What is Adverse Selection in Economics and How Does It Work?

Generally, adverse selection is a situation where either the buyer or the seller misuses asymmetric information. It is a situation where one party has more information than the other about a product/service.

Let’s discuss what adverse selection is in economics and how it work.

What is Adverse Selection in Economics?

Adverse selection in economics refers to a situation that arises due to asymmetric information or information failure.

In this situation, either the buyer or the seller in a transaction possesses more information about the product/service being sold than the other.

This scenario is commonly observed in the insurance sector, capital markets, and other economic markets where asymmetric information inevitably exists.

Adverse selection can arise in any situation where two parties try to negotiate a transaction.

For instance, a contractor will have the upper hand due to information asymmetry by utilizing the knowledge and experience of the construction industry to negotiate a contract with the buyer.

How Does it Work?

Adverse selection arises when one party in a transaction has more information than the other. This greater access to information can be due to better resources for one party or the lack of resources for the other.

The concept denies the efficient market hypothesis which claims that all publicly available information reflects on stocks (products) in a market.

This scenario leads to inefficiency in a marketplace. The seller may charge irregular prices for the same product/service in the absence of adverse selection.

Generally, adverse selection or asymmetric information affects buyers in a marketplace. They cannot negotiate prices if they don’t have the same information about the features and costs of products/services.

In some scenarios, sellers are also at a disadvantage. For instance, insurance companies don’t have the right information about the insured person/business and they rely on the insured party.

Adverse Selection in Economics

Adverse selection is a common situation in many economic scenarios. Sellers usually possess more information about the product/service being sold than buyers.

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For instance, sellers of second-hand vehicles do not disclose all faults in a vehicle. If they do, the buyer may not purchase the vehicle or pay significantly less than in the absence of that information.

We can observe the same phenomenon in the real estate industry where homebuyers typically don’t have the exact information as sellers. 

Conversely, adverse selection may exist in certain situations due to the specialized knowledge and skills of one party. For instance, an attorney will possess greater knowledge of the law with a degree and experience.

The same rule applies to other professionals as well. In this situation, the adverse selection is compensated by charging for premium services by the sellers.

Adverse Selection in the Insurance Industry

Adverse selection is common in the insurance industry.

For example, an insurer will only know about the medical history and health conditions of an applicant as much as the insured person informs.

Thus, the insurance company will be at a disadvantage by insuring a person due to asymmetric information. So, the insurance company will be at a loss if it charges an average insurance premium to such risky clients.

Similarly, auto insurance companies would charge higher premiums in high-risk areas. If the client does not provide complete information about car usage areas, the insurer will be at a disadvantage.

We can see that the insurance companies are at the receiving end due to adverse selection although buyers face disadvantages generally.

Adverse Selection in the Capital Markets

The adverse selection also affects capital markets in different ways. Retail investors and the general public do not have access to information as some corporate investors may have.

Similarly, as stock prices are directly affected by a company’s performance or financial results, insiders may have an early advantage. This is the reason insider trading is illegal but it still exists.

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Contrary to the EMH theory, all publicly available information is not symmetric. It is also not fully reflected in the share prices as the market does not fully know the investors’ reaction.

We observe commonly that stocks are either overvalued or undervalued. Both situations may affect investors adversely because these scenarios happen due to asymmetric information in the market about those particular stocks.

Adverse Selection v Moral Hazard

Moral hazard is a closely linked concept to adverse selection. It exists when one party conceals facts or does not enter into an agreement in good faith.

It means moral hazard exists when there is information asymmetry but it is due to one party’s non-cooperation or ill faith rather than unavailability.

For example, if a bank manager knows the banking industry will soon decrease interest rates on loans but doesn’t inform an applicant to increase the loan applications and achieve short-term results, it’s a moral hazard scenario.

Similarly, if a health insurance applicant is already diagnosed with a fatal disease but conceals facts from the insurance company, it isn’t an adverse selection but a moral hazard.

In short, a moral hazard exists when one party in a transaction does not act in the good faith of the other party and deliberately misuses the available information.

Solutions to Adverse Selection

There are different ways to control adverse selection for sellers and buyers.

Access to information is the foremost and important aspect. If buyers have full access to information, they can make informed decisions.

Similarly, sellers offering trial periods, guarantees, and warranty periods also act to reduce the impact of adverse selection.

Sellers can charge premium rates if buyers do not provide complete information. It is particularly useful in the insurance industry.

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Also, amending certain regulations like allowing insurance companies to examine the medical history of applicants can reduce adverse selection effects.

Crowdsourced information tools like websites, blogs, tutorials, and review magazines can also play an important role in dealing with information asymmetry.

Is Adverse Selection Always Bad?

Adverse selection is not always bad. In practice, if all information is symmetric and perfectly available to everyone, it will have no value.

For instance, brokers provide professional advice to investors and charge premium prices for their services. If the information was readily available to all investors, a broker wouldn’t have been able to charge premium prices for sharing that information.

Asymmetric information helps professionals strive for career advancement as well. They work hard to achieve higher ranks by obtaining more knowledge and information along with their careers.

Similarly, adverse selection means more bargaining and trading opportunities in the general market as well.

What are the Negative Impacts of Adverse Selection?

Generally, buyers are at a disadvantage due to adverse selection because they lack information. Sellers would charge higher prices for products/services than they would if the buyers had the same information.

For example, investors may buy overvalued stocks and lose money quickly. As a result, investors pay premium charges to obtain this valuable information which should be readily available to them for free.

As mentioned above, sometimes sellers may be at a disadvantage due to adverse selections like an insurance company paying insurance coverage to a high-risk insured person.

Similarly, adverse selection can affect the general public in the service industry when they receive wrong advice from professionals due to the lack of access to information.

For example, a patient receiving the wrong medication or a homebuyer paying overpricing of a house due to wrong advice from a real estate broker.