Adverse Selection

Adverse selection occurs when privately informed agents select actions based on their information that adversely affect the uninformed side of the market. The competitive equilibrium may not be Pareto efficient as a result — high-quality sellers withdraw because the average-quality price is below their reservation value, the residual pool's quality drops, the price drops further, and the market unravels toward a lemons-only equilibrium (the "death spiral").

When to use

Invoke adverse selection whenever one side of a transaction has private information about quality (used-car sellers, insurance applicants, borrowers) and the other side can only condition on the average of the unobserved pool. It is the central friction motivating Screening (offering a menu of contracts so types self-select) and REE (the consistency check that prices reflect the actual pool composition). The two textbook examples are Akerlof's used-car market and Rothschild-Stiglitz insurance with heterogeneous risk types.