Asymmetric Information

A used car sells for far less than a nearly identical new one because of what the seller knows that the buyer doesn't. The seller knows whether the car is reliable or a lemon; the buyer can't tell. So the buyer offers a price that reflects the average quality of all used cars on the market, good and bad mixed together. Owners of genuinely good cars won't sell at that average price, since it undervalues what they have, so they exit. That leaves a pool skewed toward lemons, which drags the average price down further, pushing out the next-best sellers, and so on. This unraveling, where hidden information drives good-quality goods or buyers out of a market, is adverse selection.

Insurance markets unravel the same way, but from the buyer's side. A health insurer can't perfectly tell healthy applicants from sick ones, so it prices a policy for the average expected cost. That price looks expensive to healthy people, who drop out or buy less coverage, leaving a pool sicker than average. The insurer raises prices again, more healthy people leave, and the pool keeps getting sicker and smaller. Mechanisms like warranties, inspections, or health screenings fix this by transferring the hidden information to the uninformed side, letting good cars and healthy buyers prove what they are and stay in the market.

Adverse selection is about who selects into a deal before it happens. Moral hazard is a different problem that happens after the deal: once someone is insured or otherwise protected from a cost, they change their behavior, taking more risks because someone else now bears the consequences. Both stem from asymmetric information, but one is about hidden traits and the other about hidden actions.