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Wednesday, January 12, 2005

A great explanation of adverse selection...

Adverse Seleciton is a perplexing issue for many professional economists, so I have sympathy for those who don't understand the fancy term thrown about by pundits and academics. Nevertheless, the idea is simple and if couched in the right words, relatively easy to understand. I found this explanation in a recent Dallas Fed article on health insurance in the United States.

What Is Adverse Selection?

An overwhelming proportion of Americans obtain their health care coverage through their jobs. Understanding why involves grasping the concept of adverse selection, which affects the market for most insurance products.

Adverse selection was propounded by Nobel Prize winner George Akerlof in his seminal article "The Market for 'Lemons.'"[1] Imagine that insurers lack the ability to determine the exact health status of individuals and set an average price for a particular group of individuals. The average price would be most attractive to people who face the highest health risks. If the group consists of an above-average number of unhealthy individuals, the insurer would be forced to increase the price. The healthy individuals would then opt out, driving up the price even further. This can lead to a never-ending spiral of rising prices and market instability. In the worst form of adverse selection, a market may not even exist.

A solution to adverse selection in the private health insurance market is to cover groups of individuals not selected on the basis of health.[2] Workplaces, it turns out, are a very efficient mechanism to pool health insurance risk, so employer-sponsored insurance has come to dominate U.S. private health coverage. Nongroup or directly purchased health insurance cannot guard against the adverse selection that can be devastating for insurance markets. As a result, the cost of obtaining nongroup insurance is substantially higher than that available through the employer.

1. "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism," by George A. Akerlof, Quarterly Journal of Economics, vol. 84, no. 3, 1970, pp. 488–500.
2. Another solution to the problem is to induce individuals to self-select into an insurance plan based on their health type.

My note: The "lemons" market is easily understood in the case of used cars. Assume two types of cars, lemons and non-lemons. Which are most likely to be sold in the used market? The lemons, because the non-lemons are worth holding onto.

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