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In economics, insurance, and risk management, adverse selection is a market situation where buyers and sellers have different information. The result is that participants with key information might participate selectively in trades at the expense of other parties who do not have the same information.
In an ideal world, buyers should pay a price which reflects their willingness to pay and the value to them of the product or service, and sellers should sell at a price which reflects the quality of their goods and services. For example, a poor quality product should be inexpensive and a high quality product should have a high price. However, when one party holds information that the other party does not have, they have the opportunity to damage the other party by maximising self-utility, concealing relevant information, and perhaps even lying. Taking advantage in an economic contract or trade of possession of undisclosed information is known as adverse selection.
This opportunity has secondary effects: the party without the information can take steps to avoid entering into an unfair contract, perhaps by withdrawing from the interaction, or a seller asking a higher price, thus diminishing the volume of trade in the market. Furthermore, it can deter people from participating in the market, leading to less competition and thus higher profit margins for participants.
Sometimes the buyer may know the value of a good or service better than the seller. For example, a restaurant offering "all you can eat" at a fixed price may attract customers with a larger than average appetite, resulting in a loss for the restaurant.