Multiple Choice
Where there is asymmetric information between buyers and sellers, which of the following is most likely to occur?
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17. Asymmetric Information, Voting, and Public Choice
Asymmetric Information: Adverse Selection and Moral Hazard
Multiple Choice
Which of the following actions best illustrates adverse selection?
A
An insurance company offers health insurance without requiring a medical exam, attracting mostly unhealthy individuals.
B
A car owner drives more recklessly after purchasing comprehensive auto insurance.
C
A bank monitors borrowers closely to ensure loan repayment.
D
A firm provides bonuses to employees based on observable performance metrics.
Verified step by step guidance1
Understand the concept of adverse selection: it occurs when one party in a transaction has more information than the other, leading to a selection of undesirable or higher-risk participants by the less-informed party.
Identify the key feature of adverse selection: it typically happens before a contract or agreement is made, where hidden information about risk or quality influences who participates.
Analyze each option to see which one involves hidden information leading to a selection problem before the contract is finalized.
Recognize that offering health insurance without a medical exam allows individuals with higher health risks (unhealthy individuals) to self-select into the insurance pool, which is a classic example of adverse selection.
Contrast this with moral hazard (like reckless driving after insurance), monitoring (bank overseeing borrowers), and performance-based bonuses, which relate to different economic concepts.
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