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Adverse selection

From Academic Kids

Adverse selection or anti-selection is a term used in economics and insurance. On the most abstract level, it refers to a market process in which bad results occur due to information asymmetries between buyers and sellers: the "bad" products or customers are more likely to be selected.

Contents

Example: Insurance

The term adverse selection was originally used in insurance. It describes a situation where the people who take out insurance are more likely to make a claim than the population of people used by the insurer to set their rates. For example, when setting rates for a life insurance contract, a life insurer may look at death rates among people of a certain age in a certain area. Now suppose that there are two groups among the population, smokers and non-smokers, and the insurer can't tell which is which so they each pay the same premiums. Non-smokers are less likely to die than average, while smokers are more likely to die than average. If the insurance company could discern smokers from non-smokers, they would charge non-smokers less, and smokers more, than the current premium. Part of the premium that non-smokers pay will therefore go to pay for claims from smokers. Non-smokers know that they are cross-subsidising smokers, so they will be reluctant to insure themselves. Smokers, on the other hand, have to pay less than they should, and so will be more likely to buy insurance. The insurance company ends up losing money, because (in the extreme) only smokers insure themselves, and they have a higher mortality rate than the one the insurance company used when it calculated the premium.

Adverse selection may also occur on the other "side" of the market. If profit-seeking health insurance companies have the ability to deny coverage to individuals (as is usual), they will try to avoid insuring all patients but those presumed to be healthy. This "cherry picking" or "cream skimming" leads to only healthy patients having private health insurance. In many cases, this dumps the less healthy patients and their higher costs on government health programs.

Asymmetric information

In the usual case, a key condition for there to be adverse selection is an asymmetry of information - people buying insurance know whether they are smokers or not, whereas the insurance company doesn't. If the insurance company knew who smokes and who doesn't, it could set rates differently for each group and there would be no adverse selection. However other conditions may produce adverse selection even when there is no asymmetry of information. For example, some US states require health insurance providers to insure all who apply at the same cost. In this case, there may not be an actual asymmetry of information, the insurance company may know who is or isn't a smoker, but, the insurer not being allowed to act on that information, there is a "virtual" asymmetry of information.

The market for lemons

The concept of adverse selection has been generalised by economists into markets other than insurance, where similar asymmetries of information may exist. For example, George Akerlof developed the model of the "market for lemons." People buying used cars do not know whether they are "lemons" (bad cars) or "cherries" (good ones), so they will be willing to pay a price that lies in between the price for lemons and cherries, had there been perfect information on the part of the buyers.

The sellers will sell fewer good cars since they think the price is too low, but they will sell more bad cars because they get a very good price for them. After a while, the buyers will realise this, and they will no longer want to pay the old price for a used car. The price will lower and even fewer cherries, and even more lemons, will be put up for sale. In the extreme, the cherry sellers will have been driven, as it were, out of business.

The "price mechanism" fails to keep the lemons off the market, even in a competitive market. Instead, they dominate the market. Guarantees (or Lemon Laws) are needed.

Note that because of the existence of information asymmetry, this is not a market with perfect competition. However, it still represents a case of atomistic competition, with no firm having monopoly price-setting power. This may be a more accurate description of real-world competition than the model of perfect competition.

See also

de:Adverse Selektion

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