Adverse Selection

Abstract

Adverse selection refers to a negative bias in the quality of goods or services offered for exchange when variations in the quality of individual goods can be observed by only one side of the market. For instance, suppose sellers of high-quality goods have a higher reservation price than sellers of low-quality goods, but that buyers cannot directly determine the quality of a specific good offered for sale. Then any mix of goods offered for sale at the market price must include the low-quality goods. That is, the market adversely selects for low-quality products.