What is adverse selection? (Definition, effects, examples)
By Indeed Editorial Team
Published 5 July 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
In an ideal transaction, both the seller and the buyer have the same amount of information as they're approaching the deal. In reality, this can look different, and the information these two parties have might vary. Adverse selection is an example of this occurrence, where one party fails to share the information that could affect the sale. In this article, we explain adverse selection, explore the effects it has on customers and markets, share ways to reduce the risk of anti-selection and share real-life business examples to help you better understand this concept.
What is adverse selection?
Adverse selection, also known as anti-selection, is a situation when one party participating in a transaction has more information about the sale than the other. For example, this can refer to some aspects of product quality. This puts one side at an advantage and increases the risk of information failure. Anti-selection is a common occurrence within the used goods market when the seller knows about the product's history and doesn't inform the buyer about it.
Importance of adverse selection
Understanding anti-selection is important because it can help you avoid the consequences of bad decisions that you'd make during transactions. When you effectively notice the first signs of anti-selection, you can reduce the risk of losing money or making bad long-term investments. This works either for yourself or the other party that has insufficient information about a product, service or the transaction you're about to finalise.
4 effects of anti-selection
When there's some form of asymmetry in how much information the buyer and the seller have, anti-selection can cause confusion or lead to potential business and even health risks. To know how to avoid them, it's helpful to review some of the most common effects that this situation has on customers and the market:
1. Higher prices for customers
When a customer has no information about a product's defects and still proceeds, it may be necessary that they invest even more money into repairs and maintenance. For example, this can happen to someone who buys a faulty car from a seller who hasn't mentioned any defects. In reality, the car could stop working after driving a few miles. As a result, the buyer, who's now the new owner, would spend more money on transporting the car to the mechanics and paying for new parts. In total, they'd spend much more on that car than the seller initially advertised.
2. Lower consumption of goods
As a result of anti-selection and customers not disclosing truthful information, some companies decide to increase their prices for all customers. As a result, fewer consumers may be able to afford a specific product or service. This is an especially risky situation for insurance firms, which may notice a decrease in revenue as a result of this.
3. Customer exclusion
In some situations, anti-selection may even lead to customer exclusion. This might happen both because of high prices that not everyone can afford and feelings of unfairness after a seller fails to share truthful information about a transaction. When someone has an unpleasant experience with a specific seller or industry, they may be reluctant to do business with them in the future.
4. Health risk
When companies fail to disclose detailed information about specific products, including food, it may increase the health risk for their customers. For example, buying a second-hand car with faulty brakes may lead to a road accident, which is a significant health risk for the buyer. Similarly, companies that don't share full nutritional information on their food product boxes may expose customers to medical risks, such as high sugar or high blood pressure. Luckily, governments all over the globe are working to reduce this risk by demanding that manufacturers share this information with the public.
Ways to reduce the risk of adverse selection
You may encounter some form of anti-selection, even if it feels like you know a lot about the other party in the transaction. Depending on which side you represent, here's how you can reduce its risk and make sure you have enough information about the product and the agreement:
In some situations, buyers can minimise the risk of anti-selection. Most importantly, it's critical that they research the companies and individuals with whom they plan to do business. A good method for this is consulting publicly available online ratings. They can also do additional research to compare prices and the quality of materials that companies used to produce goods.
Sellers can also take some steps to fight the effects or risk of anti-selection. For example, insurance and medical companies may introduce a new policy where they assess each client's health risk before calculating the cost of insurance. By distinguishing between low- and high-risk clients, they can introduce more transparency to the process and offer different medical and insurance packages to make sure everyone pays for insurance according to their situation.
Adverse selection vs moral hazard
Adverse selection often overlaps with moral hazard, as both concepts focus on the idea that one party fails to share important information about a transaction with the other side. Although these two situations can be similar, there are significant differences between them. The biggest difference is that moral hazard is more likely to occur after completing the transaction. It's also common in the insurance industry and in relationships between employees. Anti-selection usually takes place before the agreement.
Examples of anti-selection
To better understand how anti-selection works and when you may encounter it, it's helpful to review real-life examples of it. Here's how this concept works in specific business and sales scenarios:
Often, you may encounter anti-selection when finalising transactions for used cars. When purchasing a car second-hand, you generally have less information about the product than the seller who's been driving it to date. This may lead to having insufficient information about the product you're purchasing.
Example: When buying a new car, you may start the process by researching local dealerships and reviewing used car ads online. If you encounter an unfair seller, they might want to take advantage of the situation by selling the car to you at an inflated price despite being aware of the product's defects. To avoid this, it's critical to make in-depth research or ask a third party to assess the car's condition before finalising the transaction.
Stock market transactions
A similar situation can happen when you want to buy a company's stock. Typically, stock transactions involve spending more money than when you're purchasing a car or insurance. Because of this, they may be more risky to your finances if a stock trader hides important information from you, creating information asymmetry.
Example: Traders who are responsible for selling shares may have additional information about the company to which you don't have access. For example, this can refer to any high-risk company plans that might cause the price of its shares to drop. Some sellers may also overvalue shares, increasing the asymmetry of information between themselves and you as the buyer. To avoid this, it's helpful to review the company's history on the stock market or consult the purchase with a third party stock market expert.
The life and health insurance industry typically is one of the first fields that began experiencing and noticing the phenomenon of anti-selection. Anti-selection that occurs in insurance often increases the demand for insurance, which directly relates to the client's risk of loss. A good real-life example of this is the cost of insurance for smokers and non-smokers.
Example: Generally, non-smokers have a greater life expectancy than smokers of the same age. People who don't smoke are also less likely to experience lung diseases that smoking causes. Smokers are more likely to purchase more life insurance, which increases the overall mortality rate within the insured group. As a result, insurance companies pay a lot for deaths that smoking caused, which makes them increase prices for all clients, including non-smokers. This may cause non-smokers to look for another insurance policy, making the company lose clients.
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