What is adverse selection, and how does it relate to information asymmetry?

• A. Adverse selection occurs when buyers/sellers have symmetric information leading to high-quality products.
• B. Adverse selection occurs when buyers or sellers have asymmetric information before a transaction, leading to worse-than-average products.
• C. Adverse selection occurs after a transaction when incentives misalign.
• D. Adverse selection is when the government selects policies.

Answer: (B)

Adverse selection happens when one side of a transaction has more or better information than the other before the deal, so the market ends up with a worse quality of goods or higher-risk participants than average. Because sellers or buyers know something the other side doesn’t, high-quality options may drop out or be underrepresented, leaving a pool dominated by lower-quality products or higher-risk individuals. This is a direct consequence of information asymmetry before the contract is signed.

For example, in the used-car market, sellers often know more about a car’s quality than buyers, so buyers worry about getting a lemon. That fear can push prices down and leave only lower-quality cars effectively trading, which reinforces the problem. Similarly, in health insurance, individuals know their own risk level better than insurers; if insurers can’t tell who is high-risk, they raise premiums or restrict coverage, attracting sicker applicants and driving away healthier ones.

Other statements misplace the timing or the source of the problem. Adverse selection is about information asymmetry before a transaction, not what happens after a deal (which is related to moral hazard), and it isn’t about government choosing policies.