Adverse Selection

Questions

What is Adverse Selection?

Adverse selection happens when one side of a deal knows more about quality or risk than the other. Buyers who cannot tell good from bad pay average prices, which drives away the best sellers. George Akerlof showed how this can unravel the used-car market.

How do you use Adverse Selection?

Use it when hiring, buying insurance, lending or trading with strangers. Ask who knows more and who your terms will attract. Reduce information gaps with inspections, honest disclosures, trials and guarantees, just as CarMax did.

When does Adverse Selection matter?

Adverse Selection is one of the 56 mental models for strategy, the situations where you ask: How do I win when others want the same thing? Within that, it belongs to “Winning customers”, alongside Apostle Model, Churn and Customer Development.

What is an example of Adverse Selection?

Two stories show it at work: The market for lemons (1970) and CarMax (1993). Both are told in full in The Mental Models Daily Almanac, which has two stories for each of its 365 models.

Which mental models are related to Adverse Selection?

Moral Hazard, Winner’s Curse and Selection Bias. Adverse Selection itself comes from economics.