Information gaps and adverse selection
| English | 中文 | Pinyin |
|---|---|---|
| asymmetric information/ˌeɪsɪˈmetrɪk ˌɪnfəˈmeɪʃn/ | 信息不对称 | xìn xī bú duì chēng |
| adverse selection/ædˈvɜːs sɪˈlekʃn/ | 逆向选择 | nì xiàng xuǎn zé |
A decision you can investigate
- An insurer may not observe each applicant’s risk as well as the applicant does. A pension buyer may not understand a fee shown in the small print.
- A missing fact matters through the choice it changes.
Build the explanation
- With symmetric information, parties have comparable relevant knowledge; both can still face uncertainty. Asymmetric information 信息不对称 occurs when one party knows more of the information relevant to the transaction. A broader information gap can cause a consumer to underestimate costs or benefits even when no seller deliberately conceals them.
- Adverse selection 逆向选择 arises before a contract when hidden characteristics influence who chooses it. A pooled insurance price can attract higher-risk applicants and drive lower-risk applicants away. Moral hazard is different: incentives change after protection is obtained, affecting behaviour rather than merely selecting types.
Work through the evidence
- Fictional applicants have expected claims of 200 or 800 currency units per year; initially half are each type. Expected pooled claims=(200+800)/2=500. Ignore administration and profit for this example. If low-risk applicants reject a premium of 500 because their expected claim is 200, only high-risk applicants remain and expected claims rise to 800.
- This selection story assumes applicants know their type and make the stated choice. Insurance also transfers risk; expected claims alone do not determine willingness to pay. For a separate pension case, an unrecognized fee of 1% on a balance of 10000 is 100 in the stated year, before returns. A repeated percentage fee acts on changing balances, so multiplying 100 by the number of years is not a general projection.
What is the initial pooled expected claim?
With equal type shares, the mean is 500.
Test the limits
- Health decisions can omit treatment risks or long-term prevention benefits; education choices can misjudge course quality or returns; pension choices can omit fees, inflation or withdrawal restrictions. Explain which fact is missing and how the decision changes, rather than asserting that all consumers are uninformed.
- Disclosure, independent advice, quality standards or risk assessment may help, but comprehension, cost, privacy and unequal access matter. There can be legitimate limits on information collection. A price change alone cannot tell us whether selection, uncertainty or moral hazard caused an observed outcome.
If only high-risk applicants remain, what is their expected claim in this case?
The remaining type has expected claims of 800.
Adverse selection and moral hazard refer to identical mechanisms.
Selection concerns hidden types entering contracts; moral hazard concerns changed incentives under protection.
Apply and explain your answer
- Distinguish the insurer’s selection problem from a policyholder taking fewer precautions after buying cover.
- Hidden risk types influence who buys cover before contracting; reduced precautions after cover reflect changed incentives and moral hazard.
Which describes symmetric uncertainty?
Shared uncertainty need not be an information asymmetry.
Use the terms precisely
- asymmetric information: One party has more relevant information than another in a decision or transaction.
- adverse selection: Hidden characteristics affect who enters a transaction, potentially worsening the pool.
Match the terms to their meanings.
Use each term for its stated economic relationship.
Fictional applicants have expected claims of 200 or 800 currency units per year; initially half are each type. Expected pooled claims=(200+800)/2=500. Ignore administration and profit for this example. If low-risk applicants reject a premium of 500 because their expected claim is 200, only high-risk applicants remain and expected claims rise to 800. This selection story assumes applicants know their type and make the stated choice. Insurance also transfers risk; expected claims alone do not determine willingness to pay. For a separate pension case, an unrecognized fee of 1% on a balance of 10000 is 100 in the stated year, before returns. A repeated percentage fee acts on changing balances, so multiplying 100 by the number of years is not a general projection.
Health decisions can omit treatment risks or long-term prevention benefits; education choices can misjudge course quality or returns; pension choices can omit fees, inflation or withdrawal restrictions. Explain which fact is missing and how the decision changes, rather than asserting that all consumers are uninformed. Disclosure, independent advice, quality standards or risk assessment may help, but comprehension, cost, privacy and unequal access matter. There can be legitimate limits on information collection. A price change alone cannot tell us whether selection, uncertainty or moral hazard caused an observed outcome.
With symmetric information, parties have comparable relevant knowledge; both can still face uncertainty. Asymmetric information occurs when one party knows more of the information relevant to the transaction. A broader information gap can cause a consumer to underestimate costs or benefits even when no seller deliberately conceals them.