The Concept of Adverse Selection Explained

In 2001, George A. Akerlof was awarded a Nobel Prize for analysis of markets with asymmetric information (shared with other two winners). He is famous for his article 'The Market for "Lemons": Quality Uncertainty and the Market Mechanism' (1970), that talks about adverse selection in the market of used cars.

When we buy something new from the market, often, we are slightly skeptical of the seller. Why is it so? We are worried that the seller might know something which we do not know. Thus, you're scared that asymmetric information might seep in.

It is only after a good experience that we instill confidence in the seller. However, if you make a wrong selection due to concealment by the seller, you might be a victim of adverse selection. Also known as anti-selection, it is very common in the insurance sector.

Note: Asymmetric information is a situation wherein, one of the parties to the transaction has more knowledge regarding the transaction than the other. He may exploit this information for his advantage.

It is nothing but the potential loss that can be incurred by the buyer or the seller due to asymmetric information in the market. Given further are a few examples that will explain this concept further.

As such, the insurance will be less profitable for the insurer, since he is not aware of a critical information that might increase the chances of the insured event happening.

How adverse selection affects the health insurance market: This sector is most prone to adverse selection. Typically, those who are at a higher risk to health hazards will find it beneficial to buy an insurance coverage, than a healthy person who is at much lower risk.

Those who are healthy will find the premiums too high to pay and will avoid taking an insurance cover. Also, the insured might hide vital data that might threaten his health or life, and not disclose the information to the insurer. For example, a smoker is at risk to health hazards, and may buy an insurance policy to mitigate the risk, than a non-smoker.

That means, even non-smokers have to pay high premium, hence, that dissuades them from buying the insurance policy. This is a huge loss to the insurance company. Sometimes, the insurance company might not be able to distinguish between high-risk and low-risk investors, due to which, it might be difficult for them to compute the insurance premium.

To curb such a situation, insurance company might make different plans, and the potential insurance investors will choose from them. Of course, those who want a higher recovery amount will go for a plan, even if it has a high premium, and those with lesser need will go for a plan having lesser insurance premium, though it implies lesser insurance coverage.

The other alternative for the insurance company can be to incur costs in making a background check and collecting information about potential insurance investors, thereby making it easy to factor the risk areas, if any.

Adverse selection will occur due to the difference in knowledge of the informed and the uninformed traders, respectively. Those who are better informed will make more trading benefits than the less-informed.

To mitigate risk, if the lender increases the interest rates, the good parties who cannot afford high interest rates will automatically be driven out.

• If high-risk investors are more, insurance company's revenue will decrease considerably.
• Asymmetric information may lead to a lot of financial losses. For example, if you buy a used car which does not give performance as much as what is expected, your investment in that car is not getting optimum returns.

• In banking sector, if a bank lends to a high risk borrower, without charging proper interest, and failing in party scrutiny beforehand, there are chances that he will default in the payment. A bank has other risk mitigation options, like they can sell the mortgaged property. But, it is important that the bank exercises due diligence before lending money.

• Adverse selection is one of the reasons for market failure. In this case, even the good brands suffer due to the presence of bad products, since the buyer or the seller cannot distinguish between the two.

In this paper, George A. Akerlof gave a simple example to understand the impact of asymmetric information and adverse selection on the market. 'Lemon' is an informal word to describe a car that has turned out to be a defective piece after buying it, whereas, 'good car' refers to a well-maintained car.

In the market of used cars, both, the lemons and good cars are pooled together, and it is not easy for any buyer to distinguish between them. This leads to asymmetric information, since the sellers have more knowledge of the car than the buyers.

That is the reason that the buyers are skeptical before buying the car, and know there is a possibility that the car may turn out to be a lemon. Hence, buyers reduce their reservation prices, which discourages the owners of the good cars.

They are driven out of the market, and hence, essentially, only the lemons remain in the market. Instead, the lemons get a higher price than what they deserve. Thus, this asymmetric information leads to adverse selection by the consumers.

Thus, as mentioned, adverse selection is a market failure than can lead to financial losses for either the buyer or the seller. As long as there is lack of adequate information in the market, adverse selection will continue to happen.