What does "adverse selection" refer to in economics?

Adverse selection is a concept in economics that occurs when there is an asymmetrical distribution of information between parties in a transaction. Specifically, it refers to a situation where one party, typically the seller or provider of a good or service, has more or better information than the other party, usually the buyer. This imbalance can lead to market failures, as the party with less information may make suboptimal choices or be unable to adequately assess the quality or risk associated with what is being offered.

In the context of adverse selection, this could manifest in various scenarios, such as in insurance markets where policyholders know more about their health risks than the insurer. If insurers cannot accurately gauge the level of risk of their clients, they might set premiums that are either too low or too high, leading to a market where only high-risk individuals purchase insurance, thereby raising costs for insurers and potentially driving them out of the market.

The other options do not accurately capture the essence of adverse selection. For instance, the notion of consumers being unaware of product substitutions pertains more to market behavior rather than an informational imbalance. Similarly, selling higher quality goods at lower prices pertains more to pricing strategies rather than information asymmetry, and a balanced distribution of information represents the opposite of adverse selection,