Adverse Selection Examples

Jul 26, 2022

Adverse selection happens when there is information asymmetry between buyers and sellers. One side takes advantage of information that isn't known to the counterparty.

It's one of the most important economic ideas to think about when starting a company or buying or selling anything. A few examples of adverse selection in technology markets:

  • SaaS. Complicated technology can be difficult to evaluate ahead of time. For decades, companies dealt with shelfware – enterprise software that was purchased by CIOs and CTOs but never implemented. Successful software companies were rarely the best technology but rather those who were most effective at selling to management (still very true). Bottom-up go-to-market like open-source, free tiers and subscription or usage pricing has reduced adverse selection (but not eliminated it).
  • Hiring. An example of  Signaling theory1:
Let's say there are two types of employees – good" and bad. Employers are willing to pay more for good than bad ones, but they can't tell ahead of time. This risk means that the good employees are underpaid, and the bad employees are overpaid. Good employees can earn more by sending an observable signal – in many cases, education or credentials. Good employees have lower opportunity costs to get these credentials.
  • Go-to-market. The way that you reach your customers can result in adverse selection. Promotions can attract "deal seekers." Airdrops of tokens can attract Sybil attackers who immediately cash out. Even companies that use open-source as a go-to-market can sometimes attract the wrong kind of customer (e.g., the one that values open-source because it's free).
  • Investors, investing. Venture capital is a game of a few big wins and many failures, which amplifies adverse selection. Investors that only see deals after many others have passed. Incubators, programs, and deals that don't make sense to the best entrepreneurs.
  • Crypto regulation. Without sensible crypto regulation, many long-horizon companies aren't able to enter the market (e.g., Meta's stablecoin project). Meanwhile, companies that eschew regulations can operate with little oversight.

Mike Spence won the Nobel Prize in Economics for his work on Signalling Theory, among other papers.