For example, Alex is looking for someone to run his letting agency, but it’s difficult to find a perfect agent because only agents themselves know if they have a clue about real estate and whether they are any good at office management. Alex may be fooled by someone’s CV and end up hiring a moron, a deeply inefficient outcome.
This asymmetric information problem, occurring before a deal is made or a contract is signed, is referred to as adverse selection, a term first used in the US insurance industry to describe high risk customers signing up for insurance policies and ending up costing dearly in terms of claims they are due.
There are tons of examples of adverse selection in job markets, used car markets, on eBay and in online dating. Fortunately, there are ways to overcome this problem: in Alex’s case, he is clearly going to interview a candidate before hiring her and ask for some references to make sure she does not waste his time.
The problem is that in some markets it is not easy for high quality ‘agents’ to signal their ‘worthiness’ because inferior agents are very good at imitating their efforts and fooling the ‘principal’.
Consider online dating: now, I am not an expert on the subject, but I must admit that all online dating profiles look the same to me. Almost every single guy talks about “good times at the local pub”, “keeping fit” and “loving travel”! Imagine a single girl, let’s call her Claire, who would like to meet an ‘eligible bachelor' but would definitely like to avoid wasting any time on 'married accountants'. There are just two types of men in her home town, and both types would like to be picked by Claire. ‘Eligible bachelors’ are naive in that their profiles are honest and simple, and are therefore easy to copy. Naturally, married accountants want to sound ‘interesting’, so they imitate ‘cool’ profiles, Claire ends up going on a date with one of them and is once again very disappointed with online dating.
The morale of the story is this: to combat adverse selection in online dating market, ‘eligible bachelors’ must find a way to signal their good virtues to female singletons, impossible for ‘married accountants’ to replicate. Suggesting a date on a Saturday night might be an idea as is making sure that your profile stands out in the first place - gents, get creative!