Editing Adverse selection (section)

== Reducing adverse selection ==

Accounting for the significant amount of [[credence good]]s in the market,<ref>{{cite journal |last1=Dulleck |first1=Uwe |last2=Kerschbamer |first2=Rudolf |last3=Sutter |first3=Matthias |title=The Economics of Credence Goods: An Experiment on the Role of Liability, Verifiability, Reputation, and Competition |journal=American Economic Review |date=1 April 2011 |volume=101 |issue=2 |pages=526–555 |doi=10.1257/aer.101.2.526 |url=https://eprints.qut.edu.au/75882/1/75882%28pub%29.pdf }}</ref> the incentives for misbehaviour among both buyers and sellers serve as large threats to market efficiencies to society as a whole. Since adverse selection largely persists due to [[Information asymmetry|asymmetric information]], the key steps to reducing its effects starts with eliminating said asymmetry by encouraging transparency between both sides of the market.

=== Signalling and screening ===
{{main|Signalling (economics)|Screening (economics)}}

In markets where the seller has private information about the product they wish to sell, reputation mechanisms help to reduce adverse selection by acting as a signal of quality.<ref>{{cite journal |last1=Mailath |first1=George J. |last2=Samuelson |first2=Larry |title=Who Wants a Good Reputation? |journal=The Review of Economic Studies |date=2001 |volume=68 |issue=2 |pages=415–441 |doi=10.1111/1467-937X.00175 |jstor=2695935 |url=http://www.ssc.upenn.edu/~gmailath/wpapers/sell-repR2.pdf }}</ref> An example would be the online marketplace, eBay. A seller known for selling high-quality goods can further enhance its reputation by utilizing eBay's [[reputation system]]. There is an incentive for the seller to do so, as buyers who derive utility from purchasing the product are naturally inclined to source their purchase from high-quality sellers. As such, buyers are able to rely on the reputation system as a signal to filter high-quality sellers from low-quality sellers.<ref>{{cite journal |last1=Saeedi |first1=Maryam |title=Reputation and adverse selection: theory and evidence from eBay |journal=The RAND Journal of Economics |date=2019 |volume=50 |issue=4 |pages=822–853 |doi=10.1111/1756-2171.12297 |citeseerx=10.1.1.252.6245 |s2cid=241839161 }}</ref>

Unlike quality signalling where the better informed party acts first, screening is better suited when the uninformed party needs to make the initial decision in participating in a contract.<ref name="Screening, Market Signalling, and C">{{cite journal |last1=Lee |first1=Wayne L. |last2=Thakor |first2=Anjan V. |last3=Vora |first3=Gautam |title=Screening, Market Signalling, and Capital Structure Theory |journal=The Journal of Finance |date=1983 |volume=38 |issue=5 |pages=1507–1518 |doi=10.1111/j.1540-6261.1983.tb03837.x }}</ref> Recognizing that adverse selection stems from the lack of information, using [[screening games]] allows players to try and analyse if the risk of the contract's worst possible outcome makes participating worth it in the first place.<ref name="Screening, Market Signalling, and C"/> Parties can always attempt to be better informed, but if achieving new information is too costly, and the threat of economic loss from the contract is too great, screening methodologies suggest not participating in the contract at all.

For better context using the example of how adverse selection occurs in [[Capital market|financial markets]], if investors believe the risk of poor returns is too high, and the cost of consulting a trading specialist is not worth it, they have screened the possible outcomes and realize it is not worth making that initial investment from the start.<ref name="Screening, Market Signalling, and C"/>

=== Lemon law ===
{{main|Lemon law}}
Lemon laws act as a form of consumer protection in the event the buyer purchase a defective product. While usually applied to automobiles, lemon laws are also used for most consumer goods. Such regulations were enacted to reduce cases where manufacturers knowingly sold defective products. Lemon laws vary by countries, but generally require the seller to repurchase the product or replace it. For example, the Texas Deceptive Trade Practices allows for consumers to sue for triple damages in the event of sustaining harm as a result of purchasing a defective product as a result of the seller withholding information at the time of the transaction. As such, government regulations act as a deterrent against sellers exploiting the asymmetric information between the parties involved. This, in turn, reduces the problem of adverse selection, as buyers who are knowingly protected by lemon laws are more inclined to engage in transactions they previously would not have done so due to the lack of viable information available to them.

=== Warranties ===
By offering a warranty for the product the seller intends to sell, they are able to indirectly communicate private information about the product to the buyer. Warranties assist in conveying information about the seller's confidence in the product for its quality, by acting as a guarantee on the product.<ref>{{cite journal |last1=Hollis |first1=Aidan |title=Extended Warranties, Adverse Selection, and Aftermarkets |journal=The Journal of Risk and Insurance |date=1999 |volume=66 |issue=3 |pages=321–343 |doi=10.2307/253551 |jstor=253551 |citeseerx=10.1.1.202.1342 }}</ref> 
A common example is in the used car market, where apart from warranties offered by the seller itself, the buyer may purchase 
additional warranties in the form of insurance from third-party companies.