Adverse Selection:

The previous example illustrates a very important problem in real life which is called “adverse selection”. Low-quality widgets crowds out high-quality widgets, since the former are cheaper to produce and the cost of finding out the quality is very high for consumers. The term itself emanates from the insurance business and it signifies a common phenomenon encountered by insurance companies.

When insurance companies set an insurance premium (price) on one of its products (coverage against some damage) it should reflect the average probability of an accident (causing the damage) in the entire population. However, with such a premium there will be (maybe about) half of the potential customers which has a probability of the accident below this premium and half with a probability above. Most of the customers with low probabilities will not buy the insurance policy and the average probability of the customers actually buying insurance will be above the population average. The insurance company has attracted the riskiest people, by self-selection. If the insurance company increases its premium in response to losses incurred, this will only make the matter worse, since they will only attract an even worse sample of customers. It’s a common problem that markets for many types of insurance policies do not exist.

Adverse selection in the market for health insurance is such a serious problem that most countries have instituted compulsory health insurance, financed by payroll taxes. The consumers have no choice in this case, but it’s still better than having no working private market at all. The problem is, as before, that the high risks generate a negative externality which makes it impossible for low risks to buy insurance, despite the opportunity for a mutually beneficial contract to be signed, given full information.

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