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In: Economics

What are adverse selection and moral hazard?

What are adverse selection and moral hazard?

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Expert Solution

Both moral hazard and adverse selection are examples of asymmetric or incomplete information. But they are very different.

Adverse selection occurs when either party involved in the transaction (buyer or seller) has better or more information about some specific trait such as the quality fo the good, and due to the expected quality formulation by the other party, often the good seller or buyer is driven out of the market. Thus, we are left with only bad buyers or sellers. Akerlof's lemons problem is a classic example of this.

Mora Hazard occurs when once the transaction is made, one of the parties has an incentive to act in a reckless manner as they are insured against the loss but it can cause harm to the other party. For example, once your car has been insured you may drive recklessly as you are covered by insurance but the insurance company will have to pay for an accident which was avoidable.

Rahul Sunny answered 8 months ago
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