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What is Adverse Selection


may define adverse selection as a concept from which asymmetric information can
distort market participation, thus leading to the seller or buyer being at a
disadvantage before economic transactions. Within a marketplace, asymmetric
information 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 other
party. For example, if there are two goods within a market, with 2 different
quality levels and 2 different price levels, the seller knows the quality of
their products they are selling: however, the buyers do not. As a result of
this buyers would not be willing to purchase a product at a higher price as
they don’t have the inadequate information about quality and therefore have no
reason to part with paying more than their expected price of a good. This will
lead to sellers of the higher quality goods to exit the market as this
misinformation has left no demand for that product. In a buyer’s mind, they are
given two goods which they believe are identical but are given at two different
prices, the buyer would without a doubt pick the cheaper option almost every
time, this creates a disadvantage for the seller as that product is undervalued
and firm does not make any profit from the goods. This same disadvantage can be
seen in the service market where the buyers are affected. Within an insurance
firm the premiums are based on the average of claims and health issues in the
population. Individuals who rarely claim from the insurance firm (low-risk
individuals) 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 risk
individuals do not exceed the total revenue they receive from premiums, as a
result the low-risk individuals who are less likely to make a claim would
choose to not purchase insurance resulting in a loss of buyers: a reduction of
buyers inevitably leads to less profit for a firm and market failure, also
known as the death spiral. Similarly, adverse selection occurs in the labour
market, in this market workers abilities can vary from person to person, firms
do not know the ability of the workers they hire but the workers do, thus
asymmetrical information existing. If a firm decides to cut wages, talented
workers are likely to leave as they know they are able to find employment
elsewhere. Leading to workers leaving the market.

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What mechanisms can solve adverse
selection? How do they work? Limitations?

Mechanisms do exist to attempt to solve adverse
selection; the government may choose to intervene in the market in attempt to
reduce or remove the asymmetrical information between the two parties,
introducing a policy to make goods or services compulsory to purchase; such as
health insurance or mandatory to own a car, would make buyers forced to make
this purchase, because of this neither parties leave the market, both buyers
and sellers still maintain their asymmetrical information but as it disallows
anyone from leaving the market. Buyers wouldn’t leave as they can’t and sellers
won’t leave because demand for their products exist. This policy benefits
sellers as all of the population is buying from them, increasing their demand
as well as their profits, buyers also gain from this policy as they receive the
benefit of the good/service whether the need it or not. However, this
intervention has disadvantages for both parties, sellers may not be prepared
for the sudden increase in demand this shock may lead to inefficiency as the
firm 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 the
goods market, if buyers increase their demand in purchasing low price goods then  sellers may not be able to accommodate the
extra demand and therefore “selling out”, buyers would then be forced to
purchase the higher price good, buyers may take this situation in two ways, the
may either purchase the good at that price level which will decrease their
consumer surplus or they may purchase that good through the black-market, it
may be cheaper than what they are currently paying, resulting in government
failure with the law of unintended consequences. in the service market, high
risk individuals who a firm wouldn’t normally offer health insurance too would
be given this service, in the long run a firm pay out would be higher than the premiums
they receive, leading to a loss of profit and potentially bankruptcy. It may be
unequitable for some buyers as regardless if they need it or can afford it they
have to have it. In contrast, if everyone has to use the good/service then
there is an incentive for new firms to enter the market as their target market
is 100% of the population, multiple firms entering the market would create
competition, driving prices lower and lower which would be beneficial for
consumers. The government also has the option to offer the service/good themselves
to the buyers, with doing this they are able to offer whatever price they deem
suitable which would mean they can offer a price that is affordable for people
who can’t afford it, nonetheless the government may need to forgo funding in a
sector or increase their budget deficit to fund this scheme, enforcing this
scheme would also add costs to the government to ensure sellers comply with the
limitations of the policy and buyers follow the policy so that no one evades
this compulsory scheme. Although these two policies don’t give buyers a choice
it does in fact negate the effects of asymmetrical information, this
misinformation does exist in the economy but neither buyers or sellers can do
anything about it, the only difference between firms selling the service and
the government is that the government has the option to set prices to benefit
the population where as a firm intends to maximise profits and therefore
consumer satisfaction and surplus would be greater compared to when firm offer

The government can also intervene by
applying a maximum price policy within the market. This policy would limit what
a seller can charge for their goods or services, this will lead to a lower
price charged to buyers, buyers consumer surplus would increase and they will
be more likely to purchase the good, increasing demand and eventually profits
for a firm. This may have the effect to reduce a buyer’s asymmetrical
information in the service market as prices are lower, it can be more
affordable and therefore low risk individuals wouldn’t leave the market. In the
goods market, high and low-quality goods would be offered at the same price
therefore even though sellers have more information than buyers, buyers wouldn’t
leave the market as their goods from all sellers are still demanded. Within the
labour market a maximum price policy would also be known as a minimum wage, the
lowest a firm can pay workers. This will not allow firms to cut wages to a
point where workers leave. Such policy would be beneficial for an economy
during inflationary time periods, consumers are able to maintain their standard
of living as prices don’t increase relevant to income. However, sellers in the
goods market wouldn’t be content with selling their high-quality good at such a
low price, this would disinterest firms and would result in them to exit the
market, within the service market firms wouldn’t be able to make profit as high
risk individual pay-outs would be greater than the lowered price of premiums
they receive, resulting in the sellers to leave the market rather than buyers.
This policy attempts to correct adverse selection however it corrects the
misinformation from one party only and is one sided.

A way to remove the asymmetrical
information 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 they
offer so the customers understand the reason for the price adjustment, this
would mean that neither sellers and buyers has too much information and
therefore sellers would not need to exit the market as consumers who demand a
product with superior quality would have it fulfilled, equating the
equilibrium. With a downside, simply being increased costs for a firm to
advertise the qualities of their product. Within the service market if buyers
mention information such as what their job is or what their hobbies are, this
can enable a firm to establish what risk the client is (high or low), as a
result this asymmetrical information is removed and both firm and sellers have
equal information. In my opinion, this signalling to the opposing party is a
simple and honest way to remove such misinformation, it has minimal cost and
minimal time wasted. However, errors may occur within determining these
markets. Incentive compatibility constraints such as Individuals who are low
risk but are charges high premiums would appeal, revealing their personal
information 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 it
wouldn’t be of any gain for them, as such disclosing would potentially result in
higher premiums, therefore not disclosing would allow them to receive a lower
price. This imbalance the equilibrium leading to market failure and this
mechanism not working.

Another similar mechanism is screening,
parties attempt to filter out information that is helpful from information that
Is useless. sellers can give the buyers options to choose what features they
would like on their products, these options would determine which quality of
product 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 product
and therefore would not need to exit the market. similarly, in the service
market, individuals can be given the chance to select what type they are, firms
can identify what groups of people have an increased risk compared to the rest
of the population this is known as “underwriting” it can determine if they are
high or low risk; this would enable a firm to figure out the amount of premiums
to offer the buyer, this simple scheme would result in both sellers and buyers
having equal information and can potentially reduce or even remove adverse
selection. Firms can also make individual perform check-ups before they are
given insurance, this would allow the firm to gain all the information advantage
from 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 to
protect unexpected incidents and the higher premium offered would simply be the
amount to cover the existing health problems and not the potential future
incidents, potentially leading to deception and market failure.

Firms can also “cherry pick” who they
sell 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 more
likely to claim would not be offered such insurance, individuals who rarely
claim would be given this service resulting in a firm to receive higher
profits. In this situation buyers and sellers have equal information and
therefore there is no adverse selection but as firms are profit makers they
choose to exclude high risk individuals to ensure profit maximisation, because
of this discrimination high risk individuals would leave the market. The disadvantages
of this are that the people who need to the most don’t get the service which
defeats the purpose of insurance as well as this the firm are unable to
decipher whether individuals are high or low risk, they may have to use other
mechanisms to determine this. This mechanism can lead to market failure.







We often divide individuals or goods in
categories such as high and low risk/quality when discussing adverse selection,
mechanisms exist to reduce such asymmetrical information, these policies range
from making a good/service or even labour to be mandatory within its population
to limiting what parties can charge, it can be true to say that such scheme
prevents parties from exiting the market however asymmetrical information still
does exist, with the problem being that it is unethical, unequitable and unreasonable
for both parties. In my opinion, a successful mechanism
to solve adverse selection is one that is both Affordable and fair for an
individual, with minimal costs for firms, beneficial for the economy in the
long run and finally reduces or even remove asymmetrical information, therefore
it can be said that a combination of signalling, screening and government
intervention can achieve this. Customers can gain information from firms buy signalling; firms can be by adding warranties or guarantees
to products, firm are likely to add such extras to high quality products only
as they a certain that the likeliness of it to break is low compared to poor
quality goods, therefore this is an affordable way to ensure both parties have
equal information, in the long run the firms reputation increases as well as
their profits. By screening; health insurance firms interview individuals to
determine characteristics such as hobbies and lifestyles which convert into riskiness.
This scheme minimises costs for a firm and can ensure that individuals get a tailored
plan depending on their lifestyle, as a result transferring information to the
firm. However, both signalling and screening can be affected by deception, this
is where government intervention falls in place, by allowing the government to
introduce 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 may
apply would prevent “cherry picking” from occurring.

It can also be seen that over the
coming years behaviour of individuals in the service market has changed drastically,
before; health insurance was only considered and taken by those who have poor
health, but now more healthier individuals are taking health insurance, this
may be because the individuals who attempt to avoid risk by eating well and
taking care of themselves also avoid risk by buying health insurance. This propitious
selection where more healthier individuals buy health insurance compared to
riskier individual has the ability to keep a firm’s costs low, stop individuals
from leaving the market and prevent the death spiral. However asymmetric information can also lead to moral Hazard, if one
party has an information advantage to the other party, it can enable them to exploit
that advantage to reap the rewards, for example, individuals who are usually
low risk in the service market may choose to participate In risky activities as
they know that they have insurance to protect them from the risks involved, therefore
it can be debatable whether all low risk individuals in the short run can in fact
be high risk in the long run.


I truly believe that adverse
selection can be reduced to a minimum in the short run with using the policies
mentioned, but human behaviour and their choices is something that cannot be easily
manipulated and In the long run asymmetrical information may still occur,
although these policies make deception between parties harder to achieve they
must 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 premium
cost for an individual would result in low risk individual to maintain their behaviour
and not increase risk, but it is simply up to both parties to communicate their
information advantage to each other which would reduce the asymmetrical information
and prevent parties from exiting the market in the long run.

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