Question

What is adverse selection, Describe some examples of markets with adverse selection.

Answer 1

Adverse Selection is situation that occurs in a market when the information a buyer and seller has is different. Because of this difference in information it is difficult to get a fair price of a product. This mostly happens in second hand goods market when the buyer is unaware about the quality of the product and has to make a decision about buying the product only on the basis of information provided by the seller. Seller however has the full information about the product. Adverse selection therefore happens because of asymmetric information.

For example, in a market of second hand cars there are two types of cars that exists bad cars also known as "lemons" and good cars. Now the seller is aware if his car is a lemon or not but the buyer is not aware whether the car is a lemon or a good car. He has to rely on information provided by the seller. Now, for instance the buyer is willing to pay $1000 for a "lemon" and $5000 for a good car. And the seller is willing to accept $100 for a "lemon" and $2500 for a good car. Now since the buyer is not aware which car is sold to him he will be willing to pay the average price assuming there are equal number of good and bad cars in the market, i.e., [(1000+5000)/2] = $3000. Now the car is sold at $3000, if the car is sold is lemon then the seller earns more profit and if it is good car then less profit is earned. However if the reservation price (minimum price which the seller sell the car at) is greater than $3000 then only the seller will only be willing to sell "lemons" and no exchange would take place.