Adverse selection

Adverse selection is a concept in economics, insurance, and risk management, which describes a situation where market participation is affected by asymmetric information. When buyers and sellers have different information, it is known as a state of asymmetric information. Traders with better private information about the quality of a product will selectively participate in trades which benefit them the most, at the expense of the other trader. A textbook example is Akerlof's market for lemons.

The party without the information is worried about rigged trades, which occurs when the party who has all the information uses it to their advantage. The fear of rigged trade can prompt the worried party to withdraw from the interaction, diminishing the volume of trade in the market. This can cause a knock-on effect and the unraveling of the market. An additional implication of this potential for market collapse is that it can work as an entry deterrence that leads to high margins without additional entry.

Buyers sometimes have better information about how much benefit they can extract from a service. For example, an all-you-can-eat buffet restaurant that sets one price for all customers risks being adversely selected against by high appetite and hence, the least profitable customers. The restaurant has no way of knowing whether a given customer has a high or low appetite. The customer is the only one who knows if they have a high or low appetite. In this case the high appetite customers are more likely use the information they have and to go to the restaurant.

In this case, the seller suffering from adverse selection can protect himself by screening customers or by identifying credible signals of appetite. Some examples of this phenomenon occur in signaling games and screening games.

An example where the buyer is adversely selected against is in financial markets. A company is more likely to offer stock when managers privately know that the current stock price exceeds the fundamental value of the firm. Uninformed investors rationally demand a premium to participate in the equity offer. While this example functions as a good hypothetical example of the buyer being adversely selected against, in reality the market can know that the managers are selling stocks (perhaps in required company reports). The market price of stocks will then reflect the information that managers are selling stocks.

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