Dangers of Adverse Selection
One of the biggest problems with adverse selection is that if it goes unrecognized or if it is not accounted for in some way, it can quickly spiral into a situation that gets progressively worse and worse.
For instance, in the insurance example, if the insurer doesn’t figure out a way to group similar risks and charge each group accordingly, the product will be priced in such a way that it is only attractive to “bad" risks. This, in turn, will make the product unprofitable and may lead the insurance company to try to fix the problem by raising rates. But, in this case, raising rates will just make the problem worse – making it so that the product only looks like a good deal to even worse risks that are unable to purchase insurance from other sources. If the insurer continues this cycle, it will soon be left with nothing but a “bad" book of business – the complete opposite of its true goal.
In the second example involving the landlord and the independent contractor, a similar problem might occur. Since the landlord isn’t willing to pay the market rate for quality lawn care, he’s only likely to attract contractors that are either unable or unwilling to provide the level of quality work that is being expected. As a result, the rental properties may start to generate less income since they are less attractive to prospective renters. Since the landlord’s income is decreasing, he may decide to spend even less than before on property upkeep, perpetuating the cycle even further.