Question

1  Describe a situation in which you experienced or observed the problem of adverse selection. Can you suggest any possible solutions that may help correct the problem in this case? Be as specific as possible.

Answer 1

The two major types of opportunistic behavior are Adverse selection and moral hazard. Adverse selection is opportunism characterized by an informed person's benefiting from trading or otherwise  contracting with a less informed person who does not know about an unobserved characteristic of the informed person. For example, people who buy life insurance policies are better informed about their own health than insurance companies are. If an insurance company offers to insure people against death for 10 years at a fixed rate, a disproportionately large share of unhealthy people will buy this policy. Because of this adverse selection, the insurance company will pay off on more policies than it would pay id healthy and unhealthy people bought the policy in proportion to their share in the population.

Adverse selection creates a market failure by reducing the size of the market or eliminating it, thereby preventing desirable transactions . Insurance companies have to charge high rates for insurance due to adverse selection or choose not to offer insurance at all. Very few older people, regardless of their state of health, bu term life insurance, because the rates are extremely high due to adverse selection.

The two main methods for solving adverse selection problems are to restrict opportunistic behavior and to equalize information. Responses to adverse selection problems increase welfare in some markets, but they may do more harm than good in others.

1) Controlling opportunistic behavior through universal coverage

Adverse selection can be prevented if informed people have no choice. For example, Government can avoid adverse selection by providing insurance to everyone or by mandating that everyone by insurance. Many states require that every driver carry auto insurance. They thereby reduce the adverse selection that would arise from having a disproportionate umber of bad drivers buy insurance.

2) Equalizing Information

Either informed or uniformed parties can eliminate information asymmetries. Screening is an action taken by an uninformed person to determinate the information possessed by informed people. Uninformed people may try to eliminate their disadvantage by screening to gather information on the hidden characteristics of informed people. If the originally uninformed people obtain better information, they may refuse to sign a contract or insist on changes on contract clauses or in the price of a good. For example, a buyer may test drive several used cars to determinate which one starts and handles the best.

Signalling is an action taken by an informed person to send information to a less informed person. Signalling is used primarily by informed parties to try to eliminate adverse selection.  A firm may send a signal such as widely distributing a favorable report on its product by an independent testing agency to try to convince buyers that its product of high quality. In some markets, Government agencies, or nonprofit organizations such as consumers union also provide consumers with information.