What is Adverse Selection?
Adverse Selection: Definition
Adverse selection is a situation in which buyers and sellers differ in terms of information accessibility about products’ quality. One party can be more informed and hence exploit the other. Such an environment creates market participation that is prone to asymmetric information. Experts in economics have studied the effect of such conditions on product quality outcomes and found that adverse selection creates quality uncertainty and nonfunctioning markets due to the presence of unreliable facts to determine the nature of commodities against the price (Beatty, Lu, & Luo, 2013). Akerlof (1970) introduced the concept of a “Lemons” market to define the effects of information asymmetry such as degraded quality of goods (Beatty et al., 2013). Although adverse selection is a common occurrence in various industries, it can negatively affect market dynamics; hence, it should be mitigated to create an effective trading environment.
Theoretical Definition of Adverse Selection
Theorists have defined the term adverse selection in various ways. Attar, Mariotti, and Salanié (2014) discuss two alternative paradigms within which researchers have developed the theory and provided the means to understand the concept. Akerlof (1970) is among the first authors to introduce the idea of adverse selection. He suggested an environment where sellers act as price takers since they have information while buyers remain uninformed (Attar et al., 2014). The assumption is that all trades occur at the same price. Although the market has a competitive equilibrium, it may suffer from certain failures. The equilibrium affects the market because quality does not determine the cost of products (Attar, et al., 2014). Therefore, the outcome brings a situation where some parties control the market.
The second paradigm emerged six years later. Rothschild and Stiglitz (1976) proposed the theory of adverse selection as a strategic model where buyers force sellers to reveal their private information and offer to trade varied quantities at different unit prices (Attar, et al., 2014). The situation emanates in a context where some parties are more informed and use such an advantage to control the quality and price of products or services. The model proves that individuals selling low-quality goods are more efficient since they have unequal access to product quality information. On the contrary, those selling high-quality trade a suboptimal but nonzero quantity. For example, high-risk agents are covered, while low-risk ones are partially insured (Attar, et al., 2014). The insurance market does not have a pure-strategy equilibrium in an environment with high and low-risk agents. Therefore, it is evident that adverse selection endangers the market.
Real-Life Example of Adverse Selection
Adverse selection is a common issue in various industries. One of the typical examples includes a managed care model. Capitation payment is the means through which players in the healthcare industry control cost. Furthermore, the market manages the quality of services offered to patients. The model gives service providers the incentive to reduce the cost of care, which affects quality. Hence, in their effort to attract people to enroll in the managed care system, they increase quality and cost (Frank, Glazer, & McGuire, 2017). However, organizations that operate under such a strategy have facts that the service recipients do not possess, which creates information asymmetry in the market. Besides, the institutions have a leeway to make inefficient decisions about the quality and cost of services (Frank et al., 2017). Therefore, the model that is expected to serve the needs of patients and healthcare institutions creates an inefficient environment.
Remedy for Adverse Selection
Adverse selection is an ineffective outcome of information asymmetry. Therefore, players in the market, buyers and sellers, should address it. Attar et al. (2014) propose a resolution based on Akerlof’s (1970) theory. Traders can overcome the negative outcome of competitive equilibria regarding informed sellers and uninformed buyers by allowing the screening of products for different qualities. In addition, they should share information among themselves to create efficiency (Attar et al, 2014). Glode and Opp (2015) propose another strategy based on intermediation as an effective solution to inefficiencies caused by asymmetric information. The process involves the use of an uninformed third party to subsidize transactions and eliminate the dangers of adverse selection. Furthermore, informed intermediaries who value their reputation can address trade efficiency by being honest about the quality of goods (Glode & Opp, 2015). Hence, a solution to the problem will create a better market with quality goods and services.
As is evident from the analysis, adverse selection is a common practice in various industries such as the insurance market. The concept refers to a situation where buyers have information that sellers do not possess or vice versa. The condition creates information asymmetry that undermines the quality of products or services in the market. Thus, the party with the information can use it for personal gains, disadvantaging the entity without such details. The situation is common in managed care settings, where institutions can control the cost of services provided to patients. Consequently, such organizations lower the quality of services as the price goes down. A solution to the problem would be to apply the intermediation approach or use reputable agents with adequate information to serve the interest of buyers and sellers.
Attar, A., Mariotti, T., & Salanié, F. (2014). Nonexclusive competition under adverse selection. Theoretical Economics, 9(1), 1-40. Retrieved from https://onlinelibrary.wiley.com/doi/pdf/10.3982/TE1126
Beatty, R., Lu, H., & Luo, W. (2014). The market for “lemons”: A study of quality uncertainty and the market mechanism for Chinese firms listed in the US. Retrieved from http://www.af.polyu.edu.hk/files/jiar2014/cc067%20BLL_Jan1_2014_final.pdf
Frank, R. G., Glazer, J., & McGuire, T. G. (2017). Measuring adverse selection in managed health care. In J. Glazer & T. G. McGuire. (Eds.), Models of health plan payment and quality reporting (pp. 29-57). Singapore: World Scientific Publishing Co. Pte. Ltd.
Glode, V., & Opp, C. (2015). Adverse selection and intermediation chains. Retrieved from http://finance.wharton.upenn.edu/~vglode/Old_Chains.pdf