Tejvan Pettinger

Definition of adverse selection:

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.

Adverse selection explained

Adverse selection occurs because of information asymmetries and the difficulties in selecting customers.

Consequences of adverse selection

Adverse selection in health insurance

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.

Adverse selection for buyers

It is also possible that the seller will have better information than buyers, and sellers only sell the product when it is favourable to them.

Solutions to adverse selection

To avoid adverse selection, firms need to try and identify different groups of people. This is why there are health insurance premiums for people who smoke and obese people.

Insurance firms will charge different rates to consumers depending on factors, such as

This means that those who are at most risk will likely have higher premium rates.

Compulsory purchase

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.’

Economists and adverse selection


George Akerlof investigated the asymmetry of information in the market for second-hand cars.

In a 1970 paper “The Market for Lemons,” he was awarded the Nobel Prize in Economics (2001). Akerlof suggested bad cars ‘lemons’ were more likely to be put onto the second hand market, reducing price. Therefore good cars were held back and not sold. It is sometimes known as the ‘bad driving out the good.’

Akerlof suggested the problem of adverse selection distorted the market, leading to lower prices and lower average quality of cars.

Others have suggested the second-hand car market can try use warranties and quality controls to overcome this problem of poor information.

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