Adverse selection is a problem that arises from asymmetric information before a transaction occurs.
It happens when one party to a deal has more or better information than the other and uses it to their advantage, leading to a “skewed” or “adverse” outcome for the less-informed party.
It’s the reason why markets can sometimes fail to function properly, as high-quality goods or low-risk individuals may be driven out.
Key Characteristics
- Timing: Adverse selection happens before the transaction is complete.
- Cause: It is driven by private information held by one party that the other party cannot easily verify.
- Result: The less-informed party faces a greater risk of dealing with a lower-quality product or a higher-risk individual. This can lead to a breakdown of the market, where only the “bad” products or “high-risk” people remain.
Examples of Adverse Selection
1. The Market for “Lemons” (Used Cars)
In this classic example by Nobel laureate George Akerlof, the seller of a used car knows its true quality (e.g., if it’s a good car or a “lemon” with hidden problems). The buyer does not have this information.
- The buyer, fearing they’ll get a lemon, is only willing to pay a price that reflects the average quality of all used cars on the market.
- Sellers of high-quality cars find this average price too low and decide not to sell their cars.
- This leaves a higher proportion of low-quality cars (lemons) on the market, which further lowers the average price, creating a downward spiral. The market becomes dominated by lemons, and good cars are no longer traded.
2. Health Insurance
Individuals know more about their own health than an insurance company.
- People who are sick or have chronic conditions are more likely to seek out health insurance.
- Healthy individuals, who might not need insurance as much, are less likely to sign up, especially if premiums are high.
- To cover the high costs of the unhealthy, the insurance company may have to raise premiums for everyone.
- This further discourages healthy people from buying insurance, leaving the insurer with an increasingly costly pool of high-risk clients. The insurance company faces an “adverse selection” of customers.
Solutions to Adverse Selection
Markets have developed several strategies to combat adverse selection:
- Signaling: The informed party (e.g., the seller) takes action to credibly reveal their information. A car manufacturer offering a warranty on a new car signals that it’s a high-quality product.
- Screening: The uninformed party (e.g., the buyer or insurer) takes action to gather information. An insurance company might require a medical exam or a car buyer might get a mechanic’s inspection before purchasing.
- Third-Party Verification: Organizations like consumer review websites, credit bureaus, or product rating agencies help provide independent information to the uninformed party, reducing the information gap.