Microeconomics: Theory and Applications with Calculus, 4e

18.1 Adverse Selection

One of the most important problems associated with adverse selection is that consumers may not make purchases to avoid being exploited by better-informed sellers. As a result, not all desirable transactions occur, and potential consumer and producer surplus is lost. Indeed, in the extreme case, adverse selection may prevent a market from operating at all. We illustrate this idea using two important examples of adverse selection problems: insurance and products of unknown quality.

Insurance Markets

Hidden characteristics and adverse selection are very important in the insurance industry. Were a health insurance company to provide fair insurance by charging everyone a rate for insurance equal to the average cost of health ...