Definition
When you trade, you often can't tell from the outside whether something is broken on the inside. Adverse selection happens when you lack information about the other side before a deal, so you end up choosing poor-quality goods or risky partners. It is caused by the information gap between seller and buyer. As a result, good items leave the market and mostly poor-quality ones stay. In 1970, the economist George Akerlof explained it using the used car market as his example.
Why Does Only Junk Remain in the Used Car Market?
Imagine you've gone to a used car market to buy a car. The seller knows their car's accident history and hidden faults like the back of their hand. The buyer sees a car that looks fine on the outside and has no way to know its true condition.
The buyer gets nervous about being tricked and overcharged. So they won't readily offer the price of a top-quality car. They only offer "a price somewhere between a good car and a bad one," because there's no way to tell the two apart by looking.
Then the owners of really good, well-kept cars feel it's unfair. They don't sell, and they leave the market. In the end, the market is left packed with broken-down junk cars ("lemons") whose owners are happy to sell fast, even at the average price.
The Dilemma of Phone Damage Insurance
The same thing happens between a phone damage insurance company and its customers. Customers know their own habits very well. They know whether they handle their phones carefully, or whether they are clumsy and drop them several times a day.
But the insurer can't watch every customer's behavior. So it charges everyone the same average premium. Then people who treasure their phones and never drop them think, "I'll never crack my screen, so why pay this much?" and give up on the insurance.
In the end, only people who are rough with their phones or drop them often keep signing up. The insurer's repair costs swell like a snowball. Premiums go up even more, and careful users leave even faster. The company falls into a swamp of a vicious cycle.
To Be More Precise: Before the Contract vs. After
When people talk about adverse selection, many mix it up with "moral hazard" (becoming morally careless). Both problems come from information sitting on only one side. But they happen at completely different times.
Adverse selection is a problem caused by hidden information *before* the contract is signed. Because of the hidden truth, you pick the bad partner or the bad item from the start. Moral hazard, on the other hand, means behavior that changes *after* the contract is made. A person starts handling things carelessly or takes promises lightly.
So markets build many kinds of safeguards against adverse selection. One is "signaling," where the side with the information proves it is clean, like a free repair warranty on a used car. Another is "screening," like a phone carrier making you submit a photo of an undamaged screen before you buy insurance.
Common misconceptions
Adverse selection and moral hazard are the same thing with different names.
Adverse selection is making a bad choice *before* a contract because of the other side's hidden information. Moral hazard is a change in behavior *after* a contract, such as taking less care or getting lazy.
Where you meet it
On a secondhand marketplace site, buyers can't tell which sellers are honest, so good sellers leave and scam listings pile up
Only users who often drop their phones and crack the screen end up signing up for damage insurance
In one sentence
Before a deal, information sits on only one side. Because of that, the truly good products or people leave the market, and only poor-quality partners get chosen.