Adverse selection is perhaps the most academically cited example of market failure in a laissez-faire economy. The problem arises when exchanging agents have different information or conflicting incentives about product quality. According to adverse selection theory, voluntary market transactions sometimes attract the sub-optimal type or level of buyers and sellers.
Common Insurance Example
This is frequently demonstrated by using insurance as an example. When an insurance provider offers a policy, it must structure its contracts to compensate for high-risk individuals (the correct target market), which will create an extra disincentive for low-risk individuals to buy insurance they might need.
This implies that low-risk individuals have a hard time finding fair prices for their insurance needs. As low-risk consumers drop out of the insurance market – not wanting to pay $300 for a policy they only value at $75, for instance – the market experiences a deadweight loss in efficiency because suppliers and consumers are no longer coordinating optimally.
Challenges to Adverse Selection Theory
There is an understated operating assumption in adverse selection theory: Market producers are incapable of effectively distinguishing between different types of consumers and creating different goods and services on that basis.
Many economists argue that there is little reason to suspect this is true. In the insurance and automobile markets, for example, different products (policies and cars) are created for those with different risk histories or risk tolerances.
Once the underlying informational asymmetry is compensated for, the adverse selection argument doesn't have much momentum. Empirical tests for the so-called lemon problem in car markets have yielded unsubstantial results. The same is true of research for adverse selection in voluntary insurance markets.
In fact, regulations imposed on the health and car insurance markets often subsidize rates that high-risk consumers pay; this clearly implies that providers can detect different types of customers.
Asymmetry also creates a market for information middlemen. Consumer Reports, Underwriters Laboratories (UL), CARFAX and credit bureaus are all examples of market-based responses to disparate sources of knowledge.