company). On the other side, someone who knows that she is at low risk
and pays a higher price than the amount warranted by her risk is
motivated to take out less insurance than she otherwise would. In this
case, her private cost (her insurance premium) is more than the total cost
(the expected insurance payout). In both cases, resources are allocated
inefficiently because the marginal private benefit of purchasing insurance
is not equal to the marginal cost of providing it.
An excellent and familiar example of market failure caused by asymmetric
information and adverse selection is the apparent overdiscounting of the
prices of used cars because of the buyer’s risk of acquiring a “lemon.” See
the discussion of this problem in Applying Economic Concepts 16-2.
Applying Economic Concepts 16-2
Used Cars and the Market for “Lemons”
It is common for people to regard the large loss of value of a
new car in the first year of its life as a sign that consumers are
overly style conscious and will always pay a big premium for
the latest in anything. Professor George Akerlof of the
University of California at Berkeley suggests a different
explanation. His theory, contained in his now-famous paper
“The Market for Lemons,” is based on the proposition that the
flow of services expected from a one-year-old car that is
purchased on the used-car market will be lower than that