What is Adverse Selection Wemay define adverse selection as a concept from which asymmetric information candistort market participation, thus leading to the seller or buyer being at adisadvantage before economic transactions.
Within a marketplace, asymmetricinformation occurs when the seller or buyer has more information of a good/service(such as the level of quality or amount of individual riskiness) than the otherparty. For example, if there are two goods within a market, with 2 differentquality levels and 2 different price levels, the seller knows the quality oftheir products they are selling: however, the buyers do not. As a result ofthis buyers would not be willing to purchase a product at a higher price asthey don’t have the inadequate information about quality and therefore have noreason to part with paying more than their expected price of a good. This willlead to sellers of the higher quality goods to exit the market as thismisinformation has left no demand for that product.
In a buyer’s mind, they aregiven two goods which they believe are identical but are given at two differentprices, the buyer would without a doubt pick the cheaper option almost everytime, this creates a disadvantage for the seller as that product is undervaluedand firm does not make any profit from the goods. This same disadvantage can beseen in the service market where the buyers are affected. Within an insurancefirm the premiums are based on the average of claims and health issues in thepopulation. Individuals who rarely claim from the insurance firm (low-riskindividuals) would not be willing to pay premiums if the firms prices are high,this price increase is inevitable to ensure that the total pay out of high riskindividuals do not exceed the total revenue they receive from premiums, as aresult the low-risk individuals who are less likely to make a claim wouldchoose to not purchase insurance resulting in a loss of buyers: a reduction ofbuyers inevitably leads to less profit for a firm and market failure, alsoknown as the death spiral. Similarly, adverse selection occurs in the labourmarket, in this market workers abilities can vary from person to person, firmsdo not know the ability of the workers they hire but the workers do, thusasymmetrical information existing. If a firm decides to cut wages, talentedworkers are likely to leave as they know they are able to find employmentelsewhere. Leading to workers leaving the market.
What mechanisms can solve adverseselection? How do they work? Limitations?Mechanisms do exist to attempt to solve adverseselection; the government may choose to intervene in the market in attempt toreduce or remove the asymmetrical information between the two parties,introducing a policy to make goods or services compulsory to purchase; such ashealth insurance or mandatory to own a car, would make buyers forced to makethis purchase, because of this neither parties leave the market, both buyersand sellers still maintain their asymmetrical information but as it disallowsanyone from leaving the market. Buyers wouldn’t leave as they can’t and sellerswon’t leave because demand for their products exist. This policy benefitssellers as all of the population is buying from them, increasing their demandas well as their profits, buyers also gain from this policy as they receive thebenefit of the good/service whether the need it or not. However, thisintervention has disadvantages for both parties, sellers may not be preparedfor the sudden increase in demand this shock may lead to inefficiency as thefirm would not have the resources in the short run to accommodate such rise,inefficiency leads to rise in costs which can decrease a firm’s profits. In thegoods market, if buyers increase their demand in purchasing low price goods then sellers may not be able to accommodate theextra demand and therefore “selling out”, buyers would then be forced topurchase the higher price good, buyers may take this situation in two ways, themay either purchase the good at that price level which will decrease theirconsumer surplus or they may purchase that good through the black-market, itmay be cheaper than what they are currently paying, resulting in governmentfailure with the law of unintended consequences. in the service market, highrisk individuals who a firm wouldn’t normally offer health insurance too wouldbe given this service, in the long run a firm pay out would be higher than the premiumsthey receive, leading to a loss of profit and potentially bankruptcy. It may beunequitable for some buyers as regardless if they need it or can afford it theyhave to have it. In contrast, if everyone has to use the good/service thenthere is an incentive for new firms to enter the market as their target marketis 100% of the population, multiple firms entering the market would createcompetition, driving prices lower and lower which would be beneficial forconsumers.
The government also has the option to offer the service/good themselvesto the buyers, with doing this they are able to offer whatever price they deemsuitable which would mean they can offer a price that is affordable for peoplewho can’t afford it, nonetheless the government may need to forgo funding in asector or increase their budget deficit to fund this scheme, enforcing thisscheme would also add costs to the government to ensure sellers comply with thelimitations of the policy and buyers follow the policy so that no one evadesthis compulsory scheme. Although these two policies don’t give buyers a choiceit does in fact negate the effects of asymmetrical information, thismisinformation does exist in the economy but neither buyers or sellers can doanything about it, the only difference between firms selling the service andthe government is that the government has the option to set prices to benefitthe population where as a firm intends to maximise profits and thereforeconsumer satisfaction and surplus would be greater compared to when firm offerit. The government can also intervene byapplying a maximum price policy within the market. This policy would limit whata seller can charge for their goods or services, this will lead to a lowerprice charged to buyers, buyers consumer surplus would increase and they willbe more likely to purchase the good, increasing demand and eventually profitsfor a firm. This may have the effect to reduce a buyer’s asymmetricalinformation in the service market as prices are lower, it can be moreaffordable and therefore low risk individuals wouldn’t leave the market. In thegoods market, high and low-quality goods would be offered at the same pricetherefore even though sellers have more information than buyers, buyers wouldn’tleave the market as their goods from all sellers are still demanded. Within thelabour market a maximum price policy would also be known as a minimum wage, thelowest a firm can pay workers. This will not allow firms to cut wages to apoint where workers leave.
Such policy would be beneficial for an economyduring inflationary time periods, consumers are able to maintain their standardof living as prices don’t increase relevant to income. However, sellers in thegoods market wouldn’t be content with selling their high-quality good at such alow price, this would disinterest firms and would result in them to exit themarket, within the service market firms wouldn’t be able to make profit as highrisk individual pay-outs would be greater than the lowered price of premiumsthey receive, resulting in the sellers to leave the market rather than buyers.This policy attempts to correct adverse selection however it corrects themisinformation from one party only and is one sided.
A way to remove the asymmetricalinformation is to have both sellers and buyers to be compliant with each other,sellers in the goods market can show the superior quality of the products theyoffer so the customers understand the reason for the price adjustment, thiswould mean that neither sellers and buyers has too much information andtherefore sellers would not need to exit the market as consumers who demand aproduct with superior quality would have it fulfilled, equating theequilibrium. With a downside, simply being increased costs for a firm toadvertise the qualities of their product. Within the service market if buyersmention information such as what their job is or what their hobbies are, thiscan enable a firm to establish what risk the client is (high or low), as aresult this asymmetrical information is removed and both firm and sellers haveequal information. In my opinion, this signalling to the opposing party is asimple and honest way to remove such misinformation, it has minimal cost andminimal time wasted. However, errors may occur within determining thesemarkets. Incentive compatibility constraints such as Individuals who are lowrisk but are charges high premiums would appeal, revealing their personalinformation to ensure they get a lower price, as they would gain from this.Individuals who are high risk wouldn’t bother revealing such information as itwouldn’t be of any gain for them, as such disclosing would potentially result inhigher premiums, therefore not disclosing would allow them to receive a lowerprice.
This imbalance the equilibrium leading to market failure and thismechanism not working. Another similar mechanism is screening,parties attempt to filter out information that is helpful from information thatIs useless. sellers can give the buyers options to choose what features theywould like on their products, these options would determine which quality ofproduct they choose, buyers would then be able to purchase that specific good,both firms of high and low-quality goods would receive demand for their productand therefore would not need to exit the market. similarly, in the servicemarket, individuals can be given the chance to select what type they are, firmscan identify what groups of people have an increased risk compared to the restof the population this is known as “underwriting” it can determine if they arehigh or low risk; this would enable a firm to figure out the amount of premiumsto offer the buyer, this simple scheme would result in both sellers and buyershaving equal information and can potentially reduce or even remove adverseselection.
Firms can also make individual perform check-ups before they aregiven insurance, this would allow the firm to gain all the information advantagefrom the individual, a check-up may lead to disclosing too much information,leading to a price rise, but it can be argued that health insurance is given toprotect unexpected incidents and the higher premium offered would simply be theamount to cover the existing health problems and not the potential futureincidents, potentially leading to deception and market failure.Firms can also “cherry pick” who theysell their goods and services to and who to exclude. Within the service market,individuals whose potential pay-out exceed the premiums they pay and are morelikely to claim would not be offered such insurance, individuals who rarelyclaim would be given this service resulting in a firm to receive higherprofits. In this situation buyers and sellers have equal information andtherefore there is no adverse selection but as firms are profit makers theychoose to exclude high risk individuals to ensure profit maximisation, becauseof this discrimination high risk individuals would leave the market. The disadvantagesof this are that the people who need to the most don’t get the service whichdefeats the purpose of insurance as well as this the firm are unable todecipher whether individuals are high or low risk, they may have to use othermechanisms to determine this. This mechanism can lead to market failure.
ConclusionWe often divide individuals or goods incategories such as high and low risk/quality when discussing adverse selection,mechanisms exist to reduce such asymmetrical information, these policies rangefrom making a good/service or even labour to be mandatory within its populationto limiting what parties can charge, it can be true to say that such schemeprevents parties from exiting the market however asymmetrical information stilldoes exist, with the problem being that it is unethical, unequitable and unreasonablefor both parties. In my opinion, a successful mechanismto solve adverse selection is one that is both Affordable and fair for anindividual, with minimal costs for firms, beneficial for the economy in thelong run and finally reduces or even remove asymmetrical information, thereforeit can be said that a combination of signalling, screening and governmentintervention can achieve this. Customers can gain information from firms buy signalling; firms can be by adding warranties or guaranteesto products, firm are likely to add such extras to high quality products onlyas they a certain that the likeliness of it to break is low compared to poorquality goods, therefore this is an affordable way to ensure both parties haveequal information, in the long run the firms reputation increases as well astheir profits. By screening; health insurance firms interview individuals todetermine characteristics such as hobbies and lifestyles which convert into riskiness.This scheme minimises costs for a firm and can ensure that individuals get a tailoredplan depending on their lifestyle, as a result transferring information to thefirm.
However, both signalling and screening can be affected by deception, thisis where government intervention falls in place, by allowing the government tointroduce a policy to make lying to other parties a crime would prevent such deceptive behaviour,similarly introducing a policy to make firms offer insurance to whoever mayapply would prevent “cherry picking” from occurring.It can also be seen that over thecoming years behaviour of individuals in the service market has changed drastically,before; health insurance was only considered and taken by those who have poorhealth, but now more healthier individuals are taking health insurance, thismay be because the individuals who attempt to avoid risk by eating well andtaking care of themselves also avoid risk by buying health insurance. This propitiousselection where more healthier individuals buy health insurance compared toriskier individual has the ability to keep a firm’s costs low, stop individualsfrom leaving the market and prevent the death spiral. However asymmetric information can also lead to moral Hazard, if oneparty has an information advantage to the other party, it can enable them to exploitthat advantage to reap the rewards, for example, individuals who are usuallylow risk in the service market may choose to participate In risky activities asthey know that they have insurance to protect them from the risks involved, thereforeit can be debatable whether all low risk individuals in the short run can in factbe high risk in the long run. I truly believe that adverseselection can be reduced to a minimum in the short run with using the policiesmentioned, but human behaviour and their choices is something that cannot be easilymanipulated and In the long run asymmetrical information may still occur,although these policies make deception between parties harder to achieve theymust allow for their incentives to be corresponding and not conflicting, i.e.,a high quality good would be demanded for at a high price and a low premiumcost for an individual would result in low risk individual to maintain their behaviourand not increase risk, but it is simply up to both parties to communicate theirinformation advantage to each other which would reduce the asymmetrical informationand prevent parties from exiting the market in the long run.