Encyclonomic WEB*pedia: ADVERSE SELECTION

ADVERSE SELECTION:
An inefficient, bad, or adverse outcome of a market exchange that results because buyers and/or sellers make decisions based on asymmetric information. This commonly results in a market that exchanges a lesser quality good, what is termed the market for lemons. Two related problems resulting from asymmetric information are moral hazard and the principal-agent problem. Two methods of lessoning the problem of adverse selection are signalling and screening.
Adverse selection arises when the lack of information limits the quality of goods exchanged. Because buyers have less accurate information about the quality of goods, they are likely to offer a lower price, which discourages sellers from offering higher quality goods. This gives rise to what is commonly called the market for lemons, which is a market in which only low quality products ("lemons") are offered for sale.
This problem arises due to asymmetric information, which is when different people have different information. Asymmetric information occurs because even though information is beneficial it is costly to acquire. Some people are bound to find it more beneficial or less costly to acquire information than do others. They know more, others know less. When buyers know less than sellers, then adverse selection is likely to result.
Adverse selection is commonly seen in the market for used cars and provides the textbook example for the market for lemons. Other areas where adverse selection arises is the provision of health insurance, and the employment of labor.
Buying a Used Car: The Market for Lemons
The classic example of adverse selection is the market for used cars. Because this market has cars of varying quality, quality that is known to sellers but not to buyers, it is fertile ground for adverse selection.
Let's set the stage for this illustration with the market for used OmniMotors XL GT 9000 sports coupes.
First, the market has two different qualities of cars -- gems and lemons. Gems have been well maintained, are unlikely to need any repair, and are high quality cars. Lemons are not been well maintained, are likely to require some repair work, and are low quality cars.

Second, buyers have an equal chance of buying gems or lemons and have no way of knowing which is which until after the purchase. If buyers have complete information about the quality of the cars, then they would be willing to pay $8,000 for a gem and only $2,000 for a lemon.

Third, sellers know if they have gems or lemons and they know how much their cars are worth. The seller of a gem knows it is worth $8,000 and the seller of a lemon knows that it is worth $2,000.
Because buyers have an equal chance of purchasing a gem or a lemon the price they offer is the expected value of the purchase. The expected value of the car is equal to the probability of buying a gem times the price of the gem plus the probability of buying a lemon times the price of the lemon.
In this example, the expected value and the price offered is $5,000. In other words, if 100 cars are sold, half worth $2,000 and half worth $8,000, then the average price is $5,000. Moreover, the chance of paying $3,000 too much for a lemon is offset by the chance of paying $3,000 less than the value of the gem. It's a gamble.
Unfortunately, sellers have better information and know whether their XL GT 9000s are lemons or gems. At a $5,000 offer price, those selling lemons are more than willing to sell, coming out $3,000 ahead. In contrast, those selling gems are not willing to sell. They would receive $3,000 less than the value their cars.
The end result is that the ONLY cars sold are lemons. The market deals exclusively in lemons. The market adversely selects against the higher quality products in favor of the lower quality ones.
Health Insurance: Only the Sick
Adverse selection can also affect the voluntary purchase and provision of health insurance. Prospective health insurance consumers, like used cars, come in different qualities. Some are healthy, some are not. Some exercise and take care of themselves, others do not. The insurance providers have limited information about the health of their prospective customers.
Let's examine this market.
First, the market has two different qualities of health -- healthy and sickly. Heathy people are those who exercise, eat properly, and refrain from consuming alcohol, tobacco, and narcotics. Sickly people don't exercise, eat poorly, and do consume alcohol, tobacco, and/or narcotics.

Second, insurance providers have an equal chance of providing insurance to the healthy as to the sickly and have no way of knowing which is which until after the purchase. Moreover, healthy people will require only $100 in insurance benefits while sickly people will require $1,000 in benefits.

Third, prospective customers know if they are healthy or sickly and how much they will need in benefits.
What is the insurance provider to do? Like the used car buyer, the insurance provider will charge a price based on the expected cost of the benefits out. With an equal chance of insuring a healthy person as a sickly one, the price charged is $550. That is, if the insurance company covers 100 people, half healthy ($100 in benefits) and half sickly ($1,000 in benefits), the average benefit is $550.
But if the purchase of health insurance is voluntary, who will buy? The sickly, who stand to collect $1,000 in benefits, are more than willing to pay the $550 insurance cost. They come out $450 to the good. the health, who will only receive $100 in benefits, are not voluntarily wiling to pay the $550 price. They end up losing out by $450.
If health insurance is voluntarily purchased, then only the sick will buy. Once again the market adverse selects the lower quality "product." This is one reason why many types of insurance are mandatory. All drivers are required to have auto insurance. All employees of a company are automatically included in the health insurance program.
Employment: Second-Rate Workers
A third market in which adverse selection occurs is the employment of labor. In this case, prospective workers have better information about their skills, abilities, and productivity that do the employers. When employers offer an average wage based on the expected productivity of workers, then only lower quality workers will accept employment.
Let's consider the specifics of this market.
First, the market has two different qualities of workers -- first-class and second-rate. The first-class workers are productive and efficient, always on time and willing to put forth extra effort. The second-rate workers unproductive and inefficient, arrive late and leave early.

Second, employers have an equal chance of hiring first-class and second-rate workers and have no way of knowing which is which until after they are hired. The first-class workers generate $15,000 of annual production. The second-rate workers generate only $5,000 of annual production.

Third, prospective employees know if they are first-class and second-rate workers and they know how productive they are. The first-class workers knows they can generate $15,000 worth of production and second-rate workers knows they can generate $5,000 worth of production.
What wage should the employer offer to prospective workers? Without knowing the quality of a specific worker, the employer will offer a wage equal to the expected productivity. With an equal chance of hiring a first-class worker as a second-rate worker, the wage offered is $10,000. That is, if the employer hired 100 workers, half first-rate ($15,000 in production) and half second-class ($5,000 in production), the average productivity is $10,00.
What will the prospective employees do? The second-rate workers, who generate only $5,000 in production, are more than willing to accept the $10,000 wage. They come out $5,000 ahead of their productivity. The first-class workers, who generate only $15,000 in production, are not willing to accept the $10,000 wage. They lose out on $5,000 based on their productivity.
Once again the market adverse selects the lower quality "product."
Possible Solutions
The problems caused by adverse selection can be lessened through signalling and screening.
Signalling: This is the provision of small bits of information that is intended to indicate other more complete information. Sellers, for example, knowing that buyers have less information about their products might pass along signals about product quality. Guarantees and warranties are common signals. Brand names established over long periods of customer satisfaction and/or advertising are another method of signalling. Of course, the signals might not be accurate and those with less quality products might deceptively mimic the signals of the higher quality goods.

Screening: This is the attempt by those with limited information to identify indicators suggesting more complete information. Employers, for example, commonly use grade point averages, aptitude tests, or school quality as a means of screening out high quality from low quality prospective employees. Of course, screening can also be inaccurate. A good student, from a good school, with a high grade point average, might be a lousy worker.
Related Problems
Adverse selection is one of three problems arising from asymmetric information. The other two are moral hazard and the principal-agent problem.
Moral Hazard: Moral hazard exists when one person undertakes an action that is detrimental to another person after the two people have entered into an agreement. The problem is that the person harmed is unaware of the actions of the other. It is most commonly seen in the insurance industry. Once the driver has insurance, moral hazard occurs if the driver changes behavior -- drives faster, takes more risks, or fails to obey traffic laws.

Principal-Agent Problem: The principal-agent problem is a disconnection or conflict between the goals and objectives of the "principal" and those of the "agent" authorized to represent the principal. The problem arises because the principal does not have accurate information about the behavior of the agent. This problem is common in corporations, when the owners (principals) hire managers (agents) to run the company. The agents, however, might make decisions that benefit themselves (higher salaries, fringe benefits) that are unknown to and not in the best interests of the owners (profit).
Check Out These Related Terms...
     | economics of information | information search | asymmetric information | moral hazard | principal-agent problem | rational ignorance | signalling | screening | market for lemons |
Or For A Little Background...
     | scarcity | efficiency | sixth rule of ignorance | production | consumption | opportunity cost | scarce resources | market |
And For Further Study...
     | public choice | innovation | good types | market failures | financial markets | institutions | rational abstention | risk | uncertainty | risk preferences | risk aversion | risk neutrality | risk loving | marginal utility of income |
Recommended Citation:
     ADVERSE SELECTION, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2025. [Accessed: December 17, 2025].