ADVERSE SELECTION

2019 DECEMBER II
In which of the following products, the problem of adverse selection is encountered?
1. Market of insurance
2. Market of credit
3. Neither 1 nor 2
4. Both 1 and 2

Ans: 4, both 1 and 2
Adverse selection describes circumstances in which either buyers or sellers have information that the other group does not have. In these cases, when these two groups are informed to different degrees, this is known as asymmetric information. In the case of Adverse Selection, the information is asymmetric even before the contract is signed.
It generally refers to a situation in which sellers have information that buyers do not have, or vice versa, about some aspect of product quality—in other words, it is a case where asymmetric information is exploited. Asymmetric information, also called information failure, happens when one party to a transaction has greater material knowledge than the other party. Typically, the more knowledgeable party is the seller. Symmetric information is when both parties have equal knowledge.
In the case of insurance, adverse selection is the tendency of those in dangerous jobs or high-risk lifestyles to purchase products like life insurance. In these cases, it is the buyer who actually has more knowledge (e.g., about their health). To fight adverse selection, insurance companies reduce exposure to large claims by limiting coverage or raising premiums.
Naturally, the result is that one party has a consistent advantage over the other, which leads to inefficiency in the price of goods/ services within the market. It leads to ill-informed, poor decisions on the part of either buyers or sellers. Adverse selection occurs when one party in a negotiation has relevant information the other party lacks. The asymmetry of information often leads to making bad decisions, such as doing more business with less-profitable or riskier market segments. In the case of insurance, avoiding adverse selection requires identifying groups of people more at risk than the general population and charging them more money. For example, life insurance companies go through underwriting when evaluating whether to give an applicant a policy and what premium to charge.
Similar is the case with the credit market. The lender might not be in a position to exactly determine the creditworthiness of the borrower unless revealed exactly by the borrower. This asymmetry in the levels of information present in the market can lead to bad decisions such as lending credit to a borrower with a low credit score, which can prove to be riskier for the lender and can lead to inefficiency in the market.