Questions: Information Asymmetry and Adverse Selection

Question 1

In a used car market with asymmetric information, buyers offer a price based on expected average quality. High-quality sellers refuse to sell at that price. What most likely happens next?

• A. The market stabilizes at the average price, since buyers and sellers have agreed on it
• B. Average quality rises as only patient, high-quality sellers remain and wait for better offers
• C. Average quality in the market falls, causing buyers to lower their offer, which drives out more quality sellers — a self-reinforcing downward spiral
• D. Buyers raise their offer to attract high-quality cars back, restoring efficient trade

Answer: (C)

This is Akerlof's adverse selection spiral. When buyers offer an average price, high-quality sellers (whose cars are worth more than average) exit the market. The remaining pool is now lower quality on average. Rational buyers lower their offer to match this new lower expected quality. This drives out more of the remaining higher-quality sellers, lowering average quality further. The process continues until potentially only lemons are traded — or the market collapses entirely. Buyers cannot respond by raising prices because that would attract lemons, not peaches.

Question 2

Employees with chronic health conditions disproportionately enroll in a company's most comprehensive health insurance plan, while healthy employees opt for the basic plan. This is best described as:

• A. Moral hazard — coverage changes people's behavior after they are insured, leading to overuse
• B. Adverse selection — private information held before enrollment causes high-cost types to self-select into more coverage
• C. Signaling — choosing comprehensive coverage signals that the employee values their health
• D. Screening — the employer designed the plan menu to separate employee types by health status

Answer: (B)

Adverse selection occurs before the transaction: the enrollment decision is made using private information (the employee's health status) that the insurer cannot fully observe. Sicker employees know they will need more care, so they value comprehensive coverage more and select into it. Moral hazard, by contrast, refers to behavioral changes after coverage is in place (e.g., visiting the doctor more because it's now free). Both exist in insurance markets, but this scenario describes a selection effect, not a behavioral change.

Question 3

Adverse selection occurs before a transaction is completed, when private information held by one party causes a systematic bias in who chooses to trade.

• T. True
• F. False

Answer: True

The timing is the defining feature: adverse selection is a pre-contractual problem. The 'selection' happens when the market price attracts a disproportionate share of the worst types — sellers of lemons, sicker insurance buyers, riskier loan applicants. The uninformed party cannot distinguish types at the point of transaction, so any single price selects for the adverse end of the quality distribution.

Question 4

Adverse selection and moral hazard both describe post-transaction behavioral changes caused by information asymmetry.

• T. True
• F. False

Answer: False

Adverse selection is a pre-transaction problem: it concerns who enters the market, not how they behave afterward. Moral hazard is the post-transaction problem: once insured, covered, or hired, a party may change behavior because they no longer bear the full consequences of their actions. Confusing the two leads to misdiagnosed market failures and wrong policy responses.

Question 5

Why does offering a warranty on a used car help solve the adverse selection problem, and what makes it a credible signal?

Model answer: A warranty is credible because it is much cheaper for sellers of high-quality cars to offer than for sellers of lemons. A lemon seller faces high expected warranty costs (frequent repairs under the warranty), making it prohibitively expensive to offer. A peach seller faces low expected warranty costs, so they can offer the warranty at little cost. Buyers understand this incentive structure: only sellers who believe their car is reliable would offer a warranty. The warranty thus separates types — it credibly signals quality precisely because it is costly to fake.

The key to credible signaling is that the signal must be differentially costly: cheap for the high-quality type and expensive for the low-quality type to mimic. If a lemon seller could offer the same warranty at the same cost, the signal would carry no information. The self-selection logic — only peach owners voluntarily take on warranty liability — is what makes the signal informative.