Adverse selection

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Adverse selection (Engl. Adverse selection ), and adverse selection or adverse selection , in the area of life insurance and adverse selection , referred to in the New Institutional Economics a process in which it is in a market due to information asymmetry is systematically to results that are not Pareto optimal are.

The first basic model for this was developed in 1970 by George A. Akerlof , who used the example of the used car market to show how the desired providers are displaced (the so-called Lemons problem , English for the problem of Monday cars ). For this, Akerlof was awarded the Nobel Prize in Economics in 2001, together with Michael Spence and Joseph E. Stiglitz .

Information asymmetry

In microeconomic contract theory, a distinction is made between the existence of information asymmetry before and after the conclusion of a contract. The problem of adverse selection concerns asymmetrical information prior to the conclusion of the contract; for the problem of asymmetrical information after the conclusion of the contract, see moral hazard . Information asymmetry occurs when there is different information between two economic subjects, i.e. one has a knowledge advantage over another. According to the principal-agent theory , the agent (contractor) has a knowledge advantage over the principal (client), which is why the agent can only assess the agent's performance to a limited extent, which also means that he can benefit from these resources, and The reason is why he hires the agent. In everyday practice, the seller usually has a knowledge advantage over the buyer because he is trained in product knowledge and is supposed to advise the buyer.

Example for simplification

There are two goods to choose from, the quality of which is different - but only the supplier knows the difference in quality, not the customer. Since the goods do not differ from the customer's point of view, he chooses the cheaper one. This will be the worse, because precisely because of the lower quality, the provider is willing to offer it cheaper. In this way, only goods of poor quality are traded, because those of good quality cannot be recognized by the customer and is therefore not prepared to pay more accordingly.

Even if buyers are willing to buy the better good at a price that is acceptable for suppliers of a good of high quality, this trade does not take place because of the information asymmetry, although both supplier and buyer would like to trade.

Akerlof's Lemons Problem

On a market for used cars, both good and bad cars ("Lemons"; corresponds roughly to the term " Monday cars" in German ) are offered. The information about the quality of the vehicles is, however, distributed asymmetrically. Only the sellers know the quality of the cars on offer, the buyers don't.

Since the buyer cannot determine a difference between good and bad models, he will form an expected value for the quality that lies between good and bad quality and derive his reservation price from this, i.e. the maximum price he is willing to pay.

There is therefore no contract for the good cars whose minimum sale price, i.e. the reservation price of the provider, is above the maximum of the buyer. For the sellers of “Lemons”, however, the sale is attractive because their minimum selling price is below the buyer's maximum. The good providers are therefore forced out of the market, and in the end only bad used cars are offered.

Insurance markets

In the insurance market, there is an information asymmetry between insurers and policyholders. The insurers use the means available to limit this information asymmetry. For example, insurance contracts provide for detailed information requirements, various contract menus ( deductibles, etc.) are offered, etc.

A model for equilibrium in insurance markets with incomplete information was designed in 1976 by Michael Rothschild and Joseph E. Stiglitz .

example

Note: In the following, risk-neutral principals and agents are assumed. This is unusual, but it is easier to show and does not change the basic statements of the model.

An insurer V would like to offer health insurance . Two (equally large) groups of people A and B come into question as customers. While group A is very health-conscious and anticipates health costs of 50 euros per year, people in group B are heavy smokers and overweight. This group expects health costs to be 150 euros per year.

If the insurer cannot differentiate between the two groups a priori, it would calculate the expected value (plus a profit mark-up that is neglected here) and offer the insurance at this price (here 100 euros). For 100 euros, however, the health-conscious are not ready to take out health insurance. You therefore “insure” yourself and bear any costs that may arise yourself. Since only people from group B take out the insurance, this tariff can no longer be financed, the insurer must increase the price to at least 150 euros.

However, this situation is unfavorable for the people in Group A. Even if they would like to take out insurance, they cannot (or only at a very high cost). The insurer would also have an interest in offering group A people a contract. For this reason there are many different tariffs with private health insurances, for example with different deductibles and the like. Ä.

Taxes

If several countries with different tax systems are in competition with one another, adverse selection effects can also arise.

example

State A has a head tax system in which every citizen has to pay a flat rate of 100 euros in taxes. State B has a progressive income tax where the poorest do not have to pay anything, but the richest have to pay 200 euros. Before the borders between the states are opened, both budgets are in balance.

Political events lead to the opening of the borders between the states, so that the citizens of both states can freely search for their place of residence. All citizens who pay more than 100 euros in taxes under the tax regime of State B will tend to move to State A, and all citizens who have previously paid 100 euros in State A and would have to pay less in State B will be in State Pull B. As a result, State B cannot maintain its tax system because everyone who has paid more than 100 euros so far has emigrated and it is no longer generating sufficient income.

socialsystem

Similar arguments apply to funding social security measures:

These measures are borne by the above-average paying part of the respective population, who are not currently using these services themselves and may not have any direct interest in the services provided. If several states are in competition with one another, there may be a race to undercut between these states:

  • A high level of social benefits attracts those who receive these benefits.
  • The costs for this level must be borne by the providers (= net payers) of these services. However, these costs have a deterrent effect on this group.

In this way, according to the theory, a state systematically attracts recipients of social benefits, but displaces that part of the population who could pay for these benefits. The theory fails to take into account that the level of social benefits may only be one of many factors and not the only factor that determines whether someone changes country.

The economist Hans-Werner Sinn describes this process as the “selection principle”. If states are in system competition with one another, they are not in a position in the long term to maintain redistributive social systems. The state of New York is often cited as an example: New York had to abolish introduced high social benefits after the systematic immigration of poor people from other states of the USA in order to avoid bankruptcy. This pressure, triggered by migration, also explains why there is no social security system comparable to Germany or other European states in America, which is more federally structured in this respect : Even if individual states or even the entire nation wanted this, the undercutting race of the others leads States that the provision of these services is not possible.

On the occasion of the EU's eastward expansion in 2004 , this problem was discussed again in Germany. However, certain freedoms for citizens of the candidate countries are restricted for a longer period of time.

possible solutions

Various measures are available to prevent this information asymmetry from resulting in a suboptimal trading volume:

Signaling or signaling
The informed market participants (in the Lemons example: the used car sellers) try to reduce the information asymmetry. Here the providers of good cars have an interest in credibly differentiating themselves from the providers of bad cars. In doing so, they incur costs to produce a signal, for example a DEKRA / TÜV used car seal, etc. The advantages of signal production must be greater than the costs. See also principal-agent theory # Problems encountered .
Screening (also self-selection )
Suitable contract menus are offered so that the good providers and the bad providers choose different contracts. For example, the good vendors could offer a warranty cheaply , while the bad vendors would be too expensive, so any seller willing to offer a warranty would automatically be a good vendor. Another example are full and partial insurance contracts. The insurance premiums for full insurance are disproportionately more expensive compared to partial insurance. Good risks with a low probability of damage voluntarily choose partial insurance, while bad risks prefer full insurance despite the higher price. The insurance company "filters" (to screen) the good risks from the bad ones.

However, these “possible solutions” always come at a cost, so that the result achieved does not correspond to the market equilibrium with complete information and is therefore welfare suboptimal (second best).

(see also the general description under: Information asymmetry )

Furthermore, the use of intermediaries (trade brokers) can reduce the information asymmetry between providers and buyers. Using economies of scale, the intermediary assumes the costs of signaling and screening. For example, the intermediary can distribute the costs of obtaining information to a very large number of customers. Since the customers can achieve considerable cost savings by using the intermediation service, they are prepared to reward the intermediary with a commission.

literature

Individual evidence

  1. ↑ Paul Milgrom and John Roberts; Economics, Organization and Management - Prentice Hall (1992) ISBN 978-0-13-223967-7
  2. ↑ Akerlof, GA : The Market for “Lemons” , in: Quarterly Journal of Economics, Vol. 84, No. 3. (August 1970), pp. 488-500
  3. ↑ Michael Rothschild and Joseph E. Stiglitz (1976): Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information. The Quarterly Journal of Economics, 90 (4), 629-649. Retrieved from http://www.jstor.org/stable/1885326
  4. ^ Oates, W. E., Fiscal Federalism, 1972
  5. ^ Wallace E. Oates: Fiscal Federalism , New York et al. a .: Harcourt Brace Jovanovich, 1972