The Difference Between Adverse Selection and Moral Hazard.

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In your own words, discuss the difference between adverse selection and moral hazard. Provide your own example for each problem.

Adverse selection and moral hazard are both examples of market failure situation due to hidden information from the buyer or seller in a market. In adverse selection, hidden information is usually present before an agreement is made; where as, in moral hazard, hidden information is revealed after an agreement has been made.

Adverse selection refers to a situation in which one party in a contractual agreement has more knowledge or prior information about a situation than the other party involved and takes advantage of the situation or party who knows less. For example; my cousin, John who is an entertainment promoter and his friend, Tate contractually agree to share half of the expenses to retain a rapper from Atlanta to perform at a nightclub in Statesboro, Georgia. With an understanding that they would split the proceeds from patrons who pay cover charges, both John and Tate worked tirelessly to promote and advertise the event. After the event was over and the money had been counted, Tate only received 40% of cover charges eventhough he paid his fair share to promote the event. John, on the other hand, received 60% of the cover charges collected. Although John had more knowledge about the process of promoting, he failed to mention that Tate would be responsible for paying him 10% for using his trade name during the advertising phase. In other words, John took advantage of Tate’s lack of knowledge regarding the use of his trade name and the situation.

Moral hazard refers to the risk that indiviudals, groups and businesses take when there is an incentive to avoid bad economic behavior. For example, when homebuyers purchase homes without following strict lending requirements or without providing a down payment because of government subsidies, there is always a potential threat or risk that homebuyers will default on their loan...
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