HIDDEN CHARACTERISTICS ADVERSE SELECTION AND THE LEMONS PROBLEM

Adverse selection is a problem that arises in markets where the seller knows more about the attributes of the good being sold than the buyer does. In such a situation, the buyer runs the risk of being sold a good of low quality. That is, the “selection” of goods sold may be adverse from the standpoint of the uninformed buyer.

The classic example of adverse selection is the market for used cars Sellers of used cars know their vehicles’ defects while buyers often do not. Because owners of the worst cars are relikely to sell them than are the owners of the best cars, buyers are apprehensive about getting a “lemon.” As a result, many people avoid buying vehicles in the used car market. This lemons problem can explain why a used car only a few weeks old sells for thousands of dollars less than a new car of the same type. A buyer of the used car might surmise that the seller is getting rid of the car quickly because the seller knows something about it that the buyer does not A second example of adverse selection occurs in the labor market. According to another efficiency wage theory, workers vary in their abilities, and they may know their own abilities better than do the firms that hire them. When a firm cuts the wage it pays, the more talented workers are more likely to quit knowing they are better able to find other employment. Conversely, a firm may choose to pay an above equilibrium wage to attract a better mix of workers A third example of adverse selection occurs in markets for insurance. For example, buyers of health insurance know more about their own health problems than do insurance companies. Because people with greater hidden health problems are more likely to buy health insurance than are other people, the price of health insurance reflects the costs of a sicker-than-average person. As a result, people in average health may be discouraged from buy health insurance by the high price When markets suffer from adverse selection, the invisible hand does not necessarily work its magic In the used car market, owners of good cars may choose to keep them rather sell them at the low price that skeptical buyers are willing to pay. In the labor market, wages may be stuck above the level that balances supply and demand, resulting in unemployment. In insurance markets, buyers with low risk may choose to remain uninsured because the policies they are offered fail to reflect their true characteristics Advocates of government-provided health insurance sometimes point to the problem of adverse selection as one reason not to trust the private market to provide the right amount of health insurance on its own.

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