Suppose a ﬁrm offers its workers a cafeteria plan in which it allows workers to allocate a set amount of fringe beneﬁt money toward speciﬁc insurance. Mary, who has ﬁve kids needing braces, selects
The family dental coverage. This is an example of the
A) free-rider problem.
B) principal-agent problem.
C) adverse selection problem.
D) moral hazard problem.

Question

Quizplus · Accepted Answer

The selection of a specific insurance by Mary, based on her particular needs (needing braces for her five children), represents adverse selection. Adverse selection occurs when one party to a transaction has more information than the other party and uses that information to their advantage. In this case, Mary has more information about her family's dental needs, and she used that information to choose the option that will benefit her the most. This can result in higher costs for the firm if many employees choose plans that benefit them individually rather than benefitting the group as a whole.

Suppose a ﬁRm Offers Its Workers a Cafeteria Plan in Which