Adverse selection is so the problem

Alex Tabarrok at Marginal Revolution claims that Adverse selection is NOT the problem. This is not surprising given his enthusiasm for Markets Everywhere. Most of the comments address the empirical aspects of one particular case, which is the insurance industry. But while I can’t get at the papers he references (they are behind the institutional subscriber firewall) I think there is a more general issue here about asymmetric information.

For me, the key line in the post is this:

You can buy a decent used car, for example just get it inspected or certified. Only if such adjustments are illegal, or in some other way not allowed, will adverse selection become important.

But the whole thing about asymmetric information is surely that information is not non-existent, but it is costly. No one thinks that the lemons scenario is more than a first-order approximation, and signalling and screening make second-order corrections, but the problem may still remain and be important. The information problem becomes central to the whole practice of the industry, as anyone reading an insurance contract will know. Alex Tabarrok is very close to saying that costs can be neglected as long as adjustments are "illegal, or in some other way not allowed". This claim that transaction costs are unimportant seems to be one of the dividing lines between market enthusiasts (AT) and market sceptics (me).

What is more, there is often a collective action problem in obtaining that information that is particularly important when the buyers are those who are ill-informed. When the seller is ill-informed, it may be the case that they can compensate: I think that Alex Tabarrok is right that, for example, the insurance company knows as much about my life expectancy as I do, and I know considerably less about the details of my coverage than they do. I would say that in this case overcoming asymmetric information becomes a fixed
cost, leading to economies of scale in the insurance industry (which at
least in Canada is an oligopoly with fewer members by the year) and leading to market failures of a variety of types. On the other hand, when the consumer is ill-informed, the collective action problem is real.

My favourite example of an asymmetric information problem comes from beer-drinking in the UK. Small independent breweries have no mechanism for establishing a reputation (and thereby overcoming the lemons problem) unless there is a critical mass of well-informed beer drinkers who will transmit that reputation to others. In the 1970’s the beer industry in the UK was in a
Catch-22 that is typical of asymmetric information problems: there was no demand for real ale because there was no supply, and there was no supply because there was no demand. The big breweries offered low quality, but predictability. AT would have claimed, I believe, that the market was working.

The problem has been resolved to some extent by the efforts of the Campaign for Real Ale (CAMRA), who included a prominent Trotskyist in their leadership and had a strong anti-big-business slant. Their efforts have led to 300 new breweries being set up, while in the 50 years before their formation not one was founded. CAMRA has moved the equilibrium in the market, which is presumably evidence that it was failing before. And unless AT is prepared to
accept anti-business volunteer lobbying and protest groups in the requirements for a properly functioning market, it would seem that the problem was fixed by a successful organization overcoming the collective action problem.

So yes, I think asymmetric information, including adverse selection, is really a problem in many markets.

Update: on asymmetrical information in insurance, see December 18th’s Dilbert.

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  1. No doubt solving adverse selection problems is costly. But if the market prices these costs, where is the inefficiency? Presumably, if a benevolent government was going to ‘solve’ the market failure, they would need to not only know these costs but also the amount people were willing to pay to bear them. Usually the collective will of many in the market will provide a much better ‘match’ between marginal costs and benefits than any governmnet can.

  2. That is a good point, and in some cases (eg used cars) you may be right that independent assessors and so on can fix the problem — although the only used car I bought still had a $500 brake problem two weeks after buying it, fully inspected. I would say that there are at least two reasons why the market cannot be the best fix for this particular market failure:
    – when the cost of obtaining the information is high, I just don’t see how the market would work. For example, in the restaurant market an asymmetrical information problem about hygeine is solved by imposing health and safety requirements. Similarly, in retail food, there are government food inspectors who play the role of removing the asymmetrical information problem about hygeinic Would you really be in favour of leaving health and safety issues solely to the market?
    – when the collectionion of information has its own externalities. This is the Stiglitz answer, that information is characterized by non-convexities at multiple levels. I think this is where CAMRA has done something that individuals cannot, by providing the collective boot needed to overcome the collective action problem surrounding consumer information. The whole thing about the market is that too often it has no “collective will”.
    And I think CAMRA illustrates another point, which is that the division of the world into the state and the market seems too narrow a view of the world to me. Where, for example, do consumer protest groups campaigning about Wal-Mart placement or Kathy Lee garment production conditions fit? To me, these are both examples of collective action addressing asymmetrical information problems, even if the information is not of the kind that is normally present in consumer decisions. And the response of Nike, Wal-Mart, and others indicates that such activities have effects.
    Well, having looked at your blog, I’m sure I won’t have convinced you. Thanks for the comment anyway.

  3. I visited this blog first time and found it very interesting and informative.. Keep up the good work thanks..

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