Adverse Selection Law and Legal Definition

Adverse selection refers to a situation where there is an imbalance of information which results in a situation where those on the informed side of the market self-select in a way that harms the uninformed side of the market.

Adverse selection occurs when a negotiation between two people with different amounts of information, that is, asymmetric information, restricts the quality of the good traded. This typically happens because the person with more information is able to negotiate a favorable exchange. For example, people buying used cars do not know whether they are "lemons" (bad cars) or "cherries" (good ones). The sellers, on the other hand, have this knowledge. At any given price, the sellers will be more likely to sell lemons than cherries, keeping the good cars for themselves.