Suppose that someone offers to sell you an almost brand-
Probably not, for one main reason: you cannot help but wonder why this car is being sold. Is it because the owner has discovered that something is wrong with it—
You might think that the fact that sellers of used cars know more about them than the buyers do represents an advantage to the sellers. But potential buyers know that potential sellers are likely to offer them lemons—
Even a used car that is not a lemon would sell only at a large discount because buyers don’t know whether it’s a lemon or not. But potential sellers who have good cars are unwilling to sell them at a deep discount, except under exceptional circumstances. So good used cars are rarely offered for sale, and used cars that are offered for sale have a strong tendency to be lemons. (This is why people who have a compelling reason to sell a car, such as moving overseas, make a point of revealing that information to potential buyers—
Adverse selection occurs when an individual knows more about the way things are than other people do. Private information leads buyers to expect hidden problems in items offered for sale, leading to low prices and the best items being kept off the market.
The end result, then, is not only that used cars sell for low prices and that there are a large number of used cars with hidden problems. Equally important, many potentially beneficial transactions—
Although economists sometimes refer to situations like this as the “lemons problem,” the more formal name of the problem is adverse selection. The reason for the name is obvious: because the potential sellers know more about the quality of what they are selling than the potential buyers, they have an incentive to select the worst things to sell.
Adverse selection does not apply only to used cars. It is a problem for many parts of the economy—
Suppose that a health insurance company were to offer a standard policy to everyone with the same premium. The premium would reflect the average risk of incurring a medical expense. But that would make the policy look very expensive to healthy people, who know that they are less likely than the average person to incur medical expenses. So healthy people would be less likely than less healthy people to buy the policy, leaving the health insurance company with exactly the customers it doesn’t want: people with a higher-
In order to cover its expected losses from this sicker customer pool, the health insurance company is compelled to raise premiums, driving away more of the remaining healthier customers, and so on. Because the insurance company can’t determine who is healthy and who is not, it must charge everyone the same premium, thereby discouraging healthy people from purchasing policies and encouraging unhealthy people to buy policies.
As we discussed in Chapter 18, before the passage of the Affordable Care Act, adverse selection could lead to a phenomenon called an adverse selection death spiral as the market for health insurance collapsed: insurance companies refused to offer policies because there was no premium at which the company could cover its losses. Because of the severe adverse selection problems, governments in many advanced countries have assumed the role of providing health insurance to their citizens. In the United States, adverse selection in health insurance is avoided in two ways. First, U.S. government insurance programs, which provided almost half of the total payments for medical care in the United States in 2014, are financed by dedicated taxes which people cannot opt out of. Second, the ACA requires that everyone have health insurance, so healthy people cannot opt out of paying premiums.
Adverse selection can be reduced through screening: using observable information about people to make inferences about their private information.
However, adverse selection still exists in other insurance markets such as auto insurance. In general, people or firms faced with the problem of adverse selection follow one of several well-
Auto insurance companies provide a very good example of the use of statistics in screening to reduce adverse selection. They may not know whether you are a careful driver, but they have statistical data on the accident rates of people who resemble your profile—
In some cases, this may be unfair: some adolescent males are very careful drivers, and some women drive SUVs as if they were F-
Adverse selection can be diminished by people signaling their private information through actions that credibly reveal what they know.
Another strategy to counter the problems caused by adverse selection is for people who are good prospects to do something signaling their private information—
A long-
Finally, in the face of adverse selection, it can be very valuable to establish a good reputation: a used-