Medical exam required by insurance company, why?
- Info asymmetry exists btw investor (customer investing in policy) and company. If no exam was done, the insurance company would offer the policy at an average price and healthy “good” customers would not buy the policy. Only lemons would purchase the policy and this result is adverse selection. Adverse selection leads to market failure because all the good customers are pushed out of the market and eventually the insurance companies would stop offering policies. Therefore no transactions are occurring and market failure results.
- A exam helps fix the issue because it is done by a third party and provides unbiased information. The exam acts as a signal to the insurance company. The signal works because it is costly. The individual must pay for it and there is a negative correlation btw the cost of the exam and the health of the individual.
Job market and car market (market failure):
- Info asymm btw hirer and applicant. When info asymm exists, the hirer will offer an average salary because they don’t know if they are getting a lemon worker or a good worker. Only lemon workers will be willing to accept the offer and the good workers will refuse the offer. The good workers then “exit the market” leaving only a market for lemons. This results in adverse selection (the average price offered by the hirer pushes the good workers out and leaves only lemons.) When the hirer realizes he is only able to hire lemons, he will stop offering jobs and no transactions will occur leading to market