Definition
Adverse Selection is a market problem that arises when one side of a transaction possesses more or better information than the other, causing higher-risk or lower-quality participants to be more likely to participate in the market.
Why It Matters
Adverse selection can distort markets, raise prices, reduce trust, and sometimes cause markets to fail entirely. It is especially important in insurance, lending, hiring, and used-goods markets, where hidden information about risk or quality influences decisions. Economists study adverse selection to design screening methods, pricing strategies, and regulatory safeguards that improve market efficiency.
Example
If an insurance company cannot distinguish between healthy and high-risk customers, the high-risk individuals are more likely to purchase coverage. As claims rise, the insurer raises premiums, which may drive healthier customers away, further increasing average risk — a classic adverse selection spiral.