Adverse Selection in Financial Markets

When a business looks to go public with its shares, it has more information on the true value of the company. For example, the directors and decision makers work at the company every day. They know how the company is performing and whether it is functioning efficiently, so they have a greater level of knowledge of the company than the average investor.

What we can see as a result is that when companies float on the market, they are often largely overvalued due to the gap in information. For example, Twitter was sold at 41.65 USD on the NYSE back in 2013. Yet its value at the beginning of 2020 was just over 31 USD.

As those who float on the market have a greater idea on its true value, it is often sold at a higher rate than its true worth, leaving investors with ‘lemons’. Or in this case, over-priced shares.

Effects of Adverse Selection

Adverse selection occurs when there is a difference in information between the buyer and seller. This can increase costs, lower consumption, exclude customers, and potential increase the health risk. Examples of the effects of adverse selection include:

1. Higher Prices for Customers
2. Lower Consumption
3. Health Risks
4. Excluded Customers

1. Higher Prices for Customers

As customers may not know of any faults or issues, the value they place on a good is much higher. For instance, a second-hand laptop may suggest that it is in fully working order. However, it may have water damage and is no longer functioning. The price a customer would pay between a working laptop and a faulty one is the additional price paid due to adverse selection.

Now companies such as eBay look to rectify such by requiring sellers to disclose such information. As such, they are also liable, with eBay acting as the intermediary between the two. So if a seller does sell a faulty item, the customer is able to obtain a full refund assuming the issue was not disclosed.

We also have higher prices in other markets such as insurance. Customers end up paying more as insurance companies are unable to fully determine risk. For instance, gadget insurance is more useful to those who are more clumsy than those who are not. Yet it is impossible to gather such information. So they have to charge all customers an equally higher amount.

So whilst clumsy customers will make more claims and cost the insurance firm more, they tend to increase prices across the board to cover these expenses. In turn, the ‘non-clumsy’ customers end up paying more to cover those who are more accident-prone.

2. Lower Consumption

As customers pay a higher price, it goes without saying that consumption will also fall. If we take insurance for example, some customers have to subsidise those who are more at risk.

As a result, they are having to also pay for the risk that other customers are imposing onto the insurance firm. In fact, some of these customers may withdraw from the market and not purchase insurance at all.

We also have the case whereby customers become more aware of issues with faulty goods and the discrepancies in knowledge. For instance, second hand markets are generally associated with unreliable goods. Perhaps after a couple of bad purchases, consumers tend to associate the bad feelings of being ‘ripped-off’, with the relevant market they purchased the good from.

What we see as a result, is lower consumption, at least in markets with asymmetrical information.

3. Health Risk

As customers do not always have full information on a good, it may potentially be harmful to them. For example, a faulty second hand car may pose a health and safety risk to the consumer. Faulty breaks or electrics could contribute to a significant accident.

Elsewhere, food is now often labeled across many developed nations, with nutritional values placed on them.

This is so factors such as caloric and sugar content are more visible to the consumer. We can see this as a more consumer friendly option as they are still freely allowed to choose, but with more information provided to them.

4. Excluded Customers

As adverse selection leads to higher costs, it equally means fewer customers are able and willing to afford goods. For instance, as insurance premiums increase to compensate for the lack of information, fewer customers will purchase insurance.

As a result, governments often step in to enforce a universal insurance scheme. By doing so, it forces those who are healthy to subsidise the costs for those who are sick.

Furthermore, this can be extended to other markets. For instance, second hand markets generally offer cheaper goods, which attracts more price sensitive customers. However, because the customer may not have much information on the product, they may not be confident in its value; particularly if they have had bad experiences with second hand products before.

Moral Hazard vs Adverse Selection

A moral hazard is whereby a third party bears the cost of another party’s action. The classic example used is that of insurance. For instance, when an individual is insured, they may be more reckless. So rather than taking their laptop to the toilet, they may leave in unguarded in the knowledge that it can be replaced if stolen.

By contrast, adverse selection is where there is a gap in information between the buyer and seller of a good. A common example of such is in the second-hand market whereby the seller may know that the product is not fully functional.

We can look at a moral hazard as an effect that occurs AFTER a transaction has taken place. So a consumer becomes more reckless after they are insured. There is then an information misalignment in the fact that the insurer is unaware of the additional risks taken by the consumer.

This is in contrast to adverse selection, whereby it occurs BEFORE the transaction takes place. So there is a misalignment of information between the buyer and seller before the trade is made.