Adverse Selection Examples
Adverse selection refers to a situation where one party in a transaction has more information than the other, leading to a selection of undesirable or high-risk choices. Examples include insurance applicants with higher risk of claims being more likely to seek coverage, and used car sellers withholding information about a vehicle's history. These examples illustrate how asymmetric information can lead to adverse outcomes in economic transactions.
6 Key excerpts on "Adverse Selection Examples"
eBook - ePub- Bruce C. N. Greenwald(Author)
- 2018(Publication Date)
- Routledge(Publisher)
...Health and other types of insurance are important and familiar cases in point. However, in each instance the elements of the underlying structure of the market which are responsible for the importance of adverse selection are the same. And, for the purpose of clarifying the discussion which follows, it will be useful to begin by describing these elements. Four of them are central. The first is the absence of perfect information about the commodity being bought and sold. If each worker’s ability or the condition of a used car or the health of an applicant for health insurance were infallibly and completely known to the market, the process of adverse selection would play no significant role. Commodities would be differentiated by quality and workers, used cars and insurance risks would all be priced according to their true values. In the case of labor wages would then adjust to the quality of each employee and firms, forced to pay true marginal products, would have no special incentive to keep “good” workers. There would be no unusual tendency for less able workers to enter the market and no predictable degree of adverse selection. Moreover, even if “bad” workers did tend to enter the market in greater numbers they would enter as a separate category of workers and would have no special effect on the functioning of labor markets as a whole. Therefore, for adverse selection to play an important role in the operation of the labor market there must be some residual uncertainty about the abilities of workers after all the observable information (job histories, education, references, physical characteristics, etc.) has been digested. In other words, workers who look the same to the market must have significantly different capabilities. The second element is that the available information must be asymmetrically distributed with sellers (current employers) in this case having better knowledge than buyers (potential employers)...
eBook - ePub- Weiying Zhang(Author)
- 2017(Publication Date)
- Routledge(Publisher)
...8 Adverse selection, brands, and regulation Asymmetric information can be classified into ex-ante asymmetric information and ex-post asymmetric information. Ex-ante asymmetric information leads to adverse selection. Ex-post asymmetric information leads to moral hazard. So-called adverse selection refers to the bad driving out the good because of asymmetric information. For example, bad cars cause good cars to not sell, high-risk policy holders cause low-risk policy holders to be uninsured, low-quality projects cause high-quality projects to be unfinanced, fake beggars cause real beggars to be neglected, high-quality scholars cannot complete with low-quality scholars, etc. Adverse selection means a potential Pareto efficiency cannot appear. In essence, it is also a Prisoner’s Dilemma issue. Resolving adverse selection to realize a Pareto efficiency is a big issue faced by society. Methods to resolve adverse selection include both market mechanisms and non-market mechanisms. Market mechanisms include: (1) The party without private information directly collects and investigate the information; (2) specialized providers of information collect and transmit information; (3) the party without private information indirectly obtains information through mechanism design; (4) the party with private information signals private information with some costs; and (5) the reputation mechanism. The reputation mechanism primarily manifests as the party with private information establishing a brand. The value of brands depends on the degree of asymmetric information. The brand of products with more asymmetric information are worth more. The value of brands is also related to income levels and technological progress. The higher incomes are, and the more complex technology is, the more important brands are. Government regulation is the primary non-market mechanism to resolve adverse selection...
eBook - ePubRetail Banking
Business Transformation and Competitive Strategies for the Future
- A. Omarini(Author)
- 2016(Publication Date)
- Palgrave Macmillan(Publisher)
...There are generally two manifestations of asymmetric information in the financial services industry. These are called ‘adverse selection’ and ‘moral hazard.’ We describe each of these concepts in detail. 1. Adverse Selection or simply ‘incorrect’ or ‘bad choice’ generally arises when one party to a transaction has hidden characteristics. For example, a borrower has concealed certain facts about his or her true financial position, and they remain hidden from the potential lender. This creates a problem for the supplier of funds in that it cannot unambiguously differentiate between good-quality and bad-quality borrowers. A ‘lemons problem’ can arise. Let us assume that a lender cannot easily differentiate good-quality borrowers from bad-quality borrowers. The lender decides to charge the same borrowing rate to all potential borrowers. This is an average rate between the rate that is charged for good-quality borrowers and the rate that is charged for bad-quality borrowers. But we now have a major problem. Good-quality borrowers will find the borrowing rate too expensive, while the bad-quality borrowers will see the borrowing rate as very attractive when compared to their true risk status (only known to them). Hence, good-quality borrowers will exit the market. The lender will be left with only bad-quality borrowers. This is called ‘the lemons problem.’ It is also called ‘adverse selection.’ If the customer has less information about the banking product than the bank official, then the customer may make an incorrect choice. Note that this problem may occur before the transaction actually takes place. We can summarize as follows: if the customer has less information than the bank official, and this is information asymmetry, then the customer may choose incorrectly – adverse selection. 2. Moral hazard occurs after the transaction (such as the monitoring stage)...
eBook - ePub- Urs Birchler, Monika Bütler(Authors)
- 1999(Publication Date)
- Routledge(Publisher)
...More private information often leads to market failure due to so-called "adverse selection". But even more public information may destroy welfare, as we will demonstrate in an Application on the so-called insurance destruction effect (13 D). An important example of an information-sensitive market is the market for annuities, the subject of our second Application (13 E). This market raises important policy questions, like: Should the poor subsidize the rich? What information should a pension fund use (or be allowed to use)? How do we distinguish between adverse selection and beneficial sorting? As far as we know, the latter question has been largely neglected in the literature to date. In the present chapter we focus on the type of information asymmetry that exists already before deals are proposed and made, the so-called "adverse selection" case. A related type of asymmetry arises when one party acquires relevant information after a deal has been made, though this case will be discussed in Chapter 15. A fairly different case of information asymmetry relates to actions, rather than to facts. After a contract is signed, one agent can choose an action unobservable to the contract party. This leads to so-called "moral hazard", a phenomenon to be discussed in Chapter 16. 13 B Main ideas: When information prevents trading It has become somewhat easy to cheat. On internet auction sites large numbers of used or rare goods are traded. Typically, these are of unknown quality to potential buyers. Nothing seems to prevent a seller from overstating the quality or condition of his article. Given that buyers and sellers are anonymous, a disappointed buyer cannot initiate legal proceedings against the seller. While successful bidders are normally supposed to pre-pay, a seller may even choose not to send the article at all. 88 In traditional markets, trading parties are rarely anonymous. Yet, information asymmetries remain numerous. Often the seller knows more than the buyer...
eBook - ePub- Jirí Hlavácek, Michal Hlavácek(Authors)
- 2020(Publication Date)
- Karolinum Press, Charles University(Publisher)
...The insured are therefore more risky than the average population. This applies not only to the insurance market—many new customers of dating agencies have found that the supply of potential partners offered by these agencies is ceteris paribus worse than that in the average population. Generally, adverse selection can be described as a situation in which “undesirable” customers (from the point of view of the principal) are more likely to participate in voluntary exchange. For simplicity we assume the same initial income of y i = y for all n agents (insured parties) (i = 1,…, n). All agents are considered to be risk neutral with an identical utility function v i (y) = y. Moreover, those agents face an identical loss L i = L. The size of the loss L here (unlike in the moral hazard model discussed in the next section) is an exogenous variable which the agent cannot influence. We also assume that among the customers there are: • (1 – γ) ∙ n high-risk individuals who have a high accident probability π h, • γ · n low-risk individuals with a low accident probability π l, where π l < π h. Suppose that the principal (insurance company) is risk neutral and that he knows the shape of the agent’s utility function v (y) = y and his initial income y, the size of the potential loss L, the proportion of low-risk customers ɣ ∊ (0; 1) and the accident probabilities of both types of customers π h and π l, but he is not able ex ante to recognize the type of customer. This prevents the principal from charging high-risk types a premium of p h = π h ∙ L and low-risk types a premium of p l = π l ∙ L ; such insurance would correspond to the expected loss and, under perfect information, would be Pareto optimal 32 for all parties. Moreover, if the insurance company offered the “halfway” insurance premium given by the weighted average of the optimal premium for high-risk and low-risk individuals (with the weights given by the ratio of high-risk to low-risk agents), i.e...
eBook - ePub- Chris Jones(Author)
- 2008(Publication Date)
- Routledge(Publisher)
...This is referred to as the mutuality principle that holds in all the consumption-based asset pricing models examined earlier in Chapter 4. We look at insurance with common (symmetric) information in Section 5.1 and then extend the analysis by introducing asymmetric information in Section 5.2. Consumers will fully insure against individual risk in a frictionless competitive equilibrium when traders have common information and state-independent preferences. We use this as a benchmark to identify the effects of trading costs and asymmetric information. Consumers choose not to fully insure when trading costs raise the price of insurance above the probability of incurring losses. When they are minimum necessary costs of trade the competitive equilibrium outcome is Pareto efficient, where expected security returns rise to compensate consumers for the cost of eliminating individual risk from their consumption expenditure. A number of government policies, including price stabilization schemes and publicly funded insurance, are justified as ways to overcome the effects of asymmetric information on private insurance. Moral hazard and adverse selection are the most widely cited problems. With moral hazard consumers have the ability to reduce their individual risk by undertaking costly self-protection. Whenever marginal effort, which cannot be observed by insurers, is not reflected in the price consumers pay for insurance, they less than fully insure. Adverse selection occurs when there are consumers with different probabilities of incurring losses that insurers cannot costlessly identify and separate. Low-risk types suffer from highrisk types buying low-risk policies. This imposes externalities on low-risk consumers. At one extreme high-risk types may prove too big a problem for the existence of a private insurance market. These are the most common reasons cited for incomplete insurance markets...
