Adverse selection

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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

History

The notion of adverse selection was introduced by George Akerlof, in his paper The Market For "Lemons". Akerlof studied adverse selection with used automobile markets as his primary example. He claimed that this explained why the used car market was much smaller than the market for new cars.

Akerlof's paper did not make emphatic use of the term "adverse selection" -- this term was only found in a reference quoted by Akerlof during a discussion by him about adverse selection in insurance.

Definition

Adverse selection or negative 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, such that:

  • The seller's reservation price for the good (the minimum price acceptable to the seller) is greater than the buyer's reservation price for the good (the maximum price acceptable to the buyer).
  • If the buyer and seller both had complete information about the quality of the good, the seller's reservation price for the good would be less than the buyer's, and the good would have been traded.

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 10 money units to a buyer. In other words, the buyer's reservation price would be 10 units if the buyer could be certain of quality. Also, the buyer believes that there is a 50\% chance of a particular seller's good being high-quality. The buyer is thus willing to pay 5 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 5 and 10 units. If the minimum price is less than 5 units, the transaction occurs despite the information asymmetry. If the price is greater than 10 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 persuades 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

Related notions

References

Online encyclopedia/dictionary references

Weblogs/articles discussing the topic

Particular blog entries/articles on adverse selection:

Journal references

General-purpose economics textbook references

Book Pages Chapter/section More comments Link
Price theory and applications by Steven E. Landsburg, 10-digit ISBN 0324579934, 13-digit ISBN 978-0324579932More info 300-301 Google Books
Economics by Paul Krugman and Robin Wells, 10-digit ISBN 0716771586, 13-digit ISBN 978-0716771586More info 560-561 Google Books
Price theory and applications: decisions, markets, and information by Jack Hirshleifer, Amihai Glazer, David HirshleiferMore info 317-320 Section 11.3 (Asymmetric information) Google Books -- Page 319 onward (317, 318 not available in preview)
Principles of Economics by N. Gregory Mankiw, 10-digit ISBN 0324589972, 13-digit ISBN 978-0324589979More info 485-488 Google Books

Expository book references

Book Pages Chapter/section More comments Link
The Undercover Economist by Tim Harford, 10-digit ISBN 0345494016, 13-digit ISBN 978-0345494016 (paperback)More info 103-116 Chapter 5 (The Inside Story) Google Books
Naked Economics: Undressing the Dismal Science by Charles Wheelan, 10-digit ISBN 0393324869, 13-digit ISBN 978-0393324860More info 28 and 81-90 'Economics of Information: McDonalds didn't create a better hamburger