Question

Explain using the problem of adverse selection, why unhealthy individuals are more likely to buy health insurance than the average healthy person? Why is it that in the used car market, lemons tend to drive quality used cars out of the market?

Answer 1

Soln. Adverse selection theory in Economics implies that there are information of goods that only one party involved in the transaction is aware. Unhealthy individuals are more aware about their health conditions and know the probability of getting sick, to avoid such risk they are more likely to buy health insurance, in order to cover them during adverse situation. Average healthy person, knows that his health is better and there is least chance of happening bad health problem and hence are less likely to purchase health insurance.

In the used car markets, lemons are referred to defective car. Only the seller of the car is aware of the exact condition of the car. On the other hand, buyers are only aware about the average quality of all the cars. Owners of lemons cars are likely to sell their car at prevailing market value as it is still more than the actual price of the car. And, owners of good cars are reluctant to sell their car at prevailing market value as it is lower than the true value. But, when sellers know the quality of individual car, sellers of good cars may voluntarily remover their vehicles from the used car market, leaving the ratio of lemons more in the market and finally leading to over all reduction in quality of cars in the used car market.