Adverse Selection — The Dollar Dictionary

Ads end in 20 seconds

Loading location...

This content is free thanks to our sponsors

Sponsored Ad – I may earn a commission if you click and buy

Next ad in 5s

You are about to visit an external website.

This is an affiliate link, and we may earn a commission.

Continue?

Economics

Adverse Selection

A market situation where asymmetric information causes products of different quality to be priced the same, driving out higher-quality options and leaving mostly risky or low-quality ones.

Adverse selection occurs before a transaction — it's about who chooses to participate. It's distinct from moral hazard, which occurs after a transaction (once insured, people take more risks). Both stem from asymmetric information, but at different points in the process.

Markets solve adverse selection through signaling (sellers of quality goods provide verifiable signals — warranties, certifications, third-party inspections) and screening (buyers develop tools to distinguish quality — credit scores in lending, medical exams in life insurance, test drives in car sales). Without these mechanisms, markets for information-asymmetric goods tend to collapse toward the lowest-quality equilibrium.

Imagine a health insurance plan where only sick people sign up. Healthy people think 'I probably won't need it' and opt out. Now the insurer has a pool of only sick customers, loses money, raises premiums, which causes more healthy people to leave — until only the sickest remain. That death spiral is adverse selection.

Real world: The used car market is the textbook example. Sellers know whether a car has hidden problems; buyers don't. Because buyers can't tell good cars from lemons, they offer average prices. Sellers of genuinely good cars reject average prices and pull out. The market fills with below-average cars — exactly the adverse selection problem economist George Akerlof described in his Nobel-winning 1970 paper.

💡 Adverse selection is what happens when only the worst options show up — markets combat it through signals and screening that help buyers distinguish quality before committing.

← Back to The Dollar Dictionary