Matty and Rudy are the same age, live in the same town, and hold similar jobs a similar distance from their respective homes. They are so similar, in fact, that they are both offered the same auto insurance options. However, Matty has never been a particularly good driver, so he buys high-coverage auto insurance. Rudy, on the other hand, takes pride in being an excellent driver and thus only carries the minimum amount of insurance required. This example illustrates the potential for: A)risk pooling. B)risk aversion. C)adverse selection. D)diversification.

Question

Quizplus · Accepted Answer

Adverse selection occurs when one party in a transaction has more information than the other, often leading to the party with less information making suboptimal decisions. In this case, Matty knows he is a bad driver and opts for high coverage, while Rudy, confident in his driving skills, chooses minimal coverage. The insurance company may not be able to distinguish between the two, leading to adverse selection.

Matty and Rudy Are the Same Age, Live in the Same