18.2 Reducing Adverse Selection

Because adverse selection results from one party exploiting asymmetric information about a hidden characteristic, the two main methods for solving adverse selection problems are to equalize information among the parties and to restrict the ability of the informed party to take advantage of hidden information. Responses to adverse selection problems increase welfare in some markets, but may do more harm than good in others.

Equalizing Information

Providing information to all parties eliminates adverse selection problems. Either informed or uninformed parties can act to eliminate or reduce informational asymmetries. Three methods for reducing informational asymmetries are:

  1. An uninformed party (such as an insurance ...

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