Precontract Information Problems: Adverse Selection

The equilibrium price is $5,100 and only unhealthy people will buy the insurance. The following explains why. If all 50,000 people bought the insurance, the company would expect to earn $100 per customer if it priced the insurance at $3,100. It would expect to lose $1,900 on each of the unhealthy people and make $2,100 on each of the healthy peo- ple. Given that there is a .5 probability that any given person is healthy, it would expect to make [(.5 X $2,100) - (.5 X $1,900)] = $100 per person (the necessary amount to stay in business). There, however, is adverse selection at the $3,100 price-people who know that they are healthy will not buy the insurance. Since only unhealthy people buy the insurance at $3,100, the company would expect to lose $1,900 per customer. The company, therefore, prices the insurance at $5,100 and only sells to people who know they are un- healthy. The company cannot charge more than $5,100 because no one will buy the insurance. If it charges less it will not make the necessary $100 per customer to stay in business. Potential gains from trade in selling insurance to healthy people are lost unless the company can devise a way to address the adverse selection problem.