In Insurance the insurer knew each buyer's risk. Often one side of a deal knows more. With the market model of Market Equilibrium, hidden information can make a market shrink or vanish.
Key idea
Adverse selection: when one side knows the quality (or risk) before the deal and the other can't tell, the price reflects only the average, so the best types may refuse to trade. The goods (or customers) left in the market are worse on average, which pushes the price down further. George Akerlof (1970) called it the market for "lemons."
Why it works
Suppose a share $\pi$ of used cars are good and the rest are lemons, and buyers can't tell them apart. A risk-neutral buyer will pay at most the average value, $\pi B_g + (1 - \pi)B_l$. If that is below what owners of good cars require, $S_g$, those owners keep their cars. Buyers then know that only lemons are for sale, and pay at most $B_l$. Trades that would help both sides (a good car is worth more to a buyer than to its owner) never happen. The same logic hits insurance: at a price set for average risk, low-risk people may drop out, raising the average risk of those who remain.
Worked example: Does the market for good cars survive?
Half the cars are good. Buyers value good cars at \$6,000 and lemons at \$2,000; owners of good cars need \$5,000; owners of lemons need \$1,000.
- A random car is worth $\tfrac{1}{2}(6{,}000) + \tfrac{1}{2}(2{,}000) = 4{,}000$ to a buyer.
- That is below the \$5,000 good-car owners need, so they don't sell.
- Only lemons trade, at a price between \$1,000 and \$2,000, even though every good car is worth \$1,000 more to a buyer than to its owner.
Answer: No: only lemons are sold.
Worked example: The threshold
Same values. What share of good cars keeps them in the market?
- Need $\pi(6{,}000) + (1 - \pi)(2{,}000) \ge 5{,}000$.
- $2{,}000 + 4{,}000\pi \ge 5{,}000$, so $\pi \ge 3/4$.
Answer: At least $3/4$.
Common mistake
Mixing up adverse selection with moral hazard. Adverse selection is hidden information that exists before the deal (the car's quality, the buyer's health); it changes who trades. Moral hazard is a hidden action after the deal (driving carelessly once insured). Check: ask whether the problem would exist even if everyone's behavior stayed the same after signing. If yes, it is adverse selection.
Markets and governments respond in several ways: warranties and inspections, reputations and reviews, signals (next lessons), pricing by observable risk, and in some insurance markets rules that require or encourage broad participation. Which mix works best in a given market is a matter of evidence and debate.
See how beliefs about hidden types work in Incomplete Information and Bayesian Games.