Mary Jones is the president of a local bank. She knows that half of the loan applicants in town she would classify as high risk and the other half as low risk. She observes that the other banks in town charge two different interest rates, a lower rate for low risk borrowers and the higher rate for high risk borrowers. She decides that to have an advantage over the other banks she will offer an average rate to everyone. The likely result will be:

Question

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By offering an average rate to everyone, Mary's bank will attract both high and low risk borrowers, but the high-risk borrowers will be more likely to take out loans with her bank because they can't get a lower rate elsewhere. This is adverse selection, as Mary's bank will end up with a disproportionate number of high-risk borrowers who are more likely to default on their loans. This could lead to a higher rate of loan defaults and financial losses for the bank.

Mary Jones Is the President of a Local Bank