Essay on Market Failure: Asymmetric Information and Adverse Selection

This essay examines the economic concept of market failure, focusing on asymmetric information and its consequences, specifically adverse selection. The essay begins by defining asymmetric information and illustrates its impact through examples in the used car market, where sellers possess more knowledge about a vehicle's condition than buyers, leading to adverse selection. The essay then extends this concept to the insurance sector, highlighting how insurance companies face adverse selection because individuals may conceal information about their health or habits. The essay also explores potential solutions to adverse selection, including high premiums and deduction policies, suggesting that market failures can be mitigated even without government intervention. The assignment is based on the work of George Akerlof and provides a comprehensive overview of the problems associated with information asymmetry in markets.

Running head: MARKET FAILURE
Market Failure
Name of the Student
Name of the University
Student

1MARKET FAILURE
Table of Contents
Answer 1..........................................................................................................................................2
Answer 2..........................................................................................................................................2
Answer 3..........................................................................................................................................3
Reference.........................................................................................................................................4

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Answer 1
Asymmetric information is the phenomenon is economic concept that speaks about the
notion of information failure. It is found in mainly in the sectors where buying and selling of
product is involved (Lemmon & Zender, 2019). Therefore, there is always one with greater
information and thus the individual with more knowledge can exploit the one with less
knowledge by hiding information leading to adverse selection. In the market of used cars, the
seller of the car has more knowledge about true condition of the car than the buyers. It means
that the car may be looking in good condition from the outside but it has some engine problems
that arises after one hour of driving. Therefore, this information is available only to the seller
(Biglaiser, Murry & Zhou, 2017). Thus, if the seller want to gain more by selling the car then he
might hide the information regarding faults of e car and charge high price. On the other hand, the
buyer will judge the price of the car by its outer condition or by a small test drive which may be
insufficient to know the problem. Thus, this would lead to adverse selection.
Answer 2
Adverse selection due to asymmetric information is found in insurance sector too. In case
of insurance sector, the victim of this market failure due to adverse selection is the insurance
company. The insurance company sells insurance to individuals. The individuals can buy life
insurance, home insurance, motor vehicle insurance and many more. Considering, life insurance
for this discussion on adverse selection. The premium charged for a life insurance is based on the
health conditions and habits of an individual. However, the insurance company may test the
current health conditions and habits of the individual willing to buy insurance but cannot guess
the future habits. Suppose, the individual has plans to smoke or drink that affects the health and
may lead to severe diseases but hide those things from the insurance company. Due to this, the

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insurance company would under state the premium and thus charges low premium that will
increase the cost burden of the company in the future. Therefore, this information asymmetry
between the insurance company and the individual leads to market failure due to adverse
selection.
Answer 3
The problem of the adverse selection due to asymmetric information can be dealt with
government intervention. However, in this discussion, solution other than government
intervention is being discussed. Considering the case of insurance in this case to find the solution
for adverse selection. The insurance company can charge high premium to customers and if the
person is with high risk then it will avail the premium. In addition to that, the insurance company
can add the deduction policy at maturity if the customer get addicted to any kind of harmful
activities or habits like smoking or drinking (Handel, Kolstad & Spinnewijn, 2019). Apart from
that, the company can also add the provision of raising the premium if the customer deliberately
participates in harmful activities. Therefore, it can be inferred that the problem of adverse
selection can be solved even without government intervention.

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Reference
Biglaiser, G., Li, F., Murry, C., & Zhou, Y. (2017). Middlemen as Information Intermediaries:
Evidence from Used Car Markets (p. 5). Working Paper.
Ekeland, I., & Elie, R. (2018). An adverse selection approach to power pricing (No.
1706.01934).
Handel, B. R., Kolstad, J. T., & Spinnewijn, J. (2019). Information frictions and adverse
selection: Policy interventions in health insurance markets. Review of Economics and
Statistics, 101(2), 326-340.
Lemmon, M. L., & Zender, J. F. (2019). Asymmetric information, debt capacity, and capital
structure. Journal of Financial and Quantitative Analysis, 54(1), 31-59.