Adverse Selection in Principal-Agent Theory

Adverse selection means that asymmetric information prior to closing an agreement leads to only the worse options remaining in the market. The reason is that contract partners assume that the service or goods purchased might not meet the expectations. Therefore, they are unwilling to pay the complete 100% of their original willingness to pay. This makes it unprofitable for honest actors, as they have higher costs than fraudulent actors.

Example of Adverse Selection

There are typically high-quality and low-quality cars in a second-hand car market. For the customer, it is hard to distinguish what car has a good quality and what car is rather rubbish. As he cannot distinguish those cars, he chooses the cheaper one, which is typically the worse one. The consequence is that only low-quality cars are traded as they are cheaper. This selection of cars of ever-lower quality continues. This example is also known as Lemons-Problem by Akerlof.