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Managerial Economics, 8e
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Chapter 16
Adverse Selection
Chapter Review
Adverse selection arises when one party to a contractual or economic relationship knows more than the other. For example, a seller of a used car knows more than a buyer, a policyholder knows more than an insurance company, and a borrower knows more than a lender. This puts the uninformed party at a disadvantage. For example, managers at insurance companies are unable to distinguish between safe and unsafe drivers; therefore premiums are averaged over both types. This means that good drivers subsidize bad ones, and many good drivers may be tempted to cancel their insurance to avoid this subsidy. In the extreme case, adverse selection may bring a market crashing down as all the low-risk people are priced out of the market. Similarly, all sellers of high-quality used cars might decide to keep them rather than sell at a price reflecting average quality.
There are tactics managers can use to mitigate the effects of adverse selection. The obvious one is to become informed. We saw that while adverse selection exists in the annuity market, managers at life insurance companies seem to have been successful in removing the information problem by medical examinations.
Managers can also design a menu of contracts to let others reveal their asymmetric information; the contracts have differential appeal to different customers. For example, in insurance, a high-priced policy might offer full insurance; a low-priced policy might cover only part of the damage. Bad drivers worry about the partial coverage because they know they are likely to have an accident. On the other hand, good drivers might like the partial coverage because it is cheap, and they figure they are unlikely to be in a crash. In labor markets education is used as a signal of worker productivity; and producers might use warranties to distinguish their products from those of rivals.