Why One Price for Everyone Doesn't Last

What they were looking at

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. How had economics dealt with problems like that? Mostly by pushing them aside, and the paper opens by saying so.

“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. Say every insurer sells the same full policy at a price set for the average customer. A rival can come in with a cheaper policy that has less cover, one only the careful customers would want. It takes those customers, and the first insurer is left with the risky ones, still charging a price set for the average.

So what does survive competition? A menu of offers that set “both a price and a quantity” of cover (p. 629). There’s 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 that choice tells the insurer who they are.

That sorting has a cost, and the low-risk customers are the ones who 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 get stranger than that.

“not only may a competitive equilibrium not exist, but when equilibria do exist, they may have strange properties.” p. 629

So where does that leave the textbook’s single price? In their words, “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, a better guess at the average won’t solve it. You need an offer designed so different customers choose differently, and then their choice tells you who they are.

Akerlof showed the problem, and Spence showed how the side with the information can send a signal. Rothschild and Stiglitz showed how the side without it 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 your 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 come in with a narrower offer built for your best customers and take them, and you’re left with the rest.
• Read the choice. Which plan a customer picks is a signal. You can score on it, route on it and report your results by it.