Adverse selection

When buyers cannot tell good from bad, the bad can drive out the good until the market itself unravels. That self-destructive dynamic is adverse selection.

Adverse selection is a problem of asymmetric information that arises before a transaction, when the party with hidden information is precisely the one most likely to seek the deal, so that the uninformed party attracts a disproportionately bad pool. It can degrade and even destroy a market.

The market for lemons

The classic illustration, from George Akerlof, is the used-car market. Sellers know whether their car is sound or a lemon; buyers cannot tell. Unable to distinguish good cars from bad, buyers will only pay a price reflecting average quality, which is too low for the owners of good cars, who withdraw, leaving more lemons, which lowers the average further, which drives out more good cars. The market can unravel until only the worst remains, or collapse entirely, even though good cars exist and buyers want them.

Where it bites

Adverse selection appears wherever the keenest customers are the worst risks. In insurance, those most eager to buy health cover are often those who know they are unwell, so insurers offering a single price attract the sick, pushing premiums up, driving out the healthy, and threatening the same unravelling. In lending, the borrowers most willing to pay high interest may be the riskiest. In each case, hidden information before the deal selects adversely for the uninformed side.

Combating it

Because adverse selection can wreck a market, much institutional effort goes into countering it. Signalling lets the good types distinguish themselves, as warranties signal a sound car. Screening lets the uninformed side sort the pool, as insurers use medical checks or tiered policies. Mandatory participation, requiring everyone to buy insurance, prevents the healthy from opting out and the pool from unravelling. Reputations, certifications, and intermediaries likewise exist to let good types be told from bad.

Adverse selection is among the most powerful ideas to emerge from the economics of information, showing how a market can destroy itself when one side cannot judge quality. It explains the elaborate machinery, warranties, medical exams, mandates, certifications, that real markets build to keep the bad from driving out the good, and why some markets, absent such defences, simply fail to exist.