Adverse Selection

As described above if producers produce only low quality water bottles, then no transactions take place in the market. So low quality water bottles crowds out the high quality product due to high cost of acquiring information. This creates the problem of adverse selection which destroys the market. Let us understand the problem of adverse selection.
For example- In a society there are two types of people one who face high health risk and others who face low health risk . Health insurance company provides health insurance based on the average risk faced by the people. This is misleading as rates should be different for high risk bearers and for the low risk people. The premium charged reflects average risk. People with high health risk are better off as premium paid is less than the cost they are willing to pay but the low risk bearers will be unwilling to purchase the high priced insurance as premium is more than the amount they are willing to pay.
As one side of the party is not able to judge the quality of the goods sold by the other side of the market, it is also called Hidden information problem.