Adverse Selection

Gresham's law states that bad money drives out good and is the classic expression of adverse selection. In the days when coins were composed of real silver, their holders might shave a small sliver off before using the coin in exchange. Everyone realized that any coin one received might have been shaved in this manner, so people were not prepared to exchange as much for any coin as they would for a coin they knew had not been shaved. Knowing this, those who held unshaved coins would then not spend them or would shave them before using them. Bad money drives out good.

The idea of adverse selection is now a key aspect of economic theory. George Akerlof reintroduced the idea of adverse selection in his classic article based on the used-car market. In his version, every car owner knows whether his car is a good one; however, the buyer is unsure. Good cars are worth a high price to both buyer and seller, but because buyers do not know if used cars are good or bad, they will only pay the amount of a bad car. Thus, good cars will not come on the market.

Adverse selection in the health market, for example, will come about because those who know that they have or are likely to have health problems are those who are keenest on getting health insurance. The problem arises because, as in the coin and car examples, there is asymmetry of information: one contractor knows more about himself or herself than does the other. However, the other contractor can realize that there is this informational asymmetry and respond. Insurance companies need to price their products on the assumption that there will be adverse selection, making insurance in the health case more expensive for those who are not so likely to have health problems. Of course, insurance companies can also attempt to gain information, by running health checks on applicants, and making their customers pay a certain percentage of health costs on top of their insurance premium.

The idea of adverse selection is used as part of the principal-agent problem, a problem of contracting. In the principal-agent problem, adverse selection occurs because those least qualified for a job are also those most keen to attain it. At any level of remuneration, those least qualified are likely to gain the most in comparison to the job they already have and thus be more eager to get the job. They will sell themselves more and work harder to secure the position. Adverse selection only occurs where there is heterogeneity in the population of qualified candidates, and those with some characteristics that the principal does not want are most likely to be those who come forward.

In general, we can see adverse selection as an informational problem that gives one person some power over another to the latter's disadvantage. In [Page 6]that sense, this is an example of the idea that “knowledge is power.”