Question

1.Provide at least two real-life examples of adverse selection. Your example can be related to either insurance industry or the financial market.

Answer 1

Adverse selection refers to an event in which one party in a negotiation has relevant information about the situation that the other party lacks, and that asymmetry of information leads to a series of bad decisions or choices -- such as doing more and more business with less profitable or riskier market segments.

The most common example used to illustrate adverse selection is in the insurance industry. In an ideal world, everyone who wanted to purchase insurance would carry the same risk of actually making a claim on the policy. That is, the seller and the buyer would both benefit from all transactions – the insurance company by assigning the right price to the policy and the insurance buyer by paying the appropriate amount for the policy. In the real world, this is definitely not the case. Instead, the insurer would prefer to sell insurance to those customers who are least likely to make claims and, thus, “use" the insurance. Buyers, on the other hand, are generally more eager to purchase a policy if they believe they will have a need to make a claim.

Used cars: - Suppose that potential buyers are willing to pay $20,000 for a well-maintained car, but only $10,000 for a lemon. The owner of the peach won’t part with it for less than $18,000. The owner of the lemon would take $8,000 for it. If buyers can’t tell the condition of the two cars, without any additional information they might pay only the average price of $15,000. (A risk-averse buyer wouldn’t even pay that much.) That means the peach disappears from the market, leaving only the lemon for sale. The point is that buyers’ inability to observe the hidden attributes of the vehicles for sale undermines the entire market for used cars. This form of market failure is a classic result of adverse selection. The solution to the adverse selection problem in the used-car market is to reduce the cost of detecting the car’s hidden attributes, helping buyers separate the peaches from the lemons. Because this is such an important market, people have developed a range of technologies and practices to improve its function.