Adverse Selection

What goes on in your mind when you're buying a used product? Fear that you're getting something that is in worse condition than it appears? If so, you're not alone. Most people who buy used products, like a car, will always feel some level of unease because they don't know the history of the car they're buying. In contrast, a new car doesn't have this same feeling of unease. Wondering why exactly this is? Continue reading to learn more about adverse selection!

Adverse Selection Adverse Selection

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Table of contents

    Adverse Selection Definition

    Let's go over the definition of adverse selection. Adverse selection occurs when two entities engage in an agreement where one entity has more information than the other, and the entity with less information incurs large costs. The "entity" can be an individual or a business, but what is important is that one entity will have more information than the other before engaging in an agreement or contract. The entity with more information will be at an advantage, whereas the entity with less information will be at a disadvantage.

    Let's take a look at a brief example of what adverse selection may look like in the market.

    Let's say that you are buying a used car from a friend of yours. You may think that you know the condition of the car since they're your friend, but you really don't. Your friend will have far more information about his car than you will, leading to a transaction with asymmetric information.

    Your friend is at an advantage given that he previously owned the car and knows everything about it. You are at a disadvantage because you don't know the information that your friend knows about the car. What if he drove recklessly while he owned it, leading to long-term damage? What if there are internal problems with the car that you can't see on the outside? You are engaging in an agreement with your friend where you have less information, and you may incur the cost of such a transaction.

    Adverse selection occurs when two entities engage in an agreement where one entity has more information than the other, and the entity with less information incurs large costs.

    Adverse Selection Example

    What is an example of adverse selection? Generally, adverse selection is very common in the insurance market. Let's look at two different examples of adverse selection in the health insurance and car insurance markets, respectively.

    Adverse Selection Example: Health Insurance

    Think about the purpose that health insurance serves. Why do people get health insurance, and who will likely get it? People get health insurance to protect themselves from the high healthcare costs they would have otherwise paid without health insurance; the people who are most likely to purchase health insurance are those that are prone to getting sick. The problem with the health insurance market is that insurers don't truly know the health of their customers; in contrast, the consumers do know about their health. If the people who are buying insurance are mostly sick, insurers will be forced to raise premiums for everyone — which they don't want to do.

    Adverse Selection Example: Car Insurance

    The car insurance industry is also susceptible to adverse selection. Insurers do not have full access to a consumer's brain who wants car insurance. They only know so much about people who want to get car insurance. The consumer, on the other hand, knows what their intentions are when purchasing car insurance. Perhaps most people purchasing car insurance plan to drive more recklessly immediately after getting insurance. This is something insurers can't figure out or force consumers to reveal. As a result, insurers have less information than consumers; thus, insurers will incur larger costs if most of their consumers get into car accidents.

    Adverse Selection Problem

    Let's expand a bit more on the problem of adverse selection. In a situation where only two entities are engaging in an agreement with asymmetric information, adverse selection is not a huge problem. It still is an issue for the two entities, but on a macro scale, it starts and stops between those two entities. However, when adverse selection becomes prevalent within most interactions in the economy, then it can pose problems for the economy at large.

    In a situation where a majority of transactions have an adverse selection problem, most people are engaging in transactions where the buyer or seller has more information than the other party. In either instance, there will be people "losing" out on this transaction, leading to dissatisfied consumers or producers. This could cause a market failure, given that buyers and consumers do not have equal information in their interactions. Buyers will not want to buy from sellers, and sellers will not want to sell to buyers. Suddenly, the minor adverse selection problem that only occurred between two entities is now causing major economic problems.

    Want to learn more about market failure? Check out our article:

    - Market Failure

    Adverse Selection vs. Moral Hazard

    What is the difference between adverse selection vs. moral hazard? Recall that adverse selection occurs when two entities engage in an agreement where one entity has more information than the other, and subsequently, the entity with less information incurs large costs. A moral hazard is similar, but has one key distinction. A moral hazard occurs when one individual knows more about their actions and is willing to alter their behavior at the expense of another individual after an agreement.

    As we can see, both phenomena include asymmetric information, where one individual knows more than another individual. In addition, in both circumstances, the individual with less information incurs costs as a result of this agreement. The key difference between adverse selection and moral hazard is that the former occurs before an agreement takes place; adverse selection occurs after an agreement takes place.

    Let's take a look at an example to see the difference between the two.

    Wondering about asymmetric information?No worries, we got you covered!

    Simply click on this article:- Asymmetric Information

    Let's say that Mike is looking for a job where he has to work as little as possible. Mike interviews for a firm downtown in hopes that he found the perfect job. Adverse selection occurs in this scenario because Mike has more information than the interviewer — Mike knows he is going to work as little as he can at this new job if he gets hired; the interviewer does not know this, nor can the interview force this information out of Mike. Thankfully, for Mike, he gets the job.

    Now that Mike has the job, he is cutting corners at his job so that he only works 3 hours of the 8-hour workday. His boss has no idea that Mike is doing this because Mike is technically getting his work done, but he is relaxing for the majority of the shift! A moral hazard occurs in this scenario because Mike has more information than his boss about his productivity and he is altering his behavior accordingly.

    As we can see from the example above, adverse selection and moral hazard are very similar, but the difference lies in when the engagement takes place. Adverse selection occurs before the agreement, and moral hazard occurs after, when the person with more information has altered their behavior.

    Moral hazard occurs when one individual knows more about their actions and is willing to alter their behavior at the expense of another individual after an agreement.

    Want to learn more about moral hazard? Check out our article:

    - Moral Hazard

    Adverse Selection Importance

    What is the importance of adverse selection? To understand this, we need to know what adverse selection does in the market. Adverse selection engenders asymmetric information between a buyer and seller in the market. This will result in an inefficient market where there is either a shortage or a surplus.

    Adverse Selection Market Shortage StudySmarterFig. 1 - Market Shortage

    The graph above depicts a market shortage. Here, consumers demand a quantity of 60 units of a good, whereas producers supply a quantity of 20 units of a good. A market shortage can come about from adverse selection in different ways.

    Perhaps consumers have more information about the price of a new TV on the market. Consumers know that this new TV should really be priced at $300, but producers are selling it at $250. Here, the consumers know more about this product than the producers, and as such, consumers are purchasing too many TVs! This results in a shortage of TVs since producers can't keep up with the demand of consumers.

    Here, consumers are the ones causing the market shortage given the information they have over producers. Therefore, the importance of adverse selection is recognizing what causes it to ameliorate any shortages or surpluses in the market and maintain an equilibrium.

    Want to learn more about market equilibrium? Check out our article:

    - Market Equilibrium

    Adverse Selection - Key takeaways

    • Adverse selection occurs when two entities engage in an agreement where one entity has more information than the other, and the entity with less information incurs large costs.
    • Adverse selection commonly occurs in the insurance market.
    • The problem with adverse selection arises when it occurs within a majority of transactions in the market.
    • The difference between adverse selection and moral hazard is when they take place.Adverse selection occurs before an agreement and moral hazard occurs after the agreement.
    • The importance of adverse selection is knowing what causes it to ameliorate any shortages or surpluses in the market.
    Frequently Asked Questions about Adverse Selection

    Why is adverse selection important?

    Adverse selection is important since it can cause inefficiencies in the market; therefore, we need to recognize how important it is to have full transparencies in the market.

    How do you control adverse selection?

    You can control adverse selection through monitoring, assessments, and risk identification.

    What is an adverse selection example?

    An example of adverse selection occurs in the insurance market. Those who are prone to becoming sick are more likely to get insurance, but insurance companies want to insure healthier people since they want to minimize their risk.

    What is the difference between moral hazard and adverse selection?

    The difference between adverse selection and moral hazard is when they occur — adverse selection occurs before the agreement, and moral hazard occurs after the agreement.

    What are the consequences of adverse selection?

    The consequence of adverse selection is that it can result in market failure.

    Test your knowledge with multiple choice flashcards

    Adverse selection and moral hazard only differ in the time that the agreement is made.

    The insurance industry is good at avoiding adverse selection problems.

    In adverse selection, the entity with more information will incur ______ costs.

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