Adverse selection

In economics, insurance, and risk management, adverse selection is a market situation where asymmetric information results in a party taking advantage of undisclosed information to benefit more from a contract or trade.

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] 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. This opportunity has secondary effects: the party without the information may take steps to avoid entering into an unfair contract, perhaps by withdrawing from the interaction; a party may ask for higher or lower prices, diminishing the volume of trade in the market; or parties may be deterred from participating in the market, leading to less competition and higher profit margins for participants.

A standard example is the market for used cars with hidden flaws, also known as lemons. George Akerlof in his 1970 paper, "The Market for 'Lemons'", highlights the effect adverse selection has on 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]

The spiralling effect of how adverse selection worsens the quality of goods in the market

The theory behind market collapse starts with consumers who want to buy goods from an unfamiliar market. Sellers, who 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]

  1. ^ Akerlof, George A. (1978). "The market for 'lemons': Quality uncertainty and the market mechanism". Uncertainty in Economics. pp. 235–251. doi:10.1016/B978-0-12-214850-7.50022-X. ISBN 978-0-12-214850-7.
  2. ^ a b c d Akerlof, George A. (August 1970). "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism". The Quarterly Journal of Economics. 84 (3): 488–500. doi:10.2307/1879431. JSTOR 1879431.
  3. ^ "Royal Insurance—Statistics of its Operations", The Railway Times and Joint-Stock Chronicle, London, 23:38:1071 (22 September 1860): "...such a selection continuing to be exercised will tend to neutralize the adverse effects of the exercise of selection which is possessed on the other hand by the assurer against the company"
  4. ^ "The Insurance of Female Lives", The Chronicle (Chicago), 7:14:213 (6 April 1871)