Adverse Selection

When good and bad qualities of an item are both available in the market and agents cannot easily distinguish between the two, price will reflect this uncertainty about the true quality of each item. Typically, equilibrium price will tend to be a weighted average of the price of the good quality items and the price of the bad quality items where the weights are the probabilities of occurrence of the different types of the item. As a result the owners of the superior quality may find the average price too low to continue to supply the higher quality item. In effect the bad quality drives the good quality out of the market and the market fails. This tendency for the bad quality to prevail as a result of information gap is referred to as adverse selection.

Adverse selection was well illustrated by George Akerlof (1970) in his paper "the Market for Lemons." The paper investigated the market for used cars where the buyers presumably have less information about the quality of the cars than the sellers. The buyer realizes the true quality of a car only after he/she purchases it and uses it for a while. Before the actual decision is made, the buyer knows only the probability that a given car might be good or bad. The price a buyer is willing to pay is, therefore, based on his/her expectations about the average quality of the cars in the market. Since all the cars are assumed to be sold at the same price, the owners of the good quality cars will fail to command a commensurate price for their superior quality. Consequently, they will either resort to the lower quality or leave the market entirely and the average quality of cars and price in the market keep falling. In the extreme only little or no trade in used cars will take place since quality is relative.

Adverse selection is a common phenomenon in insurance markets as well. Typically, agents who face a higher probability of suffering a loss tend to buy insurance more than those who are less likely to be the victims. Again a situation may arise where the proportion of the risky agents and insurance premium keep on rising ultimately rendering some types of insurance businesses totally unprofitable. This is the reason for the increasing difficulty older people face in obtaining health insurance.

Akerlof, George A. (1970), "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism," Quarterly Journal of Economics, Vol. 84, No. 3. , pp.488-500.