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Adverse Selection

Using the Health Insurance example from the first page, we can look at it a different way. With this informational asymmetry, insurance providers would charge one price and hope to spread their costs across a diverse group of policy holders. Another way of looking at this is that the insurance provider tries to use some of their large profits from low risk/good health customers to subsidize their losses from high risk/poor health customers. However, we will likely find the buyers in poor health purchase insurance while the healthy individuals find that they are better off paying their smaller medical bills out of pocket. In this scenario, we find that insurance providers would have a difficult time operating profitably. This is called adverse selection

When adverse selection occurs, too much of the low-quality product has entered the market than the high-quality product.  This is best illustrated through the example of used cars once again.  If we suppose that there are only two types of cars for sale, only ones in good quality and ones in bad quality, yet the buyer is unable to distinguish the difference between the two.  Knowing that they have a 50 percent chance of buying a good quality car they will offer the median price to the seller, say for instance $7500 because the low-quality car is worth $5000 and the high-quality car is worth $10,000.  If this happens then all of the sellers of low-quality cars will rush the market to sell their products.  So the market for high-quality cars will have dissipated, thus resulting in a market failure, specifically adverse selection.

Source:  Colander, David C. Economics. 6th Edition. p. 432.

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