Adverse Selection - Asymmetric Information

- Siddhant Dutta


Asymmetric information in economics refers to a phenomenon when in a transaction, one party has better or more information than the other. This leads to a series of bad decisions, which in turn results in market failure due to misallocation of resources. There are various types of asymmetric information, namely adverse selection, moral hazards etc. Adverse selection is a situation in which sellers have more information than buyers (or vice versa).

A classic example of adverse selection can be seen in the case of health and life insurances. Let us consider the relationship between drinking and mortality. It is known that non-alcoholics typically live longer than smokers. If the insurance company doesn't vary prices according to drinking status, its schemes will be more profitable to alcoholics as they are more susceptible to diseases. Alcoholics will have greater incentives to buy insurance from that particular company and purchase insurance from the companies in larger amounts than non-alcoholics. The average mortality rate increases, leading to losses for the company.

In response, the company may increase premiums. However, higher prices causes responsible non-alcoholic customers to cancel their insurance, which can exacerbate the adverse selection problem and lead to a collapse in the insurance market. 

To counter the effects of adverse selection, insurers must offer insurance premiums that are proportional to the customer's risk of accident. The insurer must screen and distinguish high-risk individuals from low risk individuals. Medical insurers for instance, ask a range of questions and may request medical reports for individuals who apply to buy insurance, so that the premium can be varied accordingly, and any unreasonably high or unpredictable risks rejected all together. In many countries, law incorporates an "utmost good faith", which requires potential sutures to answer any underwriting questions asked by the insurer fully and honestly. Dishonesty may be met with refusals to pay claims.

Cases of adverse selection happen in other markets as well, especially in online markets. For example multiple cases have been reported in which buyers selling phoney gadgets on online sites such as e-bay and olx, at low prices, attracted customers lacking knowledge of the reality and making the purchases. They ended up receiving fake gadgets which would spoil in a matter of days. They were tricked into making the purchases due to asymmetric information. This leads to a misallocation of resources and finally results in market failure.

Citations:

"Adverse Selection Examples - What Is Adverse Selection and How Can It Affect Your Projects?" Brighthub Project Management. N.p., n.d. Web. 10 Jan. 2016

"Adverse Selection Definition | Investopedia." Investopedia. N.p., 18 Nov. 2003. Web. 10 Jan. 2016.

Video Link: http://www.investopedia.com/terms/a/adverseselection.asp?layout=orig