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Asymmetric Information 585

Adverse selection also operates in health insurance markets. For many of

the elderly, medical insurance is unavailable or very expensive. Why? Elderly

people in poor health are much more likely to purchase insurance; thus, the

proportion of this group in the insured pool increases, forcing up premiums.

(The increased premiums may induce the most healthy, elderly people to drop

their coverage, further worsening the proportions.) One way to contain adverse

selection is to limit or eliminate consumer discretion. For instance, under its

health care law, the state of Massachusetts requires all citizens to purchase

health insurance or to pay a fine. Since all citizens buy insurance, insurers do

not have to worry that only the unhealthy will sign on. The federal government

has adopted a similar strategy under the Patient Protection and Affordable

Care Act of 2010. (However, the provision for universal coverage is under chal-

lenge.) By subsidizing medical care for residents over 65 years of age, Medicare

achieves the same goal of universal coverage. (Because care is effectively free

to the user, all citizens opt in regardless of their health status.)

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STATION 1

Used-car dealers serve as middlemen, procuring large numbers of vehicles from many

sources and reselling them to the public. Is adverse selection present when the dealer

buys vehicles? When the dealer sells vehicles? In each case, what measures might the

dealer take to mitigate adverse consequences?

Signaling

In the presence of asymmetric information, managers gather information to

better gauge risks. For instance, auto insurers place drivers into different

risk classes according to past driving record (as well as age and gender) and

set premiums accordingly. A used-car buyer might have a licensed mechanic

thoroughly check out a prospective purchase. Banks and other lenders

devote significant time and resources to assessing borrowers’ computerized

credit histories. By obtaining better information (albeit at a cost), the man-

ager can go a long way toward reducing or even eliminating the problem of

adverse selection.

Asymmetric information poses a problem for the informed party as well.

For instance, a seller may know he or she has a high-quality used car but may

be unable to sell it for its true value due to adverse selection. Similarly, an indi-

vidual who cannot prove he or she is a good credit risk may have to pay the

same (high) interest rates as high-risk candidates. In general, “high-quality”

individuals wish to distinguish themselves from their “low-quality” counterparts.

They can do this in several ways. One way is by developing a reputation. For

example, a seller may seek to build and maintain a reputation for delivering

high-quality goods and services. A business that depends on repeat purchases

and word of mouth will find its long-term interest served by accurately repre-

senting the quality of its goods.

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