Adverse selection
This article describes a market failure situation, i.e. a situation where the rational pursuit of self-interest by individual agents leads to an outcome that fails a Pareto optimality criterion.|See a list of market failures
Definition
Adverse selection describes a situation where the two parties to a transaction (i.e., the buyer and seller) have different pieces of knowledge about the quality of the good or service being traded, and hence have different reservation prices for the good, even though if both the buyer and the seller had perfect information about the quality of the good, the trade would take place.
Adverse selection typically refers to a situation where the seller knows more about the quality of the good than the buyer, and values it higher. With less information, the buyer is unwilling to pay the full price of a high-quality good, while the seller, who has more information about quality, is unwilling to sell a high-quality good at a low price.
Adverse selection could also occur the other way, the classic example of this being insurance or other form of protection against liability, where the person seeking the insurance or protection may have more information. In this case, the insurance seller may overvalue the insurance for less risk-prone buyers because they are using gross actuarial estimates, and hence the insurance deal may not occur.
Adverse selection is a particular example of how asymmetric information (i.e., buyers and sellers having different levels of knowledge about the quality of the good) leads to a market failure. It typically occurs for experience goods.
Types of adverse selection
Conditions for adverse selection
Wide range in quality that is difficult for the less informed party to directly ascertain
Adverse selection is typically likely to occur for experience goods: goods where buyers cannot easily determine the quality of goods without purchasing them. The buyer thus faces a huge uncertainty in the possible value the good may have for the buyer.
Insurance is the reverse situation: here the seller of the good may have too little information about the person being offered insurance.
Seller (or more informed party) should have a better idea of the quality
Unlike the buyer, the seller should have good knowledge about the quality of the good being traded. If the seller is also unaware of the quality, the seller will have no problem accepting a price based on the expected value of the good. However, if the seller knows for sure that the good has high quality, the seller is unwilling to sell it at the expected value price the buyer is willing to cough up.
Insurance is the reverse situation: here the person purchasing the insurance needs to have a clearer idea about the likelihood of making a claim.
The difference in value placed on a good between buyer and seller should be less than the uncertainty in quality
This can be illustrated by an example. Suppose a high-quality good is worth money units to a buyer. In other words, the buyer's reservation price would be units if the buyer could be certain of quality. Also, the buyer believes that there is a chance of a particular seller's good being high-quality. The buyer is thus willing to pay units for the good.
Adverse selection poses a problem if the minimum price acceptable to the seller (i.e., the reservation price of the seller) is between and units. If the minimum price is less than units, the transaction occurs despite the information asymmetry. If the price is greater than units, the transaction would not have occurred even with complete information. Thus, adverse selection poses a problem when the difference in value between the buyer and the seller is less than the reduction in the buyer's offer due to the uncertainty in price.
Alternative explanations for apparent adverse selection
Moral hazard
Further information: Adverse selection versus moral hazard
Adverse selection is often confused with moral hazard, which is another type of market failure due to asymmetric information. Moral hazard occurs in situations where insuring against a risk makes the insured person more risk-prone, thus negating the benefit provided by the insurance. The difference between adverse selection and moral hazard is that moral hazard usually applies to changes in behavior as a result of the transaction (such as an insurance contract) rather than information possessed by one party prior to the transaction.
Stability of adverse selection
Further information: Adverse selection is self-perpetuating
Adverse selection is self-sustaining, and in fact, is self-perpetuating. Under circumstances of adverse selection, the sellers with the most high-quality goods pull their goods out of the market, and this results in the proportion of high-quality goods becoming smaller still. This further reduces the expected value to buyers, reducing the amount they are willing to pay for a good of uncertain quality. This persuaded more sellers to pull their goods out of the market. The process continues till the only goods in the market are inferior, low-quality goods.
Solutions to adverse selection
Guarantees and warranties
Ratings
Efficiency wage as a solution to adverse selection in wages
Further information: Efficiency wage combats adverse selection in wages