Adverse Selection
Adverse selection refers generally to a situation in which sellers have information that buyers do not have, or vice versa, about some aspect of product quality. In other words, it is a case where asymmetric information is exploited. Asymmetric information, also called information failure, happens when one party to a transaction has greater material knowledge than the other party.Typically, the more knowledgeable party is the seller. Symmetric information is when both parties have equal knowledge.In the case of insurance, adverse selection is the tendency of those in dangerous jobs or high-risk lifestyles to purchase products like life insurance. In these cases, it is the buyer who actually has more knowledge (i.e., about their health). To fight adverse selection, insurance companies reduce exposure to large claims by limiting coverage or raising premiums.
Definition: Adverse selection refers to a situation where the seller has information that the buyer does not, or vice versa, about some aspect of product quality. In other words, it is a situation that exploits asymmetric information. Asymmetric information, also known as information failure, occurs when one party in a transaction has more substantial knowledge than the other. Typically, the more knowledgeable party is the seller. Symmetric information refers to a situation where both parties have equal knowledge.
Origin: The concept of adverse selection was first introduced by George Akerlof in his 1970 paper, "The Market for Lemons: Quality Uncertainty and the Market Mechanism." He used the example of the used car market to explain how information asymmetry can lead to market failure.
Categories and Characteristics: Adverse selection can be divided into two main categories:
- Adverse selection in product markets: For example, in the used car market, the seller knows more about the car's condition than the buyer, making it easier to sell low-quality cars ("lemons").
- Adverse selection in insurance markets: For example, in health insurance, the insured knows more about their health status than the insurer, leading high-risk individuals to be more likely to purchase insurance.
- Asymmetric information: The information held by the two parties in the transaction is not equal.
- Market failure: The market is dominated by low-quality products or high-risk individuals, causing high-quality products or low-risk individuals to exit the market.
Specific Cases:
- Used car market: The seller knows more about the car's condition than the buyer, making it difficult for the buyer to assess the car's true quality, resulting in a market filled with low-quality cars.
- Health insurance: High-risk individuals are more likely to purchase insurance, making it difficult for insurers to accurately assess risk, leading them to raise premiums or limit coverage.
Common Questions:
- How to deal with adverse selection? Insurers can mitigate adverse selection by conducting health checks, raising premiums, and setting waiting periods.
- What is the difference between adverse selection and moral hazard? Adverse selection refers to pre-transaction information asymmetry, while moral hazard refers to the risk arising from changes in behavior after the transaction.
