Adverse Selection: There are two basic, related ways to explain the distinction between adverse selection and moral hazard.  The first involves what particular piece of information is subject to the asymmetry, and the second has to do with the timing of the information asymmetry.  The subject of this first section, adverse selection, can be described as a situation in which there is a hidden, unknown characteristic.  This could be something such as risk of disease for someone purchasing health insurance or the quality of a product being offered for sale.  With regards to timing, adverse selection describes a situation in which the asymmetry exists before a transaction occurs.  In most cases, say in the instance of product quality, once the transaction has occurred and the customer has the product in hand, they can easily determine its quality.  The difficulty occurs in that the decision to buy the product or not buy the product must be made in the absence of this information.

 

The classic example of adverse selection is the famous paper by George Akerlof on the market for ‘lemons’ (used cars of low quality).  A quick discussion utilizing this example is often very enlightening for students.