A situation where asymmetric information (between buyers and sellers) causes unwanted results, because the unobserved attributes lead to an undesirable selection from the perspective of the uninformed party.
A good example of adverse selection is the market for health insurance. In this market, the buyers know more about their health issues than the sellers. However both buyers and sellers know that people with health problems are more likely to get insurance than healthy people. Therefore the price of insurance will be set higher than necessary for average customers. As a result this will discourage healthy people from getting insurance and thereby intensify the adverse selection.
Because of its self-reinforcing nature, adverse selection can have significant negative effects on markets or entire industries (such as the insurance industry). Without interventions it results in a vicious circle of increasing risks for sellers or decreasing quality of goods and services for customers.
Labels: Adverse Selection, Dictionary