Question

1) What are three observations one can make that indicate existence of adverse selection in a market?

Answer 1

Adverse selection occurs when there's asymmetric information between buyers and sellers.

One party has more information than the other party.

This unequal information distorts the market and always results in market failure.

For example, buyers of health insurance may have better information than sellers. Bad type buyers may try to hide their real health status so as to avail the benefit of low premiums. If insurance company tries to charge the average premium to minimise risk and losses, good health customers might not purchase insurance and will leave the market. This will lead to inefficiency in the market.

Other example of adverse selection can be market for used cars. There may be two types of used cars- in a good position and other in a relatively bad position because of the driver’s abusive handling. While the owners know the true condition of their own cars, used-car shoppers do not know it . Used-car shoppers has less information than the owners of the car.

Other situation where adverse selection exists is stock markets.There are two types firms, one with good prospects and one with bad prospects. But the investor does not know about it and might end in buying the stock of company with bad prospects. Here, investor does not have complete information. To avoid such situation, investor is likely to pay the average price of both the stocks to minimise the losses.