What is "adverse selection"

n. (context economics business insurance English) The process by which the price and quantity of goods or services in a given market is altered due to one party having information that the other party cannot have at reasonable cost.

Adverse selection is a concept in economics, insurance, and risk management, which captures the idea of a "rigged" trade. When buyers and sellers have access to different information ( asymmetric information), traders with better private information about the quality of a product will selectively participate in trades which benefit them the most (at the expense of the other trader). A textbook example is Akerlof's market for lemons.

Buyers sometimes have better information about how much benefit they can extract from a service in which case the "bad" customers are more likely to apply for the service. For example, an all-you-can-eat buffet restaurant which sets one price for all customers risks being adversely selected against by high appetite (and hence least profitable) customers. Another example is in offering health insurance, the types of customers most likely to apply are those who are most prone to accidents.

In both cases, the seller suffering from adverse selection should protect himself by screening customers or by identifying credible signals of quality, see signaling games and screening games.

An example where the buyer is adversely selected against is in financial markets. A company is more likely to offer stock when managers privately know that the current stock price exceeds the fundamental value of the firm. Uninformed investors rationally demand a premium to participate in the equity offer.