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 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.

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 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.

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.

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.

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.

Fig. 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.

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.