What is adverse selection?
Adverse selection occurs in markets where buyers and sellers have different levels of information about the good they are trading.
The concept was famously outlined in Akerlof’s “The Market for Lemons” which focused on the market for second hand cars. Akerlof found that prospective buyers could not distinguish between high-quality cars, known as “peaches”, and poor quality “lemons”.
If buyers are uninformed about the quality level of a given car compared to the car’s current owner, they will be unwilling to pay a fair price for a peach.
This drives the market price down to below the level required for willing sellers of peaches. As a result, only lemons are willing sold by their owners. This can lead to market collapse.
Adverse selection in betting markets
Asymmetric information is at the heart of every betting market. By their very nature the bookmaker generally knows more about the probability of a given event than the bettor.
This is because the bookmaker has access to all the information available on the market from their customers, and can therefore see the full picture. The bettor usually has access to less information of inferior quality.
The bettor faces what is known as an adverse selection problem since he has an information disadvantage compared to the bookmaker. The seller (bookmaker) has the full picture and a very good idea of what the bet is worth. A bet at this stage is no different to buying one of Akerlof’s lemons.
Why do betting markets still exist?
In Akerlof’s scenario he posited that the reluctance of peach sellers would cause buyers to lose trust in the market and could eventually cause complete market collapse. Since the betting market has a similarly unbalanced informational structure, why do bettors simply not stop placing bets?
Some solutions to this suggest that answer is simply that betting is an irrational pursuit, bettors are overconfident or that the enjoyment provided by betting outweighs a bettors losses.
However, we do know that some bettors are profitable, so it is likely that the enticement of finding a peach amongst the lemons keeps bettors coming back.
Application of adverse selection to betting
There are certainly applications here for bettors aware that they are working in a market for lemons. Before placing a bet think “If I were buying a used car what would I consider?”.
Alternatively consider this. Why should a buyer wish to buy a used car if the seller wants so much to sell it at that price? After all the seller knows more about the car. In the same way ask yourself why you are “buying” a bet that a bookmaker, with access to all that information, would want to sell to you.
Do you have enough of an informational edge to overcome this disadvantage? If not, reconsider why you are placing the bet in the first place.
Are tipsters selling lemons or peaches?
In a market of lemons, the spotting a rare peach is a much sought-after skill.
“The demand for accurate predictions is insatiable whilst reliable suppliers are few and far between. The gap between demand and supply creates opportunities for unscrupulous suppliers to fill the void by gulling desperate customers into thinking they are getting something no one else knows how to provide.”
Within the betting market this allows tipsters of varying levels of reliability to offer their services. In a similar situation to Akerlof’s used car market, it could be argued that the bad tipsters are liable to drive out good ones by lowering the overall quality of predictions available within the market, eventually causing all predictors to be perceived as unreliable.
This is why analysis of a tipster’s record is so important. The used car market may not function efficiently without standards checks and consumer protection, often in the form of “Lemon laws”.
A good tipster needs to reduce the asymmetry between themselves and bettors by being open about their profitability in order to allow consumers to identify reliable peaches accordingly. Anything less than this suggests they may well be providing lemons to the market.