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Abstract

We design and test a novel insurance advice mechanism aimed at promoting trust and cooperation in markets with asymmetric information. In a buyer-seller game with third-party insurance, sellers have the option to advise buyers on whether to purchase insurance against the potential losses from the opportunistic behavior of strategic sellers. We hypothesize that advising not to purchase insurance introduces a psychological cost for defection. We develop a theoretical model that selects a pooling equilibrium where both cooperative and strategic sellers advise buyers not to purchase insurance. Once this advice has been given, strategic sellers choose not to defect if the associated psychological costs are sufficiently large. Data from a controlled laboratory experiment shows that the insurance advice mechanism significantly increases market efficiency, with buyers being more likely to purchase from sellers and sellers being more likely to cooperate. Furthermore, we find that the insurance advice mechanism is more effective when sellers can observe buyers’ insurance purchase decisions.