Adverse selection
Adverse selection is an economic concept that arises from asymmetric information between parties in a transaction, where one party possesses exclusive knowledge that the other does not. This information imbalance can lead to situations where the knowledgeable party exploits the lack of information to gain an advantage, often resulting in negative consequences for the less informed party. Adverse selection is commonly discussed in various fields, particularly in insurance, used car sales, and stock trading.
In the insurance industry, for example, adverse selection occurs when high-risk individuals purchase insurance at the same premium rate as those with lower risk, potentially leading to financial losses for insurance companies. In markets like used car sales, sellers may withhold crucial information about a vehicle's condition, resulting in buyers potentially purchasing defective cars. Similarly, in stock trading, insider information can allow sellers to profit at the expense of uninformed investors.
The implications of adverse selection can be detrimental, contributing to misinformation, inefficiencies in pricing, and reputational damage across entire markets. To mitigate adverse selection, industries often implement strategies like rigorous screening and quality assurances, such as warranties, to promote transparency and trust. Understanding adverse selection is crucial for navigating various economic transactions and ensuring fair practices.
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Subject Terms
Adverse selection
Adverse selection is a term used in many branches of economics, including insurance, sales markets, and stock trading. It relates to a lack of symmetric information between parties involved in a transaction and describes the effects caused by that asymmetry. Usually, the asymmetry involves one party having exclusive private knowledge about the details of a deal.
This exclusive knowledge may include accurate and important information about the value of the good or service being transacted. The other party does not have this knowledge, and the knowledgeable party does not share the knowledge. Rather, the party with the knowledge uses it to maximize benefit in the transaction at the expense of the other party. Generally, this practice places the party that lacks the information at a definite disadvantage and often leads to negative results.
Background
Over many millennia, human economics have developed into countless forms. Thousands of markets and industries offer increasingly diverse goods and services to consumers worldwide. For example, the insurance industry offers financial protection to consumers. Consumers may purchase policies, or plans by which they will receive monetary settlements in the event of some unfortunate event. Insurance may cover automobile accidents, floods, theft, and a wide range of other occurrences, including the death of the policyholder. Insurance works when many policyholders pay premiums, or regular payments, for their coverage. When the company needs to pay for some damage, it draws from the large pool of premium funds.
Many other important markets in the economy provide goods and services more directly. For example, many people buy consumer goods like vehicles. Consumers may purchase new or used vehicles under a wide range of conditions and agreements. Another factor of the economy is the stock market, a system by which people can invest money by buying shares, or small parts of a business. The value of these shares may change rapidly depending on many market forces and world events, and clever investors attempt to find ways to make profits.
Despite the huge variety of economic fields, most have some features in common. These commonalities include buyers and sellers, or the people who purchase or provide the goods and services. Another commonality is risk factor. Any transaction involves an aspect of risk. Risk refers to the likelihood that something will go wrong for the buyer or seller. Someone buying a used car risks discovering that the car has a faulty transmission. A company selling an insurance policy risks having the buyer file a huge claim that exceeds the available funds.
Another form of risk comes from unscrupulous business practices. Often, buyers and sellers do not have the same information about the transaction at hand. One side may not have done enough research. Alternatively, one side may be willfully concealing information to try to benefit from the other party’s ignorance. Economic experts studying this unequal symmetry of information in transactions developed the theory of adverse selection.
Overview
Techniques of adverse selection appear in many forms in many fields, industries, and scenarios. Accordingly, they can have a wide range of effects as well. Some techniques favor different parties in a transaction. In the insurance industry, adverse selection usually favors the buyers of insurance. In most other industries—including secondhand vehicle sales, real estate, and the stock market—adverse selection generally favors the seller or service provider.
Wherever it may occur, adverse selection may harm the economy in many ways. This practice may lead to losses for parties that lack accurate and adequate information about the goods or services being transacted. It may tarnish the reputation of parties that use such techniques, or even entire fields. For example, dishonest actions by some used car dealers may make the public unfairly suspicious of all used car dealers. Adverse selection can result from or cause ineffective or inaccurate pricing. It can create confusion about pricing across entire markets. For these reasons, adverse selection techniques are often viewed as harmful, immoral, and/or illegal.
The theory of adverse selection first appeared in the insurance industry, where it has remained an influential factor into the twenty-first century. In insurance, adverse selection refers to the possibility that people who buy insurance will file claims that exceed the money these people have paid in premiums. The primary result of that phenomenon is that the insurance company will lose money.
Adverse selection in insurance happens most frequently when people with higher risk factors buy insurance at premium rates set for people with average or low risk factors. For example, people who smoke, eat unhealthily, and have dangerous jobs represent high-risk policyholders. Conversely, low-risk policyholders likely eat healthily, do not smoke, and do not have dangerous jobs. Insurance companies are challenged to differentiate between these risk levels. If the company offers a policy to everyone at the same price or people lie about their risk factors, the company is likely to lose more money than it takes in through premiums.
Avoiding adverse selection is a major task for insurance companies. Companies expend great efforts to research and categorize the people who are buying insurance. Company underwriters may require applicants to describe their age, location, height and weight, health habits, risky lifestyle choices, medical and family history, occupation and hobbies, and driving record. All of these factors can determine the likely risk posed by that applicant. Based on these calculations, most insurance companies offer different levels of coverage with varying premiums and benefits.
In sales markets, adverse selection usually takes the form of sellers having exclusive information about a good or service and only selling under favorable conditions, generally while withholding the important information. This may take place on the stock market, with companies using insider information to sell shares for a much higher price than their actual value. This practice is illegal and can result in huge losses for investors.
Another well-known example is an unscrupulous used car dealer who sells a “lemon,” or a car with hidden defects, without disclosing all needed information. Consumers are likely to buy these cars for relatively low prices, but then be trapped with faulty automobiles. On a larger scale, the commonality of cheap “lemons” on the market may make fewer people buy better-quality cars for larger amounts of money. This ultimately creates a market with lower prices but lower-quality goods. Many automobile dealers have attempted to reduce this problem through warranties and other quality control assurances.
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