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How might adverse selection make it difficult for an insurance market to operate?
Adverse selection is a problem that arise because of asymmetric information where the buyersdo not have complete information and so they feel that sellers may cheat them so they try to paless assuming that goods in market are lemon. Now, when people are paying less for all thegoods then actually good goods will go out of market and market will be left with lemons only.
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Chapter 16
Information, Risk, and Insurance
How Markets Work
Markets and Welfare
The Economics of the Public Sector
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recall that adverse selection is when people who have inherently higher risk seek out insurance. What is the effect that this will remember that insurance is based on average? Is, in other words, they look at all of the people in a particular population, and they say, Okay, there are people who are very risky there, people who have almost no risk their people in the middle. They develop a mathematical model that can give them the average risk, and that's how they develop premiums. But what if the vast majority of people who are inherently risky buy insurance well, that's going to severely strained the system. How exactly is that going to happen? Well, you're going to have a certain amount of money. Let's say that is paid in premiums. And if this system was actuarially fair than the amount of payments should be roughly equal, right, and if it's actually fair, would be exactly equal. But in the real world, it should be roughly equal with some profit for the insurance company. But what is this based on? This is based on again the average person. But what if the average person is not who's primarily buying insurance What if it's primarily risky people, You're going to have a huge amount of payments relative to premiums, and that is going to make it very, very difficult for the insurance market to operate because insurers now don't know how much to actually charge in premiums because they don't know the kind of people that are actually buying insurance.
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