Adverse selection explained

Definition of adverse selection:

Adverse selection occurs when buyers have better information than sellers, and this can distort the usual market process. It can lead to missing markets as firms do not find it profitable to sell a good.

Adverse selection explained

  • A company selling life insurance will find that people at higher risk of death will be more willing to take out life insurance. If the insurance company charges an average price, but only high-risk consumers buy – they will make a loss.
  • A company insuring cars will find those living in high crime areas will be more likely to want to get car insurance. Again if the average cost is charged, it can lead to insurance firm losing out.

Adverse selection occurs because of information asymmetries and the difficulties in selecting customers.

Consequences of adverse selection

  • Higher overall price as firms insure themselves against high-risk customers taking out insurance.
  • Low-risk customers may not want to buy because it is relatively too expensive – leading to a missing market.
  • Firms may invest considerable time in identifying which groups of consumers are higher risk.

Adverse selection in health insurance

Suppose an insurance firm offered health insurance to the general public. It is likely to have the highest take-up rate amongst unhealthy people – people who don’t exercise, people who smoke. They are the group most likely to need health care; therefore, it makes sense for them to take out insurance. Healthy people are less likely to take out health insurance – if the price of health insurance is determined by the average unhealthy person.

If insurance premiums are based on the needs of smokers, then the premiums will be high. Therefore, there is no incentive for healthy people to take out the insurance.

Adverse selection for buyers

It is also possible that the seller will have better information than buyers, and sellers only sell the product when it is favourable to them.

  • For example, managers of a company may be more willing to issue shares, when they know the share price is overvalued compared to real value. Therefore, buyers can end up buying over-valued shares.
  • Another example is the second-hand car market. The seller may know about an invisible defect and charge too much to a consumer who is badly informed.

Solutions to adverse selection

To avoid adverse selection, firms need to try and identify different groups of people. This is why there are health insurance premiums for people who smoke and obese people.

Insurance firms will charge different rates to consumers depending on factors, such as

  • Age
  • Postcode.

This means that those who are at most risk will likely have higher premium rates.

Compulsory purchase

American health care is primarily based on private insurance. This has led to problems of adverse selection, with young, healthy people more likely to avoid taking out health insurance. This led to higher overall premiums – making it unaffordable for many.

One element of the Affordable Health Care act was to have a compulsory insurance element. If people choose not to take out insurance, they have to pay a tax premium. The idea is that by encouraging people to purchase, it will lower overall premiums as people with lower-risk will join the ‘insurance pool.’

Economists and adverse selection

old-car

George Akerlof investigated the asymmetry of information in the market for second-hand cars.

In a 1970 paper “The Market for Lemons,” he was awarded the Nobel Prize in Economics (2001). Akerlof suggested bad cars ‘lemons’ were more likely to be put onto the second hand market, reducing price. Therefore good cars were held back and not sold. It is sometimes known as the ‘bad driving out the good.’

Akerlof suggested the problem of adverse selection distorted the market, leading to lower prices and lower average quality of cars.

Others have suggested the second-hand car market can try use warranties and quality controls to overcome this problem of poor information.

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