How Initial Conditions Can Have Permanent Effects: The Case of the Affordable Care Act
- Florian Scheuer, Kent Smetters
Both Akerlof (1970) and Rothschild and Stiglitz (1976) show that insurance markets may “unravel”. This memo clarifies the distinction between these two notions of unraveling in the context of a binary loss model of insurance. I show that the two concepts are mutually exclusive occurrences. Moreover, I provide a regularity condition under which the two concepts are exhaustive of the set of possible occurrences in the model. Akerlof unraveling characterizes when there are no gains to trade; Rothschild and Stiglitz unraveling shows that the standard notion of competition (pure strategy Nash equilibrium) is inadequate to describe the workings of insurance markets when there are gains to trade.