What is adverse selection?
Adverse selection arises from asymmetric information before a transaction: the uninformed party attracts a disproportionate share of low-quality or high-risk counterparts. George Akerlof’s 1970 paper on the "market for lemons" made it famous; he shared the 2001 Nobel Prize with Michael Spence and Joseph Stiglitz.
📌 At a glance
- Key paper
- Akerlof (1970)
- Cause
- Pre-contract hidden information
- Examples
- Used cars, insurance
- Remedies
- Signalling, screening, mandates
Lemons and insurance
If buyers pay for average quality, owners of good cars leave the market and quality spirals down. In insurance, high-risk people are keener to buy, pushing premiums up and low-risk buyers out.
Versus moral hazard
Adverse selection is about hidden information before a contract; moral hazard is about hidden action after it.
Frequently asked questions
- What is adverse selection?
- Pre-contract information asymmetry that leads the uninformed side to attract worse counterparts.
- How can it be reduced?
- Through signalling, screening, warranties and mandatory participation.
References
- Akerlof, G. A. (1970). The market for “lemons”: Quality uncertainty and the market mechanism. Quarterly Journal of Economics, 84(3), 488–500.
- Spence, M. (1973). Job market signaling. Quarterly Journal of Economics, 87(3), 355–374.
- Rothschild, M., & Stiglitz, J. (1976). Equilibrium in competitive insurance markets. Quarterly Journal of Economics, 90(4), 629–649.