Question

What are three ways to reduce adverse selection by equalizing information? (and explain)

Answer 1

If some economic agents have greater information about the product or service than other economic agents we have asymmetric information. Asymmetric information leads to the problem of adverse selection. If there is incomplete information than the economic agent who has less information suffers due to incomplete information. This problem of asymmetric information occurs when there is unequal or asymmetric information between buyers and sellers in the market, this in turn leads to market failure.

This problem of adverse selection can be removed by equalizing information between buyers and sellers in the market. The three ways to reduce problem of adverse selection by equalizing information are –

1. Signaling

2. Screening

3. Government intervention

Signaling means that a seller credibly conveys the information about its product to the buyers in the market. Signaling is usually created by the sellers of good quality product (in the asymmetric information we have good and bad quality goods seller in the market) in such a way that it is credible and the sellers of the bad quality products will not be able to replicate. For example seller of good quality product can offer a warranty of the product after sell. This is a kind of sharing a insider information about the company or the product and services so both the buyer and seller will have equal information.

Screening refers to checking the quality of product before purchasing the product. By screening the buyer knows the true quality of the product and the incomplete information is removed. If we consider a sale transaction example if the buyer has less information about the market or product will therefore offer lower price for the goods and the seller will then provide a low quality goods to the buyer. Screening helps the buyer to obtain information about the product and then the buyer knows the correct price which should be offered for the product. Thus, buyer will be able to distinguish between low quality product and a high quality product. For example in a insurance market companies usually go through few past records, health condition, etc. to reduce the amount of risk.

Government intervention plays a vital role by issuing some guidelines that should be followed. Guidelines depend upon the product or services. For example - before making loans the banks need to monitor the financial position of borrower or in a second hand car market government may put restriction upon the quality of cars sold in the market (like low quality cars cannot be sold). Some restrictions by the government removes the incomplete information between the buyers and sellers and both are well informed about the quality of goods bought or sold.