Adverse Selection

Coen Teulings and Martijn Huysmans ()
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Coen Teulings: Utrecht University
Martijn Huysmans: Utrecht University

Chapter 8 in The Microeconomics of Market Failures and Institutions, 2025, pp 211-233 from Springer

Abstract: Abstract The Great Depression of the 1930s showed the capitalist system lacked an adequate private supply of social insurance. During World War II, William Beveridge brokered a plan for the post-war establishment of a welfare state with mandatory social insurance. This chapter delves into the market failure of adverse selection that causes the market for private social insurance to be missing. Asymmetric information can lead to two types of equilibria: pooling, where all participants participate in a collective insurance, and separating, where good types opt out, resulting in Kaldor-Hicks inefficiency. Signaling by good types reveals their type and destabilizes efficient pooling equilibria. Mandatory insurance resolves the problem of the unraveling of a pooling equilibrium. However, this magnifies the risk of moral hazard and over-insurance. The chapter also examines the analogy to education, which serves as means for both building human capital and signaling innate ability, using the US higher education market as an example. Signaling can improve welfare when it enables matching individuals to suitable jobs based on their abilities.

Date: 2025
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DOI: 10.1007/978-3-031-74987-2_8

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