Which of the following actions best illustrates adverse selection?

• A. An insurance company offers health insurance without requiring a medical exam, attracting mostly unhealthy individuals.
• B. A car owner drives more recklessly after purchasing comprehensive auto insurance.
• C. A bank monitors borrowers closely to ensure loan repayment.
• D. A firm provides bonuses to employees based on observable performance metrics.

Answer: (A)

Verified step by step guidance

1. Understand the concept of adverse selection: it occurs when one party in a transaction has more information than the other, leading to a selection of undesirable or higher-risk participants by the less-informed party.
2. Identify the key feature of adverse selection: it typically happens before a contract or agreement is made, where hidden information about risk or quality influences who participates.
3. Analyze each option to see which one involves hidden information leading to a selection problem before the contract is finalized.
4. Recognize that offering health insurance without a medical exam allows individuals with higher health risks (unhealthy individuals) to self-select into the insurance pool, which is a classic example of adverse selection.
5. Contrast this with moral hazard (like reckless driving after insurance), monitoring (bank overseeing borrowers), and performance-based bonuses, which relate to different economic concepts.