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Adverse Selection

Adverse selection arises in markets where there is asymmetric information between buyers and sellers. Asymmetric information occurs when one party in a transaction or contract has information that is not observable to the other party. Adverse selection is a term commonly used by economists, insurers, statisticians, and policymakers to explain what happens when individuals have unobserved characteristics and make their choices based on those characteristics. Moral hazard is another important aspect of health insurance markets and is often studied in the same context as adverse selection. Moral hazard defines the situation where the cost of one's action is shared with another party (e.g., insurer), and this causes one to behave differently than one otherwise would if one were responsible for the full cost of one's action. For example, an insured person may consume more healthcare with insurance than he or she would if he or she paid out of pocket. In contrast, adverse selection occurs when an individual enters a contract based on his or her private and unobservable information. An example of this is an expectant mother choosing an employer that offers generous maternity benefits over one that does not.

Insurance is designed to provide protection from unexpected risks. However, an individual may have a better understanding of his or her future healthcare needs than a health insurer. Individuals may know their expected health expenditures through their parents' medical histories or from genetic tests. Adverse selection occurs when they choose insurance coverage with this in mind. If insurance companies are not aware of individual risk levels, then insurance markets may experience adverse selection as a result of high-expected-cost individuals purchasing more comprehensive coverage. This will likely lead to higher premiums and could drive low-expected-cost individuals to less comprehensive insurance policies. In contrast, if potential risks are common information for both parties, then high-risk individuals may face barriers to coverage of predictable expenditures because insurers will exclude likely events from an insurance policy.

The Lemon's Principle

The concept of adverse selection was first formally introduced by George A. Akerlof in his 1970 seminal article titled “The Market for Lemons: Quality Uncertainty and the Market Mechanism.” In the article, Akerlof presents adverse selection in the context of a used car market where the sellers know the quality of the car they are selling and the buyers are only aware of the distribution of the quality of the cars for sale. The quality of a used car could vary from good to bad (a lemon), but the buyers have no way of identifying the quality of each car, especially if all cars are sold at the same price.

Consider a market where there are five used cars with varying quality levels for sale. For simplicity, we will assign a cardinal index of values to each of these cars: 0, 0.25, 0.5, 0.75, and 1. Assume that the seller's reservation sale price (i.e., lowest price) of each car is equal to $2,000 × quality. If the market price is set at $2,000 initially, then all five cars would be offered for sale. However, since the buyer only knows the distribution of the quality of cars, his offer price will be equal to $2,000 × average quality (0.5), or $1,000. Thus, no cars would sell for $2,000. If the market price is then brought down to $1,000 to accommodate the buyer's offer, then the two best cars would exit the market since the new market price is lower than their reservation value. The withdrawal of the two best cars results in a drop in the average quality of the remaining cars to 0.25, and the buyer's offer price would then fall to $500. Again, no cars would be sold. If the market price falls further to match the buyer's offer at $500, the next best car would exit the market, leading to a further drop in the average quality of the remaining cars in the market. A continuation of this pattern leads to bad cars driving the good cars from the market, leaving no market in the end. This example, known as the lemon's principle, is an extreme case of adverse selection. However, in most cases, trade is not totally eliminated, though market allocations may result in economic inefficiencies.

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