Buyer beware: Understanding 'adverse selection' might help you discern deals from scams

With a PhD in economics and a deep interest in politics, Northwestern managerial economics professor Sandeep Baliga has been applying economics concepts to policy issues for decades. One such concept is adverse selection, which Baliga describes as “hidden information.” Baliga, who teaches at the Kellogg School of Management, uses the concept to address everything from the war in Iraq to the strategy of terrorism.  But we can begin to understand how adverse selection works by looking at something as simple as buying a used car.

Let’s say you pop into the dealership one Saturday and spot an incredible deal: A 2014 Honda Civic with low mileage priced $2,000 less than you expected to pay.

“It’s an amazing deal,” the sales guy says, pointing to the Civic. “We just got it in, and it won’t be here long.”

Here’s where adverse selection comes in. The salesman may have some insider information about the car — its driver history, previous repairs, accidents, etc — that explains the low price. You can’t see that information and he’s not sharing it, so you’re left wondering if the car is truly a great find or just a low-cost lemon.

While it’s clear in this instance that knowing the “hidden information” about the car would help you decide to buy (or not), Baliga says hidden information is not always a bad thing. In fact, his research has uncovered scenarios in which adverse selection can be beneficial. Learn more about Baliga's research on adverse selection on the Kellogg faculty page.