Which of the following descriptions best exemplifies adverse selection?

• A. A firm cannot monitor its employees' effort levels, leading to reduced productivity.
• B. A seller provides warranties to assure buyers of product quality.
• C. A car owner drives more recklessly after purchasing comprehensive auto insurance.
• D. An insurance company offers health insurance to everyone, but individuals with higher health risks are more likely to purchase the insurance.

Answer: (D)

Verified step by step guidance

1. Understand the concept of adverse selection: it occurs when one party in a transaction has more information about a relevant characteristic than the other, leading to a selection of higher-risk or lower-quality participants that the uninformed party cannot easily detect.
2. Identify the key feature of adverse selection: asymmetric information before the transaction occurs, causing the market to attract participants who are more likely to cause losses or problems (e.g., higher-risk individuals buying insurance).
3. Analyze each option by checking if it involves asymmetric information leading to a selection problem before the contract or transaction is made.
4. Recognize that the example where an insurance company offers health insurance to everyone, but higher-risk individuals are more likely to buy it, perfectly illustrates adverse selection because the insurer cannot distinguish risk levels beforehand.
5. Contrast this with other options: monitoring effort relates to moral hazard (hidden actions after contract), warranties are a signaling mechanism, and reckless driving after insurance is moral hazard, not adverse selection.