What is adverse selection?
Adverse selection is when one party has more information about a product than the other in a business transaction. Usually, sellers have more information than buyers do – also known as asymmetric information – giving sellers an advantage in negotiating prices and terms. In this situation, the person with less information may end up paying more than necessary.
Adverse selection due to asymmetrical information can lead to making bad decisions that are unprofitable or risky.
How does it affect markets?
If the seller has more information than the buyer, it can lead to negative consequences for consumers.. Buyers may end up paying more for undervalued or defective products and services, costs may increase, and some consumers may be excluded from the market because they lack the information they need to make informed decisions. This could lead to a negative impact on a consumer’s physical or mental health. For example, if they buy a faulty product or expired medication, they may suffer injuries or illness. Consumers may even end up rejecting certain products that are good for them if they believe it is risky.
In the case of insurance, on the other hand, the company is the one with less information about the consumer. To minimize it, they go through an underwriting process where they evaluate the person’s overall medical history to assess the person’s likelihood of making a claim and the premium they should charge.
Minimizing adverse selection
To minimize adverse selection, consumers can reduce information asymmetry by gathering information about a product or service through various means: product reviews, discussion forums, blogs, and videos. Warranties and guarantees can also help users trust the brand more since they have the peace of mind that they can get the product repaired for free or return it without any risk.