Question

⦁   Discuss two methods for reducing the impact of adverse selection.

Answer 1

ADVERSE SELECTION-

when the economic participants involved have different level of information. Here Informed party gains and uninformed or underinformed party loses. It is also known as " HIDDEN INFORMATION " problem .

EXAMPLE : second hand car market - owner has more information and buyer has less information .

METHODS OF REDUCING IMPACT OF ADVERSE SELECTION -

1. OFFERING WARRANTIES OR GAURANTEES ON THE ITEMS SOLD :

Here the Individual with better information convincingly communicates that information to the individual who has less information by offering warranty or gaurantee .

HERE take example of second hand car market - (A) The used car dealer provides gaurantee for the car they sell in order to keep their goodwill.

(B) there will be automobile service centre that check the quality of the used car for a certain fee

(C) There will be use of Brand name

2. SCREENING :

Here the Individual with less information communicates and collect information from the individual who has more information by method of screening .

HERE take example of Insurance market - (A) insurance company has less knowledge about the state of health of individual who want to get their life insured .

(b) company screens potential customers based on their health records . They collect information until marginal benefit and marginal cost from extra information are equal.