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What is Adverse Selection? | Economics Definitions
Adverse Selection Explained
Adverse selection is a concept in Economics that you might need to know of. It is a cause of market failure due to information failure.
Adverse selection refers to when one side of a transaction has more information than other.
One example is the market for car insurance. A buyer of car insurance knows how risky a driver he/she is. The insurer, on the other hand, does not not the driver and can often not witness their driving ability or risky taking behaviour. Therefore, this leads to complications for the car insurance company when they need to manage risk.
Another example of adverse selection is when a seller knows more than a buyer. For example, a used car dealer might know more about their car’s history or technical faults. A buyer would have to be a car expert to stand a chance of being on equal terms with the seller. This means that sellers can often swindle or con unsuspecting buyers into overpaying for their cars for sale.
For an interesting read about the adverse selection problem in the car industry, try ‘The Market for “Lemons”: Quality Uncertainty and the Market Mechanism’ by George Akerlof.
Some more facts about adverse selection
Adverse selection and the moral hazard problem are both terms used in economics, risk management and insurance to describe situations where there is an imbalance of information which causes an information market failure
Adverse selection refers to when one side of a transaction has more information than another. This could be sellers knowing more than buyers, or vice versa
A seller or buyer might hold extra information on certain attributes of the transaction: product quality, product history, risk or some other aspect relating to product quality or performance
Moral hazard is different to adverse selection. Moral hazard occurs when somebody’s actions change after an agreement is made
Adverse selection is a part of information market failure
Adverse selection should not be confused with moral hazard (another type of information failure)
Find out more about the moral hazard problem
Find out more about imperfect information market failure here
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