Where does adverse selection collide?

The founding case of adverse selection: when buyers cannot observe quality before a sale, good units and bad units face the same price, so owners of good units withdraw, the average quality on offer falls, and the price drops further until the market can unravel. Akerlof's 1970 The Market for 'Lemons' used the used-car trade to show how asymmetric information about quality drives good cars out and can leave only the bad ones, then carried the same logic into insurance, credit, and labour. The referent is a hidden attribute fixed before the trade, a quality that one side knows and the other does not, and the skew it produces in who chooses to transact.[1]

Unit

A trade under quality one party knows and the other cannot see

Recovery means

Signals such as warranties, guarantees, and certification can restore trade by letting sellers of good units credibly separate themselves

Measured by

Observed as a price and quantity below the full-information level, and as the exit of higher-quality units from the market

Adverse selection in insurance: when an insurer cannot observe an applicant's risk type, a premium set for the average risk is a bargain for high risks and a poor deal for low risks, so high-risk individuals disproportionately buy coverage and the insured pool deteriorates. Rothschild and Stiglitz's 1976 Equilibrium in Competitive Insurance Markets showed that competitive insurers answer with a menu that trades quantity of coverage against premium, so customers screen themselves by which contract they choose, and proved such a market may have no equilibrium at all. The hidden attribute here is the buyer's own probability of loss, known before the policy is written.[2]

Unit

A policy priced without seeing the buyer's true risk of loss

Recovery means

Menus that trade coverage against premium let buyers screen themselves, and community rating backed by a mandate can hold the pool together

Measured by

Detected as a positive correlation between coverage bought and losses incurred, after pricing on observable characteristics

Adverse selection in security issuance: managers know more about a firm's true value than outside investors, so a decision to issue new equity is read as a signal that insiders think the shares are overvalued, and the market marks the price down on announcement. Myers and Majluf's 1984 Corporate financing and investment decisions when firms have information that investors do not have showed that this discount can lead a firm to pass up a good project rather than sell underpriced stock, giving the pecking order in which firms prefer internal funds, then debt, and equity last. The hidden attribute is the firm's own quality, known to insiders before the offering.[3]

Unit

A security sold by an insider who knows the firm's value better than buyers

Recovery means

Financing from retained earnings or debt avoids the signal, and the pecking order ranks sources to keep the discount small

Measured by

Seen as the negative average stock-price reaction to seasoned equity issues, and as reliance on internal funds

Adverse selection in health insurance markets: when sicker enrolees choose the more generous plan and its premium rises to cover them, healthier enrolees switch to cheaper coverage, the premium rises again, and the generous plan can spiral upward in price until it collapses. Cutler and Reber's 1998 Paying for Health Insurance traced this trade-off between competition and adverse selection at Harvard, where a move to fixed employer contributions set off a selection death spiral in the most generous plan. The standard policy remedies, a mandate that broadens the pool and risk adjustment that pays plans more for sicker members, are attempts to blunt the same hidden-information mechanism.[4]

Unit

A health plan chosen by enrolees who know their own health

Recovery means

A mandate broadens the pool and risk adjustment transfers funds toward plans that enrol sicker members

Measured by

Observed as a premium death spiral in generous plans, and as risk sorting across plan tiers