The concept of adverse selection is used to identify a market process in which low-quality products or customers are more likely to be selected as a result of the possession of asymmetric information by the two sides of the market transaction. In this situation the better-informed side may take trading decisions that adversely affect the other side, with unwelcome consequences for the market as a whole. Economists usually refer to this situation as a case of market failure: a case in which market dynamics do not lead to an efficient allocation of goods and services.
The notion of adverse selection is applied widely in contemporary economic literature because asymmetric information is often a common feature of market interactions. This typically occurs when the private information available to the sellers is not disclosed to the buyers or vice versa. The most classic example of adverse selection concerns the market for secondhand cars, which usually is referred to as the “market for lemons” since the pioneering work in 1970 of the Nobel laureate economist G. A. Akerlof.
In that market potential buyers cannot distinguish good cars (“peaches”) from bad cars (“lemons”) easily. However, the sellers are perfectly aware of the characteristics of their cars. Potential buyers are likely to offer the average market price for a particular car model. A peach owner will refuse such an offer, but a lemon owner will agree to sell his or her car for an amount that is likely to be higher than its real value. As a consequence, only sellers with bad cars will offer them for sale, and the potential buyers’ willingness to pay for secondhand cars will decrease. The resulting market equilibrium will be inefficient because there will be a number of transactions that are lower than the optimal level.
The role of adverse selection in explaining market inefficiencies has been understood since the beginnings of the economic literature. In his 1776 inquiry on the wealth of nations Adam Smith implicitly applied the concept of adverse selection to the analysis of the credit market. He intuited that a legal rate for loans much above the lowest market rate probably will attract only risky borrowers who are willing to pay a high interest rate. Safe borrowers, who are willing to pay only part of what they are likely to gain through the use of money, will not venture into the competition, and most of the capital probably will be lost.
Inefficiencies in the credit market caused by adverse selection have been used more recently to explain the causes of the Third World debt crisis of the early 1980s. Much of that debt was amassed after the 1973 oil crisis, when European and North American banks lent large amounts of money from the oil revenues deposited in their accounts. The low interest rate that was demanded attracted several Third World countries whose financial capability was not observable by those banks. For some of those countries strong financial constraints resulted in the inability to repay the debt when economic conditions worsened and interest rates increased.
SEE ALSO Banking; Insurance; Loan Pulling; Loan Pushing; Loans; Moral Hazard; Smith, Adam
Akerlof, G. A. 1970. The Market for “Lemons”: Quality Uncertainty and the Market Mechanism. Quarterly Journal of Economics 84 (3): 488-500.
Smith, Adam.  1904. An Inquiry into the Nature and Causes of the Wealth of Nations. 5th ed., ed. Edwin Cannan. London: Methuen.