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The Concept of Adverse Selection

In the business world there exist two entities, that is, the seller and the purchaser. The selling party has items and services that are required by the purchaser. In this case, it refers to a situation where the item being sold has been in use before the material day. When someone decides that he/she has had enough of the item he/she owns and wants to dispose of it, it is because that person is well acquainted with the item in question compared to the purchaser who knows very little. This is called adverse selection and this paper will shed light on how it affects the two entities of selling and buying.

In adverse selection, the purchaser is usually interested in an item because he/she feels that it can help him/her accomplish the tasks that it is intended for. On the other hand, the person who is selling a used item is more familiar with that item and understands its strengths and weaknesses. In this case, the selling party is more informed because the decision to dispose of the item could have been influenced by the shortcomings of that item. This is because if the item was still in good shape there would be no need to dispose of it.

Mankiw argues that since the seller is well informed about the item he/she wishes to dispose of he/she does her/his analysis well and comes to a conclusion that the item has become exhausted and may fail to perform in the future due to aging problems (485). The purchaser here stands to lose because the seller does not give genuine reasons as to why he/she is disposing of the item. Some may tell you that they are disposing of their television set because they have several others and they only need one, hence this builds the confidence of the purchaser.

The purchaser loses when he/she is made to believe that the item in question is still in good shape and thus its value cannot depreciate as expected. If the purchaser knew the reasons why the owner of an item decided to dispose of it, he/she would have an upper hand in negotiating for a lower price because he/she knows the faults of the item, and in some instances, he/she might decide that there is no need of purchasing such an item. Such items are even much more expensive because their durability has been exhausted and they may require regular servicing which costs the purchaser a lot of money compared to when he/she buys a new item.

Doherty explains that at times the purchaser may be more informed than the seller but this is common to service providers (72). For instance, when someone subscribes for security services for his/her home, the security company does not know whether their client has any enemies who could be determined to make any moves on their client because all they are interested in is to have a bigger base of clients.

On the other hand, the client has his/her reasons for subscribing to security services, maybe it is because he/she has received death threats from some people or it could be that he/she resides in an area that has a high rate of crime and thus reckons he/she can not do without security agents. In this case, the purchaser will pay less when he/she would have paid more if only the service provider was well informed about the risks involved.

When it is only one party that is well acquainted with the item or service being purchased, the situation is called asymmetric information. Creating a balance between the seller and the purchaser is important because it ensures that each party gets what they deserve. There are several ways of making sure that both parties are well informed because the information is used to gauge the efficiency and worth of goods and services.

One of those methods is screening which entails cross-checking an item before proceeding with the cash transactions. People who are certain about the items they sell allow their clients to evaluate their items and services with a lot of confidence. For instance, when one decides to buy a vehicle from the showroom, he/she will be allowed to conduct a test drive and also invite an independent mechanic to check if the vehicle has any mechanical problems.

In company acquisitions and mergers, the party that is purchasing the organization can vet the organization by hiring an independent auditor to analyze the financial records of that organization and identify any faults and what caused them. Without adequate screening, the customer might later on experience difficulties that are sometimes very costly and could have been avoided if only the customer or the seller had taken their time to analyze the issues at hand.

Among service providers, there are several ways of screening customers to come up with a conclusion on whether the deal is worth as it appears. For instance, an employer can decide to have the potential employee analyzed medically by a medical practitioner of their choice so that they can understand their employee’s medical condition and make an appropriate decision when they are assigning him/her medical cover. This is important because it equips the party that is hiring with information regarding the risks they are subjecting themselves to. Being informed makes sure that the buyer and the purchaser are aware of what to expect. In essence, both parties, that is, the purchaser and the seller must be informed evenly for the deal to be fair.

Works Cited

Doherty, Neil. Integrated Risk Management: Techniques and Strategies for Reducing Risk. New Delhi: McGraw-Hill, 2000. Print.

Mankiw, Gregory. (2008). Principles of Economics, Mason, OH: Cengage Learning. Print.

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