Question

10. Give an example of how the problem of adverse selection might prevent you from getting financing for something you want to do. Can you think of a way of overcoming this problem?

Answer 1

Adverse selection occurs when buyers have better information than sellers, and this can distort the usual market process. It can lead to missing markets as firms do not find it profitable to sell a good

Example

Suppose an insurance firm offered health insurance to the general public. It is likely to have the highest take-up rate amongst unhealthy people – people who don’t exercise, people who smoke. They are the group most likely to need health care; therefore, it makes sense for them to take out insurance. Healthy people are less likely to take out health insurance – if the price of health insurance is determined by the average unhealthy person.

If insurance premiums are based on the needs of smokers, then the premiums will be high. Therefore, there is no incentive for healthy people to take out the insurance.

Overcoming

American health care is primarily based on private insurance. This has led to problems of adverse selection, with young, healthy people more likely to avoid taking out health insurance. This led to higher overall premiums – making it unaffordable for many.

One element of the Affordable Health Care act was to have a compulsory insurance element. If people choose not to take out insurance, they have to pay a tax premium. The idea is that by encouraging people to purchase, it will lower overall premiums as people with lower-risk will join the ‘insurance pool.