The theory describing hidden information before a transaction that can produce poor market outcomes is adverse selection.
Adverse selection occurs when one side of a prospective trade knows something important about quality, risk, or type that the other side cannot observe before agreeing. Prices or contract terms then reflect incomplete information. The less-informed party may respond by offering terms that attract disproportionately risky or low-quality participants, causing better risks or products to leave the market.
A classic example comes from used cars: sellers may know whether a vehicle is reliable, but buyers cannot fully tell. If buyers lower the price to account for uncertainty, owners of good cars may refuse to sell, leaving a larger share of “lemons” in the market. Insurance provides another example: people who know they face higher risks may be especially eager to buy coverage, raising premiums and potentially driving safer customers away.
The key distinction is timing. Adverse selection involves private information that exists before a contract or transaction. Moral hazard arises after agreement, when a party’s hidden action or effort changes risk. The principal-agent problem is broader and can include either information problem, so it is not the single best answer here.