Adverse selection happens when one party in a deal knows more than the other, leading to unfair outcomes. This can be a big issue in areas like insurance, loans, and used car sales. While there are strategies to manage it, unchecked adverse selection can cause market problems and privacy concerns.
It’s a foundational concept in adverse selection. The idea is that one party’s superior knowledge over another can create an imbalance in transaction outcomes.
Adverse selection can lead to what’s called a “market failure”. That’s when transactions don’t occur that would have been mutually beneficial, or when poor-quality goods or services are exchanged because one party was able to exploit their better knowledge.
Examples in Insurance
Adverse selection is a well-known problem in insurance markets. People who know they are high risk are more likely to seek insurance, and if insurers can’t accurately identify and price those risks, they may end up with an undesirably risky pool of insured individuals. This can lead to inflated premiums or even market collapse if not properly managed.
In the market for used cars, adverse selection is known as the ‘lemons problem’. Sellers of used cars know more about the quality of the vehicle than buyers. If buyers can’t distinguish good quality cars (peaches) from poor quality ones (lemons), they may be unwilling to pay a fair price for peaches. As a result, sellers of peaches may leave the market, leaving only lemons.
Role in Finance
Adverse selection can also occur in financial markets. For instance, lenders have less information about borrowers’ riskiness. Riskier borrowers are more likely to seek loans, particularly at high interest rates, leading to a pool of high-risk borrowers.
There are mechanisms to reduce the impact of adverse selection such as signalling and screening. Signalling is when the party with less information encourages the other to reveal their private information. Screening is when the uninformed party takes steps to gather more information.
In some cases, government regulation is used to mitigate adverse selection, such as requiring everyone to have health insurance to ensure both high-risk and low-risk individuals are in the insurance pool.
Moral Hazard vs Adverse Selection
While both are problems arising from asymmetric information, they differ in terms of when they occur. Adverse selection occurs before a transaction takes place, while moral hazard occurs after a transaction has been made.
Effect on Economic Efficiency
By preventing certain mutually beneficial trades from occurring and allowing undesirable trades to take place, adverse selection can lead to a loss of economic efficiency.