What Is an Adverse Selection?

Adverse selection is another problem caused by information asymmetry. It means that if one party in the market can use more information than the other party to benefit themselves and damage the other party, they tend to sign an agreement with the other party to trade. Adverse selection is another major issue facing insurance companies, and it is closely related to moral hazard. In the insurance market, the person who wants to insure a particular loss is actually the person most likely to suffer the loss. Therefore, the insurance company's compensation probability will exceed the company's overall loss rate based on the law of large numbers. This is the adverse selection of the insurance company. ^[1]

adverse selection

Adverse selection refers to a situation in which if one party to a market transaction can use more information than the other party to benefit themselves and the other party is damaged, it is difficult to make a buying and selling decision easily because of the disadvantage of the information. Distorted, and lost the role of balancing supply and demand and facilitating transactions, which in turn led to

To make it clearer

Adverse selection e-commerce

Compared with the traditional market, the advantages of the e-commerce market are its lower entry barriers, lower management costs, and ease of market information acquisition. The reason why it has lower barriers to entry is because all market participants in the Intemet provide equal opportunities, where large companies have no inherent advantage over smaller companies.

In the physical market, Da is a very effective market signal, but in the e-commerce market, there is no necessary connection between product quality and quality, which reduces the barriers to market entry. Another feature of the e-commerce market is that it can be comprehensively searched to obtain information at low or no cost, because the automatic search and classification technology solves this problem. You can use the search service to search information in a large amount and effectively. Compared with the market, it has more ways, higher efficiency, and lower cost to obtain market information, which means that the information is more complete. At the same time, due to the low cost and no cost of this kind of online information search, it also means relatively low transaction costs.

Although the e-commerce market has such advantages, especially its high information efficiency, it does not mean that it has high market efficiency. In fact, compared with the traditional market, the problem of adverse selection in the e-commerce market due to the asymmetry of product quality information not only exists, but also becomes more serious. The main reasons are:

(1) Difficulty checking the quality of network products

Because digital products are mostly experience goods, their quality can only be understood after use. However, once consumers have mastered the information content of digital products, consumers are no longer willing to buy. This feature leaves manufacturers without a good way to convince consumers of the quality of their products. At the same time, because experience products can only understand their quality through experience and actual use by consumers, even if a large amount of advertising and product information is not enough to convince consumers of their quality, consumers will not buy. If you understand that quality is good for future purchases, customers may take a risk, but if you only use a product once, the risk of this risk is very small.

(2) Difficulty of identifying the value of network vendors

The identity of the seller in the electronic market is also difficult to identify. An online store can be set up in one day, or it can disappear the next day. Because of this uncertainty, the efficiency of the market operation will be very low, and it will not even work at all. Because the identity of the manufacturer is not easy to identify, it is more difficult to grasp the quality of the product.

(3) Subjectivity of network product quality evaluation

Because digital products are not just digital versions of paper products, they also include the characteristics of electronic media. For example, online newspapers are personalized and customized, and can be updated at any time. Therefore, the quality evaluation will be More and more subjective and personalized, it is more uncertain.

(4) Diversity of network producers.

Unlike physical products, digital products are manufactured and sold by virtual people on the Internet, and market sellers have a short sales time and a large number of products. With today's personal homepage and a web server that may run on any personal computer in the future, each user is a producer and potential seller. Therefore, traditional quality transmission signals, such as reputation and brand, may not play a role in the e-commerce market, so the asymmetry of quality information is greater, and adverse selection will be more serious.

problem solved

No matter it is traditional commerce or e-commerce, in order to ensure and improve the transaction efficiency of the network market, we must try to eliminate or reduce adverse selection to reduce the uncertainty of the quality of network products. However, because the adverse selection problem of the e-commerce market and the traditional market adverse selection problem have different characteristics and performances, this also determines that the solutions and approaches will be different. Some methods that are effective in the traditional market will not be effective in the e-commerce market. In the following, we will analyze and evaluate the approach to the problem of adverse selection in network transactions from the aspects of invalidity and effectiveness.

Adverse selection of ineffective solutions

(1) judging quality by price

As one of the methods to eliminate adverse selection in the traditional market, consumers can judge the quality of a product based on the price of the product in some cases, but this method is basically ineffective in online transactions. The reason is that the network product is a digital product, and it does not show physical wear like other physical products, that is, it is indestructible.

Although the initial product quality of digital products will become apparent due to consumer behavior, no matter how long or how often they are used, the quality of digital products will not decline, that is, digital products are not durable and not durable. In terms of points, there is no difference between products bought from manufacturers and second-hand goods. It is precisely because of this situation that manufacturers of digital products will adopt a sales strategy that is intentionally outdated and frequently upgraded. As it is unknown whether the quality of many new versions is higher than the old version, the quality uncertainty problem will be more prominent at this time. Although the price of products is increasing, the increase in price does not mean the improvement in quality. Therefore, the signal quality through prices in the online market will be weak. If the price level is used as a method to reduce adverse selection, it is basically ineffective.

(2) Manufacturing and spreading signals

In the traditional market, the manufacturing and dissemination signals are mainly used by manufacturers to provide customers with quality guarantee, warranty, and return through branding, advertising, or other methods, so that consumers distinguish their products from "lemon" in order to believe that its products high quality. However, the role of this approach in the Internet market is limited. The reason is that most of these signals are indirect information. The basis for achieving results in this way is based on repeated purchases by consumers. When consumers do not repeat purchases, reputable companies have little advantage.

In the traditional market, manufacturers may establish high-scale and high-grade shops and warranty shops, so that consumers can judge the quality of goods from the elegant appearance of the store environment or the seller's logo, and are willing to buy the manufacturer's products. However, in the virtual market of e-commerce, these indirect signals cannot be provided or change frequently. Therefore, the indirect signals available in traditional markets are almost meaningless in the e-commerce market. As for the unwarranted return policy for guaranteeing product quality in the traditional market, it is difficult to achieve in the e-commerce market. This is because, first of all, digital products are easy to copy, in fact "returned" products have no meaning; secondly. Refunds are also not feasible, because in the case of purchasing low-value items, the processing cost is much higher than the value of the items.

Of course, this is not to say that signals lose their status and role in the Internet market. In 2009, there were many brands and reputable websites and vendors in the online market. However, compared with the traditional method of making and propagating signals in the traditional market, in the network market, to establish reputation through signals, network service providers will spend more costs. Generally, they must bear The loss suffered, offering information products at free or low prices-because before they can build credibility, they can't charge high prices for their products, even if their information products are of high quality. Therefore, in terms of the operability of the method itself, the method of making and propagating signals is very limited in network transactions.

(3) Establish quality standards

In the traditional market, the government, consumer associations, etc. often establish standards for product quality, and use this standard to ensure product quality. However, the quality compliance standard actually only sets the minimum requirements for the product, indicating that the product can be used, not a quality standard. Therefore, it cannot guarantee the quality of the product. At the same time, even if this standard is set, the quality standard setting of network products is much more complicated than that of physical products. Therefore, if this is used as a method to reduce adverse selection, its operability is very small.

Adverse selection of effective solutions

(1) Use network intermediary

In the online market, the intermediary is also the network intermediary. It plays an important role in the e-commerce market. It plays a particularly important role in reducing the uncertainty of the quality of network products. They participate in the market but do not consume products themselves. In markets where buyers and sellers cannot adequately address quality uncertainty, market mechanisms based on network intermediaries can be more effective than market mechanisms without intermediaries or rules. A decisive reason why network intermediaries can solve the "lemon" problem by providing quality information is that intermediaries can sell products from many manufacturers. If an intermediary for a single product can collude with a manufacturer to share profits and continue to sell despite consumer complaints, then when an intermediary for multiple products colludes with a supplier and continues to sell the product in question, consumers will At the same time stop buying other products of this agency. This "information overflow" mechanism will prompt intermediaries to stop selling and punish unscrupulous products, thereby encouraging manufacturers to maintain high quality. Therefore, starting in 2009, in the online market, intermediaries will be a good solution to reduce the problem of adverse selection. Although the intermediary's participation in solving the "lemon" problem actually increased transaction costs, more importantly, it also increased the transaction efficiency of the market.

(2) Web search

In the online market, consumers can use the Internet s extremely powerful delivery and search advantages to change their information disadvantages. This is also a more effective way to avoid the "lemon" problem, such as using search engines (web), Usenet News Group etc. Compared with the search method in the traditional market, its search cost is much lower than it, so it is more effective for the e-commerce market than the traditional market. Of course, the prerequisite for search to work is that the search service or database foundation needs to remain objective and fair.

(3) Bundle sales

Using bundling sales in the online market is also a better way to reduce quality uncertainty, because it can save consumers' search costs and enable high-quality sellers to keep it low enough. The price effect and the signal effect of the high quality of past products attract customers. Of course, at this time, consumers are also facing a lock-in situation.

(4) Attention sales

In the era of information explosion, the phenomenon of information overload is very serious, in which case attention has become a scarce resource. Because the quality of attention can be calculated from the "click-through rate" statistics using web technology that started in 2009, it can be sold like a product. Selling audience attention is an attractive way to support the provision of information. When a network vendor can provide high-quality information products, it is willing to pay a high price for attracting attention first in order to build credibility. In this sense, it is also a way to reduce product quality uncertainty.

(5) Provision of incomplete contract

The so-called incomplete contract means that the buyer and seller only make rough or ambiguous provisions on certain terms or responsibilities in the signing. Once there is a problem with the quality of the product, the contract will be permanently terminated. Incomplete contracts provide a penalty and incentive mechanism here, which prompts suppliers to provide high-quality products. In other words, the reward for high-quality products is the continuation of the contract. Once the existence of a low-quality product is found, the contract will be terminated. Although this method first appeared in traditional transactions, it also serves as a method to reduce adverse selection in network transactions.

Adverse selection base point

The above is just an analysis of methods to eliminate quality uncertainty or to reduce adverse selection. To be sure, any method has its use conditions and scope of use, and we need to continue to explore and design according to changes in the market environment and trading methods. The methods that work well in the traditional market may not be applicable in the online market. Similarly, the methods with network transaction characteristics may not be able to eliminate the asymmetry of information more than the traditional market. For example, the price discrimination method with Internet marketing features. Although its advantage is that it can build the price of the product based on the user's evaluation and strive to reach the best point of price and quality, they are solving the adverse selection. The role played by the problem is very limited, because this method will cause a huge price difference for products of the same quality-this will in turn worsen the consumer s information disadvantages on product quality and also increase consumption. The adversary's face.

It should be noted that, whether in the traditional market or the e-commerce market, although some methods have been used to make the inefficient market due to adverse selection regain the market efficiency. However, the failure of the method may put the market that has regained efficiency into a new cycle of efficiency. When the economic system generally has problems caused by asymmetric information such as adverse selection and moral hazard, it is difficult to believe that Pareto optimal efficiency can be achieved, and only Pareto suboptimal efficiency can be achieved.

Grossman. In his 1980 article "On the impossibility of informational efficient markets," Stieglitz proposed what he called the "Grossman-Stiglitz paradox". Stiglitz paradox). This conclusion is made up of two proven contradictory propositions: if the price information on the market is fully transmitted, then market equilibrium does not exist; if information is obtained There is a price to pay, and there will be no competitive equilibrium in the usual sense. The "equilibrium" paradox derived from the above two conclusions completely denies the premise that the information implicit in traditional economics is fully transmitted. It shows that complete information does not effectively improve market efficiency. On the contrary, it may hinder the exertion of market efficiency.

Therefore, extremely high and extremely low information efficiency can hinder the improvement of market efficiency. Of course, to what extent should the efficiency of information be maintained, information economics does not tell us. But it is certain that the incompleteness or asymmetry of market information is not only real, but also inevitable and even necessary. All we have to do is to continuously use the new methods provided by network technology to minimize the network. Adverse selection in transactions to improve the efficiency of market transactions-this is the basis of our economic and technical design.