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Contents:-
1. Objective 2
2. Introduction 3
3. Body
Adverse Selection 5
Why Adverse Selection is called “hidden selection
problem” 6
What is Moral Hazard and why it is called 7
“hidden action” problem
4. Conclusion 9
5. Acknowledgement 11
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Objective:-
Why Adverse Selection is called “hidden selection
problem”
Why Moral Hazard is called “hidden action problem”
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Introduction:-
In economics information asymmetry deals with the study of
decisions in transactions where one party has more or better
information than the other. This asymmetry creates an
imbalance of power in transactions which can sometimes cause
the market mechanism to fail. It is often assumed that full
information is available uniformly throughout the market.
However, this assumption which is intrinsic to the efficient
functioning of a market, does not always apply in the real
world. In fact, full information is not always available to all
agents in the market. It is often the case in many market
transactions that one agent has an information advantage
o0ver the other. There are many examples of this
phenomenon---
When sellers know better than the buyers about the
quality of their products.
The Policy holder know more than the insurance company
about their accident risk etc.
When two parties have asymmetric information about their
transactions, the trades actually completed may be biased to
favour the agent with better information and this will fail the
maximize gains from trade.
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In 2001, the Nobel Memorial Prize in Economics was awarded
to George Akerlof, Michael Spence and Joseph Stiglitz for their
“analysis of markets with asymmetric information”.
The key paper in the economics of asymmetric information in
Akerlof’s classic paper, “The market for lemon: Quality
uncertainty and the market Mechanism”’, which has been
described as “the single most important contribution to the
literature on economics of information.” Now, there are two
types of asymmetric information problems—
I. Adverse Selection
II. Moral Hazard
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Body:-
Adverse Selection:-
Adverse selection occurs when one person cannot identify the
hidden type or character of the second person or the quality of
some good or service.
Akerlof’s paper considers the markets for used cars or defective
old cars as lemons. He considered that the owner of a car has
more information about its quality than any potential buyers.
Thus the market of used cars involves asymmetric information
in the form of adverse selection. As quality is undistinguishable
by the buyers due to asymmetric due to asymmetric
information they would tend to believe information they would
tend to believe that incentive exists for the seller to pass off
low quality cars as higher quality ones. This would cause
potential buyers to pay price corresponding to the expected car
value- in between the price of high car and the price for a
lemon. But this price may be too low to induce the owners of
high quality cars to put their cars up for sale. As a result high
quality used cars will be driven out of the market and the
market will be dominated by lemons. He observes that as
people takes this fact, the used car price drops further- making
the owners of good cars even less willing to bring their cars to
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market. Thus, the uninformed buyer’s price creates an adverse
selection problem that drives the high quality cars from the
market. Adverse Selection is a market mechanism that can lead
to a market collapse. In the extreme case, a “no trade
equilibrium may be the outcome of the model”. Akerlof
concluded that asymmetric information can either cause an
entire market to collapse or contract it into an adverse
selection.
Why Adverse Selection is called “hidden selection
problem”?
Let us take another example—
Assume there are two sets of people in the population those
who smoke and do not exercise and those who do not smoke
and do exercise. It is common knowledge that those who
smoke and don’t exercise have shorter life expectancies than
those who don’t smoke and do exercise. Suppose there are
two individuals who are looking to buy life insurance, one who
smokes and does not exercise and one who doesn’t smoke and
exercise daily. However the insurance company cannot
differentiate between the individual who smokes and doesn’t
exercise and the other person.
So, the Insurance Company asks the individuals to fill out
questionnaires to distinguish them. However, the individual
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that smokes and doesn’t exercise knows that answering
truthfully means higher insurance premiums, so he lies and says
he doesn’t smoke and exercise daily. This leads to adverse
selection, where the life insurance company is at disadvantage
and then charges the same premium to both individuals.
However insurance is more valuable to the non-exercising
smoker than the exercising non-smoker.
So the Adverse Selection problem exists when one person
cannot identify the hidden type or character of the second
person or the hidden quality of some goods or service. This it is
sometimes referred to as a hidden Selection Problem.
What is Moral hazard and why it is called “hidden
action” problem:-
Moral Hazard is the lack of incentive to guard against risk
where one is protected from its consequence by insurance or
some policy.
Economics Paul Krugman describe moral hazard as any
situation in which one person makes the decision about
how much risk to take while someone else bears the cost if
things go badly.
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Problems of Moral Hazard
When one party is fully insured and cannot be accurately
monitored by an insurance company with limited
information its behavior may change after the insurance has
been purchased. This is what we call the problem of Moral
Hazard.
When the Party to be insured can affect the probability or
magnitude of the event that triggers payment the problem of
moral hazard occurs.
We can further discuss it with the help of an example:-
A person taking car theft insurance and then becoming more
careless in locking the car doors. In absence of insurance the
person who have been sufficiently careful. But with the
insurance available the car owner no longer has to bear the full
cost of the car theft hence becomes less careful there by
increasing the chances of theft.
Similarly we have one more example, suppose the originators
of subprime loans may have suspected that the borrowers
would not be able to maintain their payments in the long run
for those loans are going to be worth much however still they
are giving the loan.
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At the end we can say that when moral hazard problem arises
when actions of a person are unobservable to a second person.
Thus it is referred to as “hidden action” problem.
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Conclusion:-
From the given examples it is quite evident that adverse
selection and moral-hazard can cause inefficiencies in the
market of goods and services and results in market failure.
No buyer can be able to evaluate the value of the product by
their personal information before sale is made between two
parties. And in such a case sellers can be able to assess the
value of the product more accurately before the sale is
conducted. So it is clear that because of asymmetric
information there’s a great possibility to become better off for
one group and worse off for another group, so by efficiency it is
not the optimum solution of market mechanism and creates
many more problems in the society.
So, a hidden information or characteristic is intrinsic to an
agent. Hidden characteristics are things that one side of a
transaction knows about itself that the other side does not.
Hidden actions are actions taken by one side of an economic
relationship that the other side cannot observe. These two
concepts apply to the case of adverse selection and moral
hazard.
Adverse selection occurs where’s lack of symmetric information
prior to a deal between a buyer and a seller whereas moral
hazard occurs when there is asymmetric information between
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two parties and change in behavior of one party after a deal is
struck.
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Acknowledgement:-
We would like to express our gratitude to our Professor Sushma
Subba, who gave us the golden opportunity to do this project
on the topic of adverse selection and moral hazard.