Adverse Selection

Weekly I/O#59

Adverse Selection: Asymmetric information in transactions can lead to the less-informed side potentially making bad choices.

Article: Adverse Selection: Definition, How It Works, and The Lemons Problem

Adverse selection often refers to a situation where sellers have more information that buyers don't have, or vice versa, about some aspects of a product. Therefore, the party with more information exploits this asymmetric information.

For instance, in the market for used cars, a seller knows more about the vehicle they are selling than the buyer. A used car seller may sell a vehicle that looks good on the outside but has mechanical issues that are not obvious. Therefore, a buyer without enough expertise to identify potential issues may end up overpaying for a car with hidden problems, leading to the lemon problem.

Similarly, in the insurance market, individuals with higher risk profiles, such as those with pre-existing medical conditions, are more likely to purchase health insurance than healthy individuals. This can lead to adverse selection for the insurance company, as they may pay more claims to individuals with higher risk profiles than initially expected.

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