Discuss the Terms Moral Hazard and Adverse Selection

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Essay: Discuss the terms moral hazard and adverse selection. In your discussion you should consider the following: a) When does it arise? b) What are its consequences? And c) What can be done about it?

WORD COUNT: 2502

Today we live in the information age, characterized by the internet, social networking and twenty four hour news with a constant stream of information flowing between users. This has lead to an economy where buyers can get immediate access to information about rival products, via for example product comparison websites, and sellers can reach virtually an unlimited number of customers through the vast network of information distribution. (Mansfield, 2005)

Information in the economy and the role it plays in markets has then received increasing attention from economists, and in particular how information poses special problems in markets. Information for most part is easily accessible and once this information is known to one person, it is often available quickly to someone else, especially with the rapid dissemination tools available today. However some information is not easily accessible and where this is the case, economic markets can be prone to market failure, where the normal market allocation of goods and services is not efficient. Normally in the analysis of supply and demand, buyers and sellers have enough information to make informed choices, a perfect information world where there are fully informed buyers and sellers; this leads to markets operating efficiently, generating equilibrium quantity and price for goods and services. This is not so where there is a lack of information in markets, called asymmetric information. Asymmetric information is where one party either a buyer or seller, has better information than the other party during an economic transaction. The market failure is caused because one party can take advantage of special knowledge in ways that change the nature of the transaction, due to this special knowledge not being equally available to both parties. (Chrystal, 1997) From this results two important indicators of market failure arising from asymmetric information, which are adverse selection and moral hazard.

Adverse selection arises when an individual has hidden characteristics - characteristics which are known to the individual but are unknown to the other party in the economic transaction, giving us a situation of hidden information. (Baye, 2010) This leads to the adverse selection problem where the uninformed side of the transaction must choose from an undesirable or unfavourable selection of goods or services. (O’Sullivan, 2010) Moral hazard on the other hand is caused when one party to the transaction takes hidden actions, actions that it knows the other party cannot observe which once again leads to hidden information. (Baye, 2010) More specifically moral hazard is an incentive for a party to a transaction to engage in unfavourable behaviour to the disadvantage of the other party, because the transaction entered into protects the first party against loss. (Truett, 2004) Many transactions completed daily in various markets such as selling a car, securing a mortgage, buying health, car or house insurance, the buyer and seller (parties to the transaction) have different information available to them. The seller of a used car usually knows more about the overall quality of that car than the buyer. The person applying for a mortgage will undoubtedly know more about their credit worthiness and ability to repay all they borrow than the bank they are getting the loan from. The same goes for policy holders of insurance where these will once again have more and better information on their health, state of car and house. Consequently in these situations where the buyers and sellers have different levels of information, it can lead to adverse selection within the market. (Mansfield, 2005)

Adverse selection in health insurance, for example, can be examined...
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