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Adverse Selection also termed as anti-selection, or negative selection is used in economics, insurance, statistics and risk management. The term adverse selection was originally used in insurance.
Indeed, adverse selection arises when products of different qualities are sold at the same price because, prior to purchase, the buyer (The Principal) cannot distinguish between products of different qualities. Alternatively, adverse selection could arise because a product of uniform quality is sold at the same price to buyers of different income groups or different status (The Agents) and, prior to sale, the seller (The Principal) cannot distinguish between consumers of different qualities. Whatever the sources of adverse selection, the consequence is the same: low-quality products, or high-risk buyers, 'crowd out' high-quality products, or low-risk buyers, so that what is observed is an adverse selection of products (as sellers of high-quality products withhold their products) or an adverse selection of buyers (as low-risk customers withhold their custom).
The very first distinction between moral hazard and adverse selection is in the definition itself. Moral hazard refers to cases where people who are in possession of asymmetric information, and where the accuracy of the information they possess cannot be monitored or challenged, have an incentive to behave differently - either in a dishonest way or in a way that might not provide the full benefit to the principal, on the other hand Adverse selection refers to cases where asymmetric information leads to goods and services being bought and sold that are not of the quality expected. The selection by either the seller or the buyer is adverse.
Moreover, adverse selection represents market failure since 'good' products and 'good' customers are under-represented, and 'bad' products and 'bad' customers are over-represented, in the market. The source of the market failure is the externality between products and between customers: when a seller of a low quality product increases sales, he lowers the average quality of the production the market, reduces the price the consumer is willing to pay and, thereby, hurts sellers of high-quality products; when a high-risk person buys insurance, he raises the average risk of the contingency; this increases the average premium the insurance company charges and, thereby, hurts low-risk persons.
Under adverse selection, therefore, sellers of high-quality products will have an incentive to signal to the consumer the quality of their product. This may take the form of: reputation; standardization ; informative advertising; offering warranties in the event of defects. The signal may be offered through third parties: recommendations by friends or by consumer reports; certification of quality by a professional association.
The Drill Example - Mr Bricolage
This might be linked to the idea that 'you get what you pay for'. A simple example could be if we go a local retailer (Mr Bricolage) to buy a new drill, we are faced with quite a selection. We look at the branded names and they are all very expensive, they don't look all that different and have very similar specifications. We look at the cheapest drills and come to the conclusion that the retailer would not be selling rubbish so go for the cheap drill. Three weeks later the thing breaks down - We should have known! In the above example, the Agent is the seller and the Principal is the buyer:
Quality comes at a price - doesn't it?.
On the other hand, the problem for the manufacturers of recognised brands (The Agents) is that they have difficulty convincing buyers (The Principals) that their product is really worth paying the extra for. They are forced to reduce their prices to compete with the cheaper products, but this is often not commercially viable. In the end, they might give up producing in that market altogether.
ADVERSE SELECTION VERSUS MORAL HAZARD
From a market point of view, we shall discuss below the differences and similarities between adverse selection and moral hazard as both are examples of market failure situations, caused due to asymmetric information:
Key Difference: Before versus after the deal
Adverse selection: asymmetry in information prior to the deal
Adverse selection occurs when the seller values the good more highly than the buyer, because the seller has a better understanding of the value of the good. Due to this asymmetry of information, the seller is unwilling to part with the good for any price lower than the value the seller knows it has. On the other hand, the buyer, who is not sure of the value of good, is unwilling to pay more than the expected value of the good, which takes into account the possibility of getting a bad piece.
It is this asymmetry of information prior to the transaction that prevents the transaction from occurring. If both the seller and the buyer were uncertain of the quality, they would be willing to trade the good based on expected values. Similarly, if both the seller and the buyer were certain of the quality, they would be willing to trade the good based on its actual value.
Moral hazard: asymmetry in information / inability to control behavior after the deal
Moral hazard is seen for services such as insurance and warranties. In these cases, after the deal is done, one of the parties to the deal (in this case, the person purchasing the insurance or warranty) may be more careless because he/she has the insurance, and thus does not need to pay the full cost of a damage. For instance, a person possessing insurance against theft may be less careful about closing the windows when leaving the house. Here, it is not the prior information that either party has, but the inability of the insurance provider to control and monitor increased risk-taking behavior that creates the potential for market failure.
Also, while in adverse selection, the seller is usually the one possessing more information, moral hazard usually has the buyer (of the insurance service) having too much control.
Examples of situations where adverse selection occurs but moral hazard does not
In most situations that do not involve insurance, warranties, legal liabilities, renting services, or any form of continued contract and obligation, moral hazard is unlikely to occur. On the other hand, adverse selection can occur for any experience good, i.e., any good whose value is determined only after buying it and using it.
For instance, when selling a used car, the seller does not need to worry about how the buyer will treat the car after the deal is done, because the seller has no continued obligation to the buyer to ensure that the car remains in good condition. However, the problem of adverse selection may still occur if buyers have no easy way of evaluating the quality of the car without actually buying it.
Examples of situations where moral hazard occurs involve a somewhat different form of adverse selection
Any situation involving moral hazard also involves adverse selection to at least some extent. This is because, as in the case of health insurance, the person who could indulge in potentially risk-taking behavior may have prior information about his/her excessive risk-taking tendencies and this prior information may have influenced the decision to purchase insurance. This makes insurance sellers set overly cautious rates, and thus, the buyers who are actually less risk-prone end up not buying insurance.
However, this adverse selection differs from the more usual adverse selection seen in used-car markets. In the adverse selection seen in insurance, it is the buyer who has more information, and it is this that makes the buyer unlikely to purchase an insurance that is based on actuarial estimates made by the seller.
Examples of situations where adverse selection and moral hazard are related
Health insurance is an example of a service that suffers both from adverse selection and from moral hazard, and often it is difficult to differentiate the two. Here are some examples:
The insured person may choose to conceal certain unhealthy habits or genetic traits that make the insurance attractive for the person but unprofitable for the company. This is an example of adverse selection: The person getting insured has more information about the quality of his or her health than the insurance company.
After getting insured, the person is more careless about health. For instance, he/she may take fewer dietary precautions, smoke or drink more, or indulge in physical activities dangerous to the health. This is an example of moral hazard.
There is some fuzziness between the problem of concealing a habit prior to getting insured, and becoming more reckless after getting insured.