Information economics I: Adverse selection

Adverse selection is a case of asymmetric information. It occurs when both parties assign or are subject to a different probability of a same (normally adverse) event occurring. In this case, the agent that has the best information is clearly at an advantage. We say that this advantage is ex-ante because, contrary to moral hazard, the advantage occurs before the ‘contract’ (real or otherwise) is signed.

In order to clarify this concept, let’s take a quick look at an example: insurance premiums. The person taking out an insurance policy is at an advantage versus the insurer, who therefore charges a premium for the risk derived from their imperfect information, aside from any mark-up designed purely in order to generate benefits.

Lucy takes out a health insurance plan but ‘forgets’ to tell the insurer that she has been a heavy smoker, drinker and lunatic driver for 50 years. Lucy knows that her probability of contracting heart or lung disease is significantly greater than the national average. The insurance company does not know that she is a hell raising grandmother and base their calculation for her premium based on the probability of an average person being hospitalised for a long stay, an average person who is probably much younger and much healthier than Lucy. Lucy’s advantage is ex-ante. At the same time, healthy Hanna who is 30 will be put off by the price of the premiums because of people like Lucy and will probably never subscribe to a policy.

Of course, insurance companies have ways of getting around this to a certain extent. But an insurance company is never going to be able to segment their policies fully: when was the last time you were asked about your driving style when subscribing to a dental plan? And most sane people won’t risk their life just because their healthcare is covered (in fact, most countries with a free, national health service have longer life expectancies and shorter hospital stays than countries that don’t), but how many of us park our friend’s car more carefully because we are not insured in it?

There are ugly consequences deriving from this example, which can be generalised to markets other than the insurance market, as seen in The Market for Lemons, an article by George Akerlof, or in the article about credit rationing by Joseph E. Stiglitz and Andrew Weiss. Since people like Hanna are asked for premiums higher than the ones they would get with perfect information, this people will decide not to take insurance. The lack of healthy and careful people will make the ‘average person’ considered by insurers be less healthy and careful, which will force insurers to raise premiums. This will encourage people healthier than this ‘average person’ to stop paying insurance, which would start the process all over again. Theoretically, the healthcare insurance market would disappear, since no one wants to pay premiums that high.