Adverse Selection

Discipline: Economics

American economist George Arthur Akerlof (1940- ) first noted adverse selection problem (sometimes referred to as the lemon problem), which arises from the inability of traders/buyers to differentiate between the quality of certain products.

The most cited example is the second hand car industry, in which a trader dealing in, for example, Minis possesses product information that the other buyers/sellers in that market lack. He thus operates at a comparative advantage as the other people in the market cannot tell if he is selling a 'lemon' (poor quality car).

Consequently, there is risk involved in purchasing the good and while the lower price buyers are willing to take this risk, traders selling quality cars are not willing to sell at such a low price.

There are three components to this theory:

(1) there is a random variation in product quality in the market;

(2) an asymmetry of information exists about the product quality;

(3) there is a greater willingness for poor quality car seller to trade at low prices than higher-quality owners. Insurance and credit markets are areas in which adverse selection is important.

Also see: asymmetrical information

Source:
G A Akerlof, 'The Market for "Lemons": Quality Uncertainty and the Market Mechanism', Quarterly Journal of Economics, vol. LXXXIV (August, 1970), 3

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