Adverse Selection

With health care reform in the news, there’s been quite a bit of talk about adverse selection and the degree to which it is actually a problem in health care and health insurance markets. Some people have even gone so far as to question whether significant adverse selection effects exist at all outside of textbooks since when they look at the marketplace, they have a hard time finding it.

But the thing is, if you go looking for it in the marketplace, you aren’t likely to find it. Unless the problem has been largely overcome either the government intervention or the through private sector institutions constructed to fix the problem (generally intermediaries who can solve the information problem that generates the market failure), the market will fail to exist at all. So you will either observe a fairly well-functioning market that has overcome the problem, or you won’t see a market at all.

So if you want evidence of adverse selection, you should look for the institutions designed to overcome the problem – used car dealers with the expertise needed to overcome the one-sided information problem on car quality, and then issue quality guarantees (or develop a reputation for quality) acting as intermediaries, that sort of thing – and those types of intermediaries are easy to find. Evidence of the institutions needed to overcome adverse selection – and evidence thqat the problem exists – aren’t hard to find. Furthermore, very often government intervention isn’t needed, the market can solve this on its own.

And the market will solve it on its own in the case of health care, but we may not like the solution the market comes up with. First, it violates our sense of equity since the solution will be to prevent people with conditions that show up with genetic testing, or are preexisting, etc., from getting insurance. But we will still have to provide for them, we can’t just abandon them to suffer when help can be provided. It’s one thing if someone cannot sell their car due to market failure, it’s quite another if they cannot get the medicine or care they need to maintain their health. So the private sector solution may not be morally acceptable. Second, because we have to provide for the sick in any case, the resources that are devoted to excluding people are wasted resources, all that happens is that the problem is shunted off to a generally more expensive option.

So it’s not that the private sector cannot solve this problem at all, that’s not why we need government to intervene, it’s that the solution the market imposes violates our moral sensibilities and wastes resources that could be used more productively.

About Mark Thoma 243 Articles

Affiliation: University of Oregon

Mark Thoma is a member of the Economics Department at the University of Oregon. He joined the UO faculty in 1987 and served as head of the Economics Department for five years. His research examines the effects that changes in monetary policy have on inflation, output, unemployment, interest rates and other macroeconomic variables with a focus on asymmetries in the response of these variables to policy changes, and on changes in the relationship between policy and the economy over time. He has also conducted research in other areas such as the relationship between the political party in power, and macroeconomic outcomes and using macroeconomic tools to predict transportation flows. He received his doctorate from Washington State University.

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