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Adverse selection

A form of asymmetric information in which one side of the market has more information regarding the transaction of a product than the other side of the market. creating a form of market failure. The most commonly used example of adverse selection is the market for second-hand cars, in which sellers have superior knowledge of the true quality of the car over the car buyers. Creating a market with only low-quality cars.

However, there are also instances in which the buyers can have more information than the sellers. For instance, in the insurance market, buyers of insurance have superior information about their true health characteristics and future behaviour patterns than the insurance provider. This leads to the risk that an insurance product is more likely to attract high-risk than low-risk customers e.g. unhealthy people are more likely to take out health insurance policies.

This form of asymmetric information can only be removed if there are appropriate screening (health checks on the buyer of health insurance) or signalling (warranties on the second-hand cars to verify their quality) policies in place to correct the market failure.


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