Crossroads Chronicles

A look into asymmetric information in markets and how it drives adverse selection

If you have ever seen the movie The Amityville Horror (not judging if it was just for the plot named Ryan Reynolds), you might recall the scene where the seller, giving the family a tour of the house, notices a shadow flying past the unsuspecting couple, and says nothing. What follows for the next hour and a half is a series of grisly events which could have been prevented had the family been aware of all that had happened inside this house. This perfectly captures asymmetric information in action, where one party in a transaction has more information than the other.

George Akerlof first presented the issue in his 1970 paper titled ‘Market for Lemons‘. The paper noted the market for used cars and showed that even if the market is competitive, it simply cannot work if sellers know a lot more about the quality of the cars than the buyers. Suppose half the cars for sale are peaches (good, reliable vehicles) worth $10,000; while the other half are lemons (cars with hidden defects) worth only $5,000. Sellers know exactly what they own, but buyers cannot tell the difference and assume there is a 50-50 chance of getting either type. A rational buyer will therefore offer around $7,500, the average of the two values. Owners of peaches refuse to sell at that price because they know their cars are worth more, so mainly lemons remain for sale. Seeing a quality drop, buyers cut their offers, further pushing out the last good cars. The process repeats until only lemons are left and buyers stop buying altogether. In the end, the market disappears, even though many people would like to trade and buy themselves a decent car.

This cascade, where good products are driven out because buyers cannot distinguish them from bad, is a case of adverse selection, the market failure that arises when hidden information causes the participants you want to trade with to exit. The failure is commonly seen in health insurance. Imagine an insurer that cannot perfectly tell how healthy each applicant really is. It sets a single annual premium of, say, $6,000 based on the average medical costs of the population. People who know they are fit and rarely visit the doctor look at that price and decide it is not worth it, while those who quietly expect higher medical bills sign up in larger numbers. With a sicker pool of customers, the company’s payouts rise, so it raises the premium to $7,000 the next year. Even more healthy customers drop out, the risk pool worsens, and premiums climb again. Step by step, the market tips toward the costliest, least healthy buyers which sets out a spiral that can make affordable insurance disappear entirely.

One way insurers try to break this cycle is by tailoring premiums to risk instead of charging everyone the same flat rate. They collect vital information like age, medical history, and lifestyle habits, to properly estimate how likely an applicant is to require care. People who appear healthier are offered lower premiums, while those with higher expected costs pay more. By narrowing the gap between the price and each customer’s true risk, insurers keep low-risk individuals in the pool and prevent the market from collapsing. In economic terms, this kind of “risk-based pricing” helps align what the seller knows with what the buyer pays, cutting down the adverse selection problem.

Beyond risk-pricing, there are two common approaches to address this kind of market failure. Screening by the less-informed side means banks, employers, and insurers invest in ways to learn more about the people they deal with. Lenders demand credit reports and collateral; employers run skills tests and probationary periods; insurers require medical exams or detailed questionnaires. These steps cost money up front, but they narrow the information gap so that high-quality borrowers, employees, or policyholders can be distinguished from risky ones. That keeps the market from being dominated by “lemons.”

Signalling by the better-informed side is when the party with private information can also prove their quality voluntarily. Job seekers showcase advanced degrees; companies hire auditors to certify financial statements; used-car sellers pay for third-party inspections or offer warranties. A credible signal has to be costly or difficult to fake, so that low-quality participants will not bother. Effective signalling reassures buyers and lets high-quality sellers stay in the market at fair prices.

Together, screening and signalling show that while information asymmetry can sink a market, smart incentives can keep it afloat.