the same logic to show that in selection markets four principles of the United States Horizontal Merger Guidelines are often reversed.