Adverse Selection

principle that says that those who most want to buy insurance tend to be those most at risk, but charging a high price for insurance (to cover the high risk)will discourage those at less risk from buying insurance at all When a negotiation between two people with asymmetric information restricts the quality of the good traded. This typically happens because the person with more information can negotiate a favorable exchange. This is frequently referred to as the "market for lemons." For example, let's say you're searching for a car, knowing that some are "high-quality" and others are "low-quality." However, you don't know which category a particular car is in. Suppose there's an equal chance of getting either a high-quality or low-quality car. If you're willing to pay $2,000 for a high quality car, but only $1,000 for the low quality car, how much would you offer for a given car of unknown quality? The expected value of the car is $1,500. In other words, if you bought hundreds of cars, half worth $2,000 and half worth $1,000, the average value of the cars is $1,500 each. Not knowing the quality of a given car, the price you would offer is $1,500- the average or expected price. The chance of overpaying for a low-quality car is offset by the chance of underpaying for a high-quality car. Unlike you, each owner is better aware of the quality of his or her car--they have more information than you. Your $1,500 offer would be accepted by the seller of a low-quality car, but refused by the seller of the high-quality car. Due to the lack of buyers' information, high-quality cars would not be sold. The only cars exchanged would be low-quality cars ("lemons"). Asymmetric information tends to limit quality of products exchanged, adversely selecting the lower quality cars.