The adverse selection describes the negative risk selection, which comes about due to different information from two contracting parties before the purchase
In this chapter you will learn what adverse selection is and when it plays a role. We also go into the advantages and disadvantages of adverse selection. You can then test this acquired knowledge with the help of our exercises.
What is adverse selection?
According to beautyphoon.com, the adverse selection always comes into play if there is an information asymmetry before two contracting parties conclude a contract. This means that the two potential contractual partners have different information, with one of the parties having a knowledge advantage over the other. Another form of asymmetrical information is the moral risk, also called moral hazard, which plays a role after the conclusion of a contract.
The uneven distribution of information and the resulting phenomenon of adverse selection lead to a failure of the market mechanisms. This leads to the displacement of providers of good quality, as the willingness of potential customers to pay is minimized due to a lack of information.
In the end, this leads to the fact that the average quality of the products offered on the market also falls, as the providers of good quality withdraw from the market even though there are potential buyers. The lack of information therefore leads to negative developments on both sides.
The best-known example of adverse selection is the example of Akerlof’s “ Market for Lemons ” from 1970, for which he even received the Nobel Prize. However, it is not about the trade in fruit, but is derived from the English term “lemon” for low-quality cars. Based on the used car market, the negative risk selection is explained as follows:
The potential buyer of a used car has insufficient information about the quality of the used cars on the market. His willingness to pay therefore moves around the average expected price of good and bad quality. So he is not willing to pay the price for a high-quality used car.
However, since the seller of the high-quality used car knows about its quality, he is not prepared to accept the price that corresponds to the customer’s willingness to pay, as it is significantly lower than the value of the vehicle. As a result, high quality used cars are no longer available. On the other hand, providers of poor quality are rewarded in the short term, as they can still charge the average price of good and poor quality for inferior quality.
In the long term, however, there is a negative selection, as providers of good quality withdraw from the market and consequently the potential customers also correct their expected price downwards, since the average quality on the market also drops.
If there were no asymmetrical distribution of information between seller and buyer, i.e. if the buyer would also know about the quality of the cars, all used cars could be offered at a price that corresponds to the quality of the vehicle.
Adverse selection: Market for Lemons
Why is adverse selection important?
Understanding the phenomenon of adverse selection is therefore important in order to be able to understand mechanisms and developments in the market. This understanding is the basis for developing countermeasures that can counteract a failure of the market.
As in the used car market, an asymmetrical distribution of information and thus the phenomenon of adverse selection can also occur in the insurance market.
In the example of a health insurance provider, this could look like this:
Before the contract is signed, the insurance company has no information about the state of health and relevant characteristics of its potential customers. As a result, it offers an average price tariff for all customers. For customers with a very high health risk, this is a godsend, as the premium is significantly lower than it would correspond to their risk. For healthy customers, however, the price is above their willingness to pay, which is why they decide not to take out insurance.
The present negative risk selection therefore attracts customers with a high risk and discourages “good” customers. As a result, the risk to the insurance company also changes, which further increases the premiums.
With knowledge of this phenomenon, countermeasures can be initiated to compensate for the asymmetrically distributed information before the contract is signed. Insurance companies always ask health questions before taking out health insurance in order to be able to assess the customer’s risk.
In order not to deter less risky customers, so-called risk surcharges are required on the normal premium for customers with high risk in order to cover the increased risk and the associated costs.
How can the problem of adverse selection be solved?
The phenomenon of negative selection in markets has negative consequences for both the seller and the buyer. In order to circumvent the problem of adverse selection and thus prevent market failure, there are two mechanisms that market participants can use to remove the inequality of information:
With signaling, the side with the information advantage tries to increase its credibility and to convince the side with the information deficit of the quality of the product. It provides information and provides credible evidence of it.
In the example of the used car market, this could be a TÜV certificate, for example, which certifies the quality of the car. In our insurance example, the potential customer can have a medical certificate issued to convince the insurance company of the “quality” of their state of health and thus get a cheaper premium.
During the screening , the side with the information deficit provides itself with information on the quality of the product on offer.
In the used car market, this can be done, for example, by comparing different offers or checking the selected vehicle by a specialist. In the insurance industry who use company questionnaires on the health of potential customers to assess their risk to.
Advantages and disadvantages of adverse selection
- Market participants with poor quality benefit because the consumer price is higher than the actual value of the product.
- Suppliers with high quality products are withdrawing from the market.
- The average quality on the market is falling continuously.
- The prices to be achieved also decrease, since the expected price of the potential customers adapts to the decreasing quality level (in the insurance example, the price increases accordingly).