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Adverse Selection tells us how asymmetrical information to the buyers or the sellers leads them to make decisions. It tells how these decisions lead to adverse selection or bad outcomes. Let us take the case of the health insurances in the market and study further.
The Market Scenario
It is known to all that these health insurance schemes are primarily for sick but they also target the all as all individuals can fall sick. It should be noted that not all are sick who apply for the insurance. There are a number of healthy people, few are not who apply for the media claims. Among these people, some try hard and take care of their health while the others do not do so. The insurance providers do not have much information to which they are providing their service.
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The Market Scenario:
a) First, important thing is that there are two qualities of health in this market. There are those who exercise and eat healthy in order to remain fit and healthy. On the other hand, the sickly people would be the ones who do not eat their meals properly or do not exercise. They may even be engaged in consuming alcohol or tobacco.
b) The insurance providers do not provide service until they become their customers. They would take equal chances on each customer till they are aware of their health status. But when it comes to healthy people they would need their health expenses to below but while the others need more.
c) The main thing would be that the customers themselves would know if they are healthy or not and in accordance they can take up the schemes.
The Role of the Insurance Provider
The insurance provider thinks wisely and requires all to pay a price that would be an average for the healthy and the sickly. For example, the healthy would need $100 and the sickly need $100. Let us consider he would have 100 customers, and then he would consider half to be healthy and half sick. Then the average would be $550 which he would make all the customers pay him.
But what happens in the case of voluntary health insurance is that when something like this is charged, the sick would be ready to pay as they would save a lot of money. The healthy would not take up the insurance as they would lose money out of it. This is the reason why many of the health insurances are mandatory.
There are two possible solutions for the adverse selection cases. It can be signaling and screening.
a) Signaling: This would be indicated by the customers’ small information that would lead them to more data. It can be in the form of the brand name, advertising, and more. Though they may not be accurate, they are helpful in most cases.
b) Screening: This would be removing the products of low quality, like in the case of an employer who uses grade points.
Related Problems would be the moral hazards associated and also the Principal-agent problems.