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| How Financial Innovations Fix Credence Goods Market Failure:Evidence from a Natural Experiment in China |
| DUAN Baige, WANG Yongqin, XIA Mengjia
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| School of Economics, Fudan University |
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Abstract Problems caused by the credence goods (such as food, drugs and health care products) market have been plaguing China and the rest of the world for years. Asymmetric information on the quality of goods and services caused by moral hazard and adverse selection can lead to market failure of credence goods. To fix credence goods market failure, a common solution is government regulation. However, many economists advocate more market-based solutions (e.g. financial innovations such as compulsory liability insurance), but smoking gun evidence has been yet to come. A priori theories suggest that compulsory liability insurance has two opposite effects: reduced moral hazard by insurer's monitoring and induced moral hazard of the insured companies.
Fortunately, China's policy innovations and reform experiments on compulsory food safety liability insurance was phased in China from 2011 to 2017 and is leading the world. In other countries such as the United States, food, drugs and other products are usually covered by product liability insurance, as food safety liability insurance is rarely separately set up. China's food safety compulsory liability insurance constitutes a rare and ideal natural experiment for two reasons. First, it has been phased in at different times in different provinces. This exogenous shock enables us to use the difference-in-difference method to identify the causal effects. Second, liability insurance is not all mandatory in western countries, which brings about mixed effects of moral hazard and adverse selection and makes it difficult to disentangle these two effects. In China, however, the compulsory nature of food safety liability insurance shuts down the adverse selection channel, enabling us to disentangle the moral hazard channel.
The paper exploits the natural experiment to identify the causal effects of liability insurance on credence goods market using the compulsory liability insurance on food program. Specifically, we examine whether insurance-based financial innovation helps solve credence goods market failure through reducing moral hazard problem. The paper finds that the liability insurance significantly reduces the probability of food safety accidents. After the implementation the compulsory liability insurance, the average number of outbreaks of food borne diseases in every 10,000 people has decreased by about 6. Both parallel trend test and direct test of insurers' monitoring effect further support the results. These results reveal that the mandatory financial innovation can be an effective tool for risk management.
The study shows that financial innovations are a powerful tool to solve social and economic problems. Financial innovations including liability insurance can be an effective alternative solution to credence goods market failure. On the one hand, insurance companies can solve the adverse selection problem by assessing the risk types of different insured enterprises. On the other hand, to stay competitive, insurers have the incentive to push the insured to reduce risk, thus mitigating the moral hazard problem. Compared with government regulation, market-based mechanisms can make better use of insurers' expertise in monitoring and screening. Insurance companies can use their market advantages to collect data for actuarial analysis and the estimation of premia according to expected losses. From the perspective of solving negative externalities, this is tantamount to tailor-made Pigou taxes, which requires agents to pay the same costs as their externalities to prevent socially harmful actions, namely, to internalize the externality. Interestingly, from the perspective of mechanism design, the solution is equivalent to the Lindahl equilibrium, where the agents pay the corresponding “taxes”. That is to say, compulsory liability insurance is an efficient implementation of Lindahl equilibrium in resolving credence goods market failure.
More interestingly, compulsory insurance is also consistent with the idea of second-best theory. The second-best theory implies that if there are many distortions in the economy, eliminating one or several of them (but not all distortions) may make things worse rather than better. On the contrary, adding one distortion may achieve Pareto improvement. In the case of compulsory insurance, government coercion is a distortion by itself, but in the presence of information asymmetry, it can lead to Pareto improvements when combined with market-based solutions.
Some problems remain for further study. For example, different credence goods and their markets may require different regulatory responses and financial innovations. These heterogeneities await further research in the future.
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Received: 31 January 2019
Published: 27 September 2019
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