Research library Adverse selection
One Price Can't Survive. A Menu Can.
Rothschild and Stiglitz showed that when insurers can't see who's risky, a single price for everyone falls apart. What survives is a menu that gets customers to sort themselves.
Michael Rothschild and Joseph Stiglitz, 1976
What they were looking at
Insurance. Every customer faces the same possible loss, but some are much more likely to have an accident than others, and the insurer can’t tell who’s who. The paper opens with a complaint about how economics had handled problems like this:
“Economic theorists traditionally banish discussions of information to footnotes.” Rothschild & Stiglitz (1976), p. 629
What they found
In a competitive market, one price for everyone doesn’t last. Suppose every insurer sells the same full policy at a price set for the average customer. A rival can offer a cheaper policy with less cover, one only the careful customers would want. It takes them, and the first insurer is left with the risky ones at a price set for the average.
What survives competition is a menu: offers that set “both a price and a quantity” of cover (p. 629). Full cover at a high price, which the high-risk customers choose, and cheaper cover with a deductible, which the low-risk customers choose. Each customer picks the option meant for their type, and the choice tells the insurer who they are.
That sorting has a cost, and the low-risk customers pay it:
“By their very being, high-risk individuals cause an externality: the low-risk individuals are worse off” p. 629
They’re stuck with partial cover, because full cover at their price would attract everyone. And the market can be stranger still:
“not only may a competitive equilibrium not exist, but when equilibria do exist, they may have strange properties.” p. 629
Their conclusion: “the single price equilibrium of conventional competitive analysis was shown to be no longer viable” (p. 648). Stiglitz shared the 2001 Nobel prize in economics with Akerlof and Spence.
What it means
When you can’t see who’s who, the answer isn’t a better guess at the average. It’s an offer designed so that different customers choose differently, and their choice reveals them.
Akerlof showed the problem. Spence showed how the informed side can send a signal. Rothschild and Stiglitz showed how the uninformed side can build a test into the offer itself. Economists call that screening.
Where it shows up in a revenue team
- Plans, tiers and commitments sort customers. Annual versus monthly, a setup fee, a minimum volume: each one is a question the customer answers by choosing.
- One flat offer invites a competitor to take your best customers with a narrower offer built for them, leaving you with the rest.
- Read the choice. Which plan a customer picks is a signal. Score on it, route on it, and report results by it.