Becker-DeGroot-Marschak Contract Term Mispricing

In Simple Words

It is like bidding on a car warranty where buyers pay slightly more for a policy covering flat tires but fail to realize that another policy covering total engine failure is worth ten times more money.

Research question

Consumers evaluating complex financial insurance contracts recognize qualitative value changes but struggle to correctly estimate the economic magnitude of specific contract terms relative to actuarial risk.

Participants

N = 1,978 farmers in Andhra Pradesh, India bidding on four distinct insurance contract variations.

Study Design

Incentive-compatible Becker-DeGroot-Marschak (BDM) field experiment eliciting willingness to pay across systematic contract term modifications.

Results

Raising the exit threshold increased willingness to pay by Rs. 11 despite increasing expected payout by Rs. 40–70, whereas reducing millimeter deficit payments reduced willingness to pay by Rs. 12–13 while only lowering expected payout value by Rs. 10–20.

Takeaway

Regulate and standardize retail index insurance contract parameters to prevent commercial insurers from offering policies that exploit consumer misvaluation of severe tail events.

Related findings

• Financial Sophistication & Valuation Sensitivity →Finance & microfinance

  Imagine two shoppers looking at a car warranty. An average driver notices the contract changed but doesn't calculate the math, whereas a trained mechanic calculates the exact cost of replacing an engine versus fixing a dent and adjusts their bid sharply based on true repair costs.

• Financial Sophistication Valuation Alignment →Finance & microfinance

  Think of two buyers examining a smartphone warranty. An experienced technician reads the exact fine print to see if battery replacement is covered and pays extra for it, while an inexperienced buyer pays the same price for a shiny logo regardless of whether the battery is covered.

• Index Basis Risk Sensitivity →Finance & microfinance

  Imagine buying a home fire insurance policy whose payout is triggered only if a smoke detector located in a neighboring town 10 miles away goes off. If a fire destroys a house but the smoke fails to reach the distant detector, no payout occurs, making the homeowner view the insurance policy as nearly worthless despite its official coverage terms.

• Retail Commercial Viability & Loading Factors →Finance & microfinance

  Imagine an arcade game where every $1 step costs $2 to play because of electricity and venue rent; players refuse to play until modern technology cuts the venue's operating costs so low that the game costs only $1.20 per play.