Adverse selection occurs when an information imbalance occurs in a transaction – when one side knows less – then they will adjust the pricing to make it a more favorable risk to enter the trade.
A buyer that knows less than the seller will lower the price.
A seller that knows less than the buyer will raise their price.
Signaling occurs when:
- A seller has more information about the product they are selling, believes that they have a good product, and – if the product is good – will raise the price of the transaction (as in a used car).
- A buyer has more information about the product they are buying, believes that their purchase would benefit the seller, and signals their credentials to lower the price of the offer (as in buying wholesale).
Screening occurs when:
- A seller has less information about the product they are selling, wants to know that the buyer is a good risk, and – if the buyer is a good risk – will lower the price of their offer (as in life insurance).
- A buyer has less information about the product they are buying, wants to know that the product is good, and willing to pay a premium price once it is found to be good (as in a house).
Assuming the product or buyer is good, the seller will signal to raise the price of their product and screen to lower the price of their product.
Assuming the product or seller is good, the buyer will screen to raise the price of their product and signal to lower the price of their product.
If the seller, buyer or product is bad, then it is better from a pricing standpoint to exchange goods on a market that does not have signaling or screening.
In a transaction determine where the information imbalance lies to determine price pressure.