Adverse Selection


Adverse selection occurs when individuals have hidden characteristics which make make them undesirable and a selection process has occurred in which individuals with these undesirable hidden characteristics have been selected resulting in an undesirable selection of individuals.

Take, for example, a college which makes its entrance decisions based solely on high school GPA. The school believes that those with high GPAs are motivated learners and will add value to the campus. All high schools and classes within those high schools are not created equal. Some are much more difficult and challenging than others. The college has no way to determine which schools and classes have more educational merit than others. The students know however. Due to this situation, students who do not want to work hard and are not interested in learning but take easy classes will have higher GPAs than motivated students with intellectual curiosity who will most likely take harder courses and therefore get lower grades. This results in motivated students not being admitted and the college recruiting students who are not there for learning but only to get a degree and who will add little value to the campus.





Questions


1. An insurance company which sells car insurance to people __ will experience adverse selection.
(A) who own bicycles
(B) with past accidents
(C) who drive sedans
(D) None of the above


#1 Answer: B. with past accidents
The insurance company has no way of knowing whether the past accidents are the result of poor driving or bad luck. The customers of the insurance company will know this information however. Due to the increased chance of a future accident the insurance company will have to charge large premiums to cover costs. The only people who will be willing to pay this are the people who know they are more likely to be in another accident because they are bad drivers. Therefore the company will experience adverse selection.