Adverse selection is a type of market failure that can occur when people with better knowledge about a good or service are able to buy it while those who know less are unable to. This often happens because the seller does not have enough information about the buyer to know whether they would be a good or bad customer. As a result, the prices of goods and services can become distorted, and it may become difficult for some people to access them. Adverse selection can lead to inefficiency and waste in an economy, as well as social problems such as inequality.
When buyers have more information than sellers, this is called “asymmetric information.” Adverse selection is one example of asymmetric information leading to market failure. It can happen in insurance markets, credit markets, and labor markets, among others.
Adverse selection can be prevented or minimized through regulation, education, and other measures. For example, the Affordable Care Act includes provisions to prevent adverse selection in the health insurance market. In general, it is important for policies to be designed with adverse selection in mind so that market failures can be avoided.