Adverse selection

In economics, insurance, and risk management, adverse selection is a market situation where buyers and sellers have different information. The result is the unequal distribution of benefits to both parties, with the party having the key information benefiting more.

In an ideal world, buyers should pay a price which reflects their willingness to pay and the value to them of the product or service, and sellers should sell at a price which reflects the quality of their goods and services.^[1] For example, a poor quality product should be inexpensive and a high quality product should have a high price. However, when one party holds information that the other party does not have, they have the opportunity to damage the other party by maximizing self-utility, concealing relevant information, and perhaps even lying. Taking advantage of undisclosed information in an economic contract or trade of possession is known as adverse selection.

This opportunity has secondary effects: the party without the information can take steps to avoid entering into an unfair (maybe "rigged") contract, perhaps by withdrawing from the interaction, or a seller (buyer) asking a higher (lower) price, thus diminishing the volume of trade in the market. Furthermore, it can deter people from participating in the market, leading to less competition and thus higher profit margins for participants.

Sometimes the buyer may know the value of a good or service better than the seller. For example, a restaurant offering "all you can eat" at a fixed price may attract customers with a larger than average appetite, resulting in a loss for the restaurant.

A standard example is the market for used cars with hidden flaws ("lemons"). George Akerlof in his 1970 paper, "The Market for 'Lemons'", highlights the effect adverse selection has in the used car market, creating an imbalance between the sellers and the buyers that may lead to a market collapse. The paper further describes the effects of adverse selection in insurance as an example of the effect of information asymmetry on markets,^[2] a sort of "generalized Gresham's law".^[2] Since then, "adverse selection" has been widely used in many domains.

The theory behind market collapse starts with consumers who want to buy goods from an unfamiliar market. Sellers, who do have information about which good is high or poor quality, would aim to sell the poor quality goods at the same price as better goods, leading to a larger profit margin. The high quality sellers now no longer reap the full benefits of having superior goods, because poor quality goods pull the average price down to one which is no longer profitable for the sale of high quality goods. High quality sellers thus leave the market, thus reducing the quality and price of goods even further.^[2] This market collapse is then caused by demand not rising in response to a fall in price, and the lower overall quality of market provisions. Sometimes the seller is the uninformed party instead, when consumers with undisclosed attributes purchase goods or contracts that are priced for other demographics.^[2]

Adverse selection has been discussed for life insurance since the 1860s,^[3] and the phrase has been used since the 1870s.^[4]