The Principle of Adverse Selection

by Simon. Average Reading Time: about a minute.

Adverse selection, anti-selection, or negative selection is a term used in economics, insurance, statistics, and risk management. On the most abstract level, it refers to a market process in which bad results occur due to information asymmetries between buyers and sellers: the “bad” products or customers are more likely to be selected.

Take the Volvo car as an example. Volvo’s cars are perceived to be ‘safe’ by many people. However, Volvo drivers are more likely to crash because:

  1. Bad drivers choose a Volvo because of the perceived safety qualities of the car, which supposedly offset their inability to drive.
  2. Good drivers push their driving skills to higher limits, testing their abilities, therefore taking greater risks whilst driving a Volvo.

The concept of adverse selection has been generalised by economists into markets other than insurance, where similar asymmetries of information may exist. For example, George Akerlof developed the model of the “market for lemons.” People buying used cars do not know whether they are “lemons” (bad cars) or “cherries” (good ones), so they will be willing to pay a price that lies in between the price for lemons and cherries, a willingness based on the probability that a given car is a lemon or cherry.

For instance, if the probability of getting either a lemon or a cherry is 0.5, and the price for a lemon and a cherry is £5,000 and £10,000 respectively, the price they are willing to pay for a used car would be (0.5×5,000) + (0.5×10,000) = £7,500.

If buyers had perfect information they would know the value of a car for certain, and they would simply pay an amount equal to the value of the car.

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