Ambiguity and Asymmetric Information

The theoretical literature has found that advantageous selection could be observed in equilibrium when there is multi-dimensional heterogeneity of customers or both hidden action and hidden information are employed. This paper proposes a third approach for advantageous selection. Based on the classic Rothschild and Stiglitz (1976) model, we consider ambiguity-averse individuals who face a general risk and a specific risk in a perfectly competitive insurance market. The individuals have private information regarding the specific risk but have unbiased ambiguous beliefs regarding the general risk. Individuals' preferences are characterized by Klibanoff, Marinacci and Mukerji's (2005) smooth model, and they are homogeneous except for their risk type. We find that both pooling and separating equilibria can exist. Furthermore, we find that when the single crossing property does not hold, equilibrium could be determined based on adverse selection or advantageous selection.