The Concepts ‘moral Hazard’ and ‘adverse Selection’

‘Explain the concepts ‘moral hazard’ and ‘adverse selection’ and illustrate how they lead to ‘market failure’ in one area/sector of the economy’.

The risk that a party to a transaction has not entered into the contract in good faith, has provided misleading information about its assets, liabilities or credit capacity, or has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles. This problem is called moral hazard, i.e., “hidden actions”; and can be severely restrict the formation of a free market in insurance. The definition of moral hazard is closer to the concept of sequential contracting in contract theory. For example, the agent receives private information in multiple stages during the contractual relationship. Hence the principle first offers a menu of contracts and the agent chooses one contract. After receiving additional private information the agent selects his best action within the previously chosen contract.

Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to hold some responsibility for the consequences of those actions. The problem of Moral hazard convincingly shows that the optimality of complete insurance is no longer valid when the method of insurance influences the demand for the services provided by the insurance policy.

Adverse selection arises where the very act of selling insurance leads to demand for it by bad risks. Insurer is unable to distinguish between high and low risk individuals, and offers a premium based on average risk. For the high risk group this premium may be attractive, but the low risk group finds that the premium is unattractive. As a result, the insurer ends up with an ‘adverse selection’ of risk.

The example above shows that the high risk group finds the premium (£750) more attractive, as it is higher than what they expect (£700).  

Here is an example of adverse selection, i.e. information asymmetry. Suppose lemon represents the low quality good, and plum represents the high quality good.

The example above describes that the good quality good is driven by the bad quality good out of the fruit market, as the high quality good cannot distinguish itself. The price of lemon is obviously lower than plum, however, consumers are expecting to spend on an average price of £9500, so they will choose lemon and will not choose plum as it’s price is higher than what they expect. Consequently, all lemons is sold and some plums are left in the market. Due to asymmetrical information and a price difference in two goods, large number of bad quality good will be sold in trade and the good quality is left over. As a result, the average quality of goods in trade market is worse. The fruit market model provides an example of how, if information is distributed asymmetrically, agents on the uninformed side of the market find themselves trading with exactly the wrong people. This problem arises in the market for insurance.