Question

Explain the concept of adverse selection. How can that lead to market failure? Using the example of insurance markets, outline some ways in which market failure can be avoided or reduced?

Answer 1

The problem of adverse selection is a great economic problem which may lead to market failures unless proper research is conducted. It arises, primarily due to the concept of asymmetric information in a transaction

This refers to one party of a transaction having more knowledge than the other and engaging in a transaction which thereby may lead to raised costs for the party and overall market failure.

Insurance Sector Example

In the insurance sector, demand and supply play a vital role and the probability of risk is what defines the pricing of most insurance plans across the globe. Here the problem of adverse selection happens, when the buyer has a greater access to information and knows that he may engage in risky activities which may cause harm to his health or for example in car insurance to the car itself.

When this happens, insurance companies may not have equal knowledge about such risks and this ultimately leads to losses for the enterprise respectively.

At the economic level the entire market would begin to fail if the same happens with multiple companies.

The ideal way of avoiding the same is to collect as much information and research to the maximum this would let us know, the correct pricing strategy for insurance companies. Further many have also increased their pricing to accommodate for those people that have a higher risk trend or reduced the pay-out to these people thus protecting the industry and company by large.

Conclusion: -

Thus, we can conclude our discussion by saying that adverse selection problem arises when one player in the market has higher knowledge than the other. In insurance this happens when those with higher risk of damaging themselves (Health Insurance) such as workers in factories or their vehicle or other insured equipment purchase insurance policies and the insurance company has lesser knowledge about such people.

To avert such issues, market research should be conducted to influence high pricing for those at a higher risk factor or reduced payments or prepayments by the insured towards making sure that the market does not collapse.

Please feel free to ask your doubts in the comments section if any.