The Basics
- Simple definition: When those who are most undesirable from the other party’s perspective are most likely to engage in a transaction, due to hidden information.
- Core idea: Bad products or risks drive out good ones because buyers can’t tell the difference.
- Think of it as: The lemons problem – used car market fills with clunkers because good cars are withdrawn.
What It Actually Means
Adverse selection occurs before a transaction when one party has private information. In insurance, high-risk individuals are more likely to buy. In credit, risky borrowers seek loans most eagerly. In labor markets, less productive workers may accept jobs more readily. This can lead to market unraveling prices based on average quality attract below-average, forcing above-average to leave, prices fall further, and the market may collapse.
Example
A Pakistani bank offering loans at a fixed rate attracts mostly risky borrowers (they have few alternatives). Safe borrowers find the rate too high and don’t apply. The bank faces high defaults, must raise rates, driving away safer borrowers, and creating an adverse selection spiral.
Why It Matters
Adverse selection explains many market failures and institutional responses – mandatory insurance, credit screening, warranties, and government interventions.
Don’t Confuse With
Moral Hazard – adverse selection is hidden characteristics before the deal; moral hazard is hidden actions after the deal.
See also
Asymmetric Information • Moral Hazard • Lemons Problem • Screening • Signaling
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