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Adverse Selection Definition

George Akerlof, in 1970 was the economist who addressed the problem and solutions associated with adverse selection. He called the problem of adverse selection as a lemon problem. Adverse selection may occur when one agent’s decision depends on unobservable characteristics. That adversely affected other agents.

The term “adverse selection” refers to a circumstance in which one party has knowledge about a certain feature of a product’s quality that the other party does not, or opposite.

How Does Adverse Selection Work?

Adverse selection happens when one side in a transaction has more correct information than the other. The side with more correct information typically benefits as much from the deal, placing the other party, who has less precise data, at a disadvantage.

The information asymmetry leads to inefficiencies in the price charged for specific products or services. Such occurrences are possible in the stock markets, the insurance industry, as well as in regular marketplaces.

What is an example of adverse selection?

In the insurance sector, adverse selection occurs when a person gets coverage at a price that is lower than their actual risk level. Insurance adverse selection occurs when a person who has smoking receives insurance at the same price as someone who does not have a smoking habit.

The importance of adverse selection

Because it can have negative effects on both sellers and purchasers depending on the circumstance, adverse selection is crucial. An example of adverse selection would be when a seller knows about a product issue but refuses to mention it to the buyer.

To learn more about Adverse selection, read the following article.

Introduction to Economics

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