19.1 Adverse Selection and Moral Hazard

Adverse selection and moral hazard are key concepts in the economics of information. These phenomena arise from asymmetric information, where one party has more knowledge than the other in a transaction or relationship.

Understanding these concepts is crucial for grasping market inefficiencies and economic behavior. They explain why some markets fail, why insurance premiums rise, and why companies implement certain policies to align incentives and mitigate risks.

Adverse Selection in Markets

Types of Markets Affected by Adverse Selection

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• Adverse selection occurs when one party in a transaction has more or better information than the other led to suboptimal outcomes
• Insurance market exemplifies adverse selection where individuals with higher health risks are more likely to purchase comprehensive health insurance
• Used car markets often experience adverse selection as sellers have more information about the vehicle quality than potential buyers
• Credit markets face adverse selection when lenders have limited information about borrowers' creditworthiness potentially led to higher interest rates for all borrowers
• Labor markets may experience adverse selection when job applicants have more information about their skills and productivity than potential employers
• Financial markets can encounter adverse selection when companies issuing securities have more information about their true value than potential investors
  • Example: A company may choose to issue bonds when they know their financial situation is deteriorating
  • Example: Investors may avoid certain stocks due to fear of hidden problems, even if some companies are actually healthy

Consequences of Adverse Selection

• Drives out high-quality goods or services resulted in a "market for lemons" scenario
  • Example: In used car markets, buyers may assume all cars are low quality, causing sellers of good cars to leave the market
• Causes markets to shrink or collapse entirely reduced overall economic efficiency and social welfare
  • Example: Health insurance markets may offer only high-premium plans if too many high-risk individuals enroll
• Increases transaction costs as parties attempt to mitigate risks through screening, monitoring, or contractual arrangements
  • Example: Employers may implement extensive background checks and multiple interview rounds to assess candidates
• Creates underinvestment in socially beneficial activities due to the inability to appropriately price risk
  • Example: Lenders may be reluctant to provide loans to small businesses in certain industries perceived as high-risk

Moral Hazard in Principal-Agent Relationships

Common Scenarios of Moral Hazard

• Moral hazard occurs when one party (the agent) takes on more risk because another party (the principal) bears the cost of those risks
• Insurance markets face moral hazard led to policyholders engaging in riskier behavior or overusing services because they are not directly bearing the full cost
  • Example: A person with comprehensive car insurance may drive more recklessly
• Principal-agent problems in corporate governance result in executives (agents) making decisions that benefit themselves at the expense of shareholders (principals)
  • Example: CEOs pursuing risky acquisitions to boost short-term stock prices and their bonuses
• Banking sector experiences moral hazard when deposit insurance encourages banks to take on excessive risks knowing the government will bail them out
  • Example: Banks investing in high-risk, high-yield assets with the expectation of government support if they fail
• Healthcare systems may face moral hazard when patients with comprehensive insurance coverage overuse medical services or opt for more expensive treatments
  • Example: Patients requesting unnecessary tests or brand-name drugs when generics are available

Additional Manifestations of Moral Hazard

• Government bailouts of failing companies create moral hazard by encouraging excessive risk-taking in the private sector
  • Example: Automotive companies taking on unsustainable debt, expecting government assistance if they face bankruptcy
• Team settings can experience moral hazard manifested as free-riding where individuals exert less effort because the costs are shared among the group
  • Example: In group projects, some members may contribute less, knowing others will complete the work
• Tenants with property insurance may be less careful about maintaining the property led to increased wear and tear
• Employees with generous sick leave policies may be more likely to take unnecessary days off reduced overall productivity

Impacts of Information Asymmetry

Economic Inefficiencies

• Adverse selection leads to market failure by driving out high-quality goods or services resulted in a "market for lemons" scenario
  • Example: In the health insurance market, low-risk individuals may opt out, leaving only high-risk individuals and driving up premiums
• Moral hazard results in overconsumption of resources or services led to allocative inefficiency and deadweight loss in the economy
  • Example: Overuse of medical services when patients have low copayments increased healthcare costs for everyone
• Information asymmetries increase transaction costs as parties attempt to mitigate risks through screening, monitoring, or contractual arrangements
  • Example: Employers spending significant resources on background checks and multiple interview rounds

Long-term Market Effects

• Presence of adverse selection causes markets to shrink or collapse entirely reduced overall economic efficiency and social welfare
  • Example: The market for annuities may become very small if only individuals with above-average life expectancy purchase them
• Combination of adverse selection and moral hazard creates a negative feedback loop further exacerbated market inefficiencies over time
  • Example: In credit markets, as interest rates rise due to adverse selection, more low-risk borrowers exit the market, worsening the problem
• Social welfare may be reduced due to the misallocation of resources and the potential for increased inequality resulting from information asymmetries
  • Example: Talented individuals from disadvantaged backgrounds may be unable to signal their abilities effectively reduced social mobility
• Underinvestment in socially beneficial activities occurs due to the inability to appropriately price risk
  • Example: Potentially profitable but novel business ideas may struggle to secure funding due to information asymmetries

Solutions for Adverse Selection vs Moral Hazard

Strategies to Combat Adverse Selection

• Screening mechanisms such as credit checks or medical examinations help reduce adverse selection by revealing hidden information
  • Example: Insurance companies requiring medical exams before issuing life insurance policies
• Signaling where informed parties voluntarily disclose information helps mitigate adverse selection in markets like education and employment
  • Example: Job applicants obtaining certifications to demonstrate their skills to potential employers
• Risk-based pricing strategies address adverse selection by charging higher prices to higher-risk individuals or entities
  • Example: Car insurance companies charging higher premiums to drivers with a history of accidents
• Market design solutions like creating standardized products or platforms for information sharing improve market efficiency in the presence of adverse selection
  • Example: Standardized used car history reports (CarFax) help buyers assess vehicle quality

Approaches to Mitigate Moral Hazard

• Deductibles and copayments in insurance contracts help reduce moral hazard by ensuring policyholders bear some of the costs of their actions
  • Example: Health insurance plans with copayments for doctor visits discourage unnecessary medical care
• Performance-based compensation and monitoring systems alleviate principal-agent problems and reduce moral hazard in corporate settings
  • Example: Tying executive bonuses to long-term company performance rather than short-term stock prices
• Government regulations such as mandatory insurance or disclosure requirements help address information asymmetries and their consequences
  • Example: Requiring public companies to disclose financial information helps investors make informed decisions
• Implementation of risk-sharing mechanisms in contracts ensures both parties have an incentive to act responsibly
  • Example: Franchisees paying a percentage of profits to the franchisor aligns interests in business success