Abstract:

Both Akerlof (1970) and Rothschild and Stiglitz (1976) show that insurance markets may “un- ravel”. 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.

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