Adverse Selection

CORE DEFINITION

In economics, insurance, and risk management, adverse selection is a process where asymmetric information between buyers and sellers leads to a non-Pareto-efficient market outcome. As a result, participants with critical information may selectively engage in transactions at the expense of others who lack the same information. Ideally, the price paid by buyers should reflect their willingness to pay and the value of the product or service to them, while the seller's price should reflect the quality and quantity of their goods and services. For example, low-quality products should be cheap, and high-quality products should be expensive. However, when one party has information that the other does not, they have the opportunity to harm the other by maximizing their own utility, concealing relevant information, or even lying. Exploiting economic contracts (see contract economics) or undisclosed information in trade is called adverse selection. This opportunity has secondary effects: the uninformed party may take measures to avoid entering into an unfair (possibly 'manipulated') contract, possibly by withdrawing from the interaction, or the seller (buyer) may demand a higher (lower) price, thereby reducing the volume of market transactions.