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Information Failure - What is Adverse Selection?

Level:
AS, A-Level, IB
Board:
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 8 Apr 2023

Adverse selection is a market phenomenon that occurs when the parties in a transaction have asymmetric information, meaning that one party has more or better information than the other party. This can lead to an imbalance in the transaction, as the party with the advantage can use their superior information to make decisions that are not in the best interest of the other party.

Examples of adverse selection include:

  • Insurance: Adverse selection can occur in the insurance market when individuals with higher risk of making a claim are more likely to purchase insurance than individuals with lower risk. This can lead to higher premiums for everyone and discourage healthy individuals from purchasing insurance.
  • Used car market: Adverse selection can occur in the used car market when sellers have better information about the condition of their car than buyers. This can lead to buyers paying too much for a car that is in poor condition, or to sellers undervaluing a car that is in good condition.
  • Employment: Adverse selection can occur in the labor market when employers have better information about job candidates than the candidates themselves. This can lead to employers discriminating against candidates based on factors that are not observable to the candidates, such as race or gender.

How can adverse selection be mitigated / overcome

There are a number of ways to avoid or mitigate the effects of adverse selection in economic transactions:

  • Disclosure requirements: One way to reduce adverse selection is to require parties to disclose relevant information about the transaction. For example, in the insurance market, individuals may be required to disclose information about their health history in order to get a policy. This allows insurers to accurately assess the risk of insuring an individual and charge premiums that reflect that risk.
  • Standardisation: Standardizing the terms of a transaction can also help to reduce adverse selection. For example, in the mortgage market, lenders may require borrowers to meet certain standards in order to qualify for a loan. This helps to reduce the risk of lending to borrowers who may not be able to repay the loan.
  • Regulation: Government regulation can also be used to reduce adverse selection. For example, in the securities market, regulatory agencies may require companies to disclose financial information in order to prevent insider trading and other forms of adverse selection.
  • Market mechanisms: Market mechanisms, such as auctions, can also help to mitigate the effects of adverse selection by allowing buyers and sellers to reveal their preferences and valuations through the prices they are willing to pay or accept.
  • Education and information: Providing education and information to market participants can also help to reduce adverse selection. For example, in the used car market, providing information about the condition of a car can help buyers to make more informed decisions and reduce the risk of being taken advantage of by sellers with superior information.

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