Search, Moral Hazard, and Equilibrium Price Dispersion

We characterize optimal contracts for insurance coverage of a service whose price may vary across service providers. Households must engage in costly search to learn the price of a particular service firm, and the presence of insurance reduces incentive to search. We construct a general equilibrium model where the interaction of the insurer, consumers, and service firms endogenously determine the distribution of service prices and the intensity of search. We find that when the insurance firm is a monopolist, the equilibrium contract results in full insurance and no price dispersion among service firms. A perfectly contestable insurance market results in a contract with partial insurance coverage at a competitive premium and significant price dispersion; moreover, the contract maximizes household ex-ante utility. Reductions in search effort not only directly decrease the likelihood of the household finding a low price, but indirectly weaken price competition among service firms. We find that the indirect effect is far more important than the direct effect, responsible for at least 89% of the cost of moral hazard in search.