Adverse Selection Details

Adverse selection (or asymmetric information) is typically used in insurance and economic markets. Essentially, it's a strategy where you force your opponents to take disadvantageous options. Meanwhile, you take the most profitable options using informational advantage as your primary leverage.

In the business world, more information equals better decisions, and better decisions equal more profit. When you buy a product, there's an expectation that the seller will place a price equivalent to their product’s quality and average price. A buyer will buy that product, knowing that the product offers a great value proposition to the buyer. Oftentimes, this isn’t the case.

Not everyone has access to complete information regarding the market condition, product quality, or customer demography. Either party could possess data or knowledge that's hidden from the other, which is often referred to as inside information. As a result, that seller might capitalize on that information by focusing on other locations for better sales, adjust product prices, or bundle them with other products.

Example of Adverse Selection

Mark has a 1960 Volkswagen Beetle given by his older relative. The car is still in good condition since the previous owner took good care of it. However, Mark doesn't know much about antique cars. He's a practical person and would rather buy a car that's faster and more efficient. So, Mark decides to sell the car for $10,000—believing that to be a reasonable price. He plans to use the money to fund his new car.

John is an automobile enthusiast. He especially likes antique cars and is up-to-date on their current value. One evening, he browses the used car market and sees Mark’s Volkswagen Beetle on sale. He knows that, typically, a Volkswagen Beetle in good condition would cost somewhere closer to $20,000. John and Mark agree to meet at Mark’s house to inspect the car.

In this case of adverse selection, Mark sold the Volkswagen Beetle at a relatively cheap price because he didn’t think that the car had any additional market value. Meanwhile, John, who has more information regarding the market condition of antique cars, sees Mark’s car as a bargain. Upon physical inspection by John, he finds that Mark’s Volkswagen Beetle could actually be worth up to $30,000 since it's been so well-preserved. John agreed to buy Mark’s Volkswagen Beetle at the listed price of $10,000.

In the end, John finds himself with a profit of $10,000 to $20,000 because he had additional information that the seller didn't. And Mark failed to realize that he could maximize his car’s actual value.

Adverse Selection vs Moral Hazard

Adverse selection is the difference between information understood by the seller and the buyer. On the other hand, moral hazard is an exploitative behavior incentivized by a contract. Asymmetric information causes both adverse selection and moral hazard. The main difference between moral hazard and adverse selection is the timing.

In adverse selection, the information difference is exploited upon reaching an agreement. In moral hazard, the user actively abuses and exploits an agreement in a way that it’ll bring them the most benefit. Usually, the effects of moral hazard are much more severe than adverse selection because changing an agreement is much harder than establishing an agreement in the first place.

For example, a group of five friends is going out for dinner. They all agreed to split the bill evenly, no matter how much food they order. An individual exercising the effects of moral hazard might order more expensive meals, more desserts, and more beverages. They know they can get away with ordering expensive meals because the overall price will be split evenly, and that person will end up paying less for their meal than they would if they were paying separately.